One person’s trash is another person’s treasure, as the saying goes. And in the world of investing, one company’s junk bond is certainly another investor’s profit.
What Is a Junk Bond?
A junk bond, also known as a speculative-grade bond, is a high-yielding fixed income security with a high risk of default on payment.
When you buy bonds, you’re lending money to the bond issuer—a company or a government entity—that promises to pay you back with interest when the bonds mature. The thing is, not all companies can deliver on that promise.
That’s where bond ratings come in. They are letter grades issued by an independent bond ratings agency—Standard & Poor, Moody’s or Fitch—that suggest the likelihood a company will repay what it borrows. Like in school, A’s and B’s are generally better and indicate a high chance of repayment, while lower letter grades signal a company’s bonds may be a risky bet.
Securities with a rating of BBB (or Baa on Moody’s scale) or higher are considered “investment-grade” bonds, meaning the bond rating agency thinks it’s pretty likely investors will get their money back.
Bonds with a rating below BBB/Baa have a higher likelihood of failure to repay their debts, and they’re called speculative-grade or non-investment grade bonds—a.k.a. junk bonds. They’re normally issued by companies that are relatively new or that have faced recent financial difficulties.
The Appeal of Junk Bonds
Given their higher risk of leaving you high and dry, why do some investors seek out junk bonds? The answer lies in their potential returns.
To attract investors, bonds of all types have to offer interest payments when they borrow money. Investment-grade bonds tend to have much lower interest rates because they pose less of a risk for investors. Junk bonds, meanwhile, have to really sweeten the proverbial pot to convince investors to risk their money. And over time, that can really pay off for certain investors.
“Over long periods of time, a diversified portfolio of junk bonds has outperformed investments in Treasury bonds,” says Robert Johnson, Ph.D., a chartered financial analyst (CFA) and chartered alternative investment analyst (CAIA). “From 1983 through 2020, a diversified portfolio of junk bonds returned 8.8% compounded annually while a diversified portfolio of Treasury bonds returned 6.2% compounded annually.”
Junk Bond Pros and Cons
Junk Bond Pros
Junk bonds have higher potential for bigger profits. Because of the increased risk, junk bonds tend to have higher yields than investment-grade bonds.
Bonds may appreciate if an issuer improves. If a company is actively paying down its debt and improving its performance, the bond can appreciate in value as its issuing company’s rating improves.
More dependable than individual stocks. While they’re riskier than investment-grade bonds, they may not be as risky as individual stocks. For example, if a company goes bankrupt, bondholders are paid back before stockholders.
Junk Bond Cons
Junk bonds have higher default rates. Junk bonds typically have a higher potential for default than investment-grade bonds. According to S&P Global Ratings, the default rate for junk bonds was 5.5% in 2020. By contrast, the default rate for investment-grade bonds is 0.00%.
Lack of liquidity. High-yield bonds sometimes have liquidity issues, meaning it may be difficult to sell them for cash when you need it.
Junk bond values can fall if credit ratings are downgraded. The value of junk bonds can decrease. If a company’s credit rating drops even lower, the bond will become worth even less.
Junk Bond Examples
You may think of junk bonds as being issued by smaller corporations or very troubled companies. But just as often they are issued by well-known companies with long histories, or new companies without an established track record. Some recent examples include Coinbase and Crocs.
Coinbase is a cryptocurrency exchange that experienced massive demand in 2020 and 2021 as more consumers bought crypto, like Bitcoin and Dogecoin. Coinbase went public in April 2021, and in September it saw huge demand for a big junk bond offering. Its initial offer was $1.5 billion in seven- and 10-year bonds, but demand was so strong that Coinbase expanded the issue to $2 billion.
Moody’s initiated a Ba2 junk grade on Coinbase after it announced the sale, citing an “uncertain regulatory environment and fierce competition” for the non-investment grade rating. While Moody’s noted Coinbase has a leading franchise in crypto, its profits are almost entirely dependent on highly volatile cryptocurrency trading.
Crocs, the maker of comfortable yet hideous clogs that people love to hate, announced in August 2021 that it would sell $350 million of junk bonds to fund stock buybacks. Moody’s rates Crocs a Ba3, just slightly behind Coinbase’s Ba2 speculative-grade rating.
In its analysis, Moody’s notes that Crocs has a well-known brand, a leading position in the market for clogs and pretty good liquidity. However, it points out the high level of competition in the footwear sector and the company’s narrow product focus (clogs) as reasons for it not having a higher rating. In addition, it looked back to the period before it cleaned up its business to a time when profits were erratic.
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As an individual investor, there are a couple of different ways to buy junk bonds:
Buy individual bonds. You may be able to buy junk bonds through your online brokerage account’s trading platform, just like you can stocks or funds. But as with buying individual stocks, this is very risky as it concentrates your money in individual junk bonds and increases the likelihood that you lose the money you invest.
Invest in bond funds. High-yield or junk bond mutual funds and exchange-traded funds (ETFs) provide diversified exposure to hundreds of low-rated bonds. This decreases the chance you lose money overall by spreading your investing dollars across many different junk bonds. Keep in mind that many of these funds are actively managed, meaning a team of professional experts pick and choose which bonds to include. This kind of insight may be particularly helpful for investors navigating unfamiliar industries, like the junk bond space, but it does come at a cost. Junk bond funds will likely charge higher expense ratios than low-cost index funds, which can diminish long-term investment returns.
Should You Buy Junk Bonds?
For investors looking to diversify their portfolios but earn higher returns than investment-grade bonds offer, junk bonds can seem like a smart solution. But not so fast, cautions Johnson.
“Junk bonds should not play any role in most investors’ portfolios,” he says. “Sophisticated investors may want to have a relatively small allocation to junk bonds via diversified junk bond funds.”
Instead, he recommended that the average investor would be better off sticking to low-cost index funds. “For the vast majority of investors, the KISS mantra—keep It simple, stupid—should guide their investment philosophy,” he says.