Investing in junk bonds
A bond is essentially a way of lending money to an entity, such as a country (government), municipality or corporation. This means that we need to trust that the entity we lend the money to will be both willing and able to honour their obligations when it comes to paying interest and ultimately repaying the debt. How risky it is to invest in bonds is, therefore, strongly tied to the bond issuer’s creditworthiness.
There are credit rating agencies that evaluate and rate the creditworthiness of bond issuers. When a bond issuer has very low creditworthiness, it must pay higher interest to attract investors. A bond that carries a high risk of default is normally only appealing to the market if the high risk is outweighed by high rewards.
Bonds that come with a very high risk of default are known as junk bonds. They have been rated as being below investment grade. They are typically high-yield bonds because otherwise, the market would not be interested in them. Junk bonds tend to experience much bigger price swings than bonds of higher quality.
Buying junk bonds
Junk bonds can be purchased individually through a broker.
It is also possible to get indirect exposure to junk bonds by investing in a junk bond fund.
As mentioned above, credit rating agencies will evaluate and rate the creditworthiness of bond issuers.
One of the most well-known and respected credit rating agencies is Standard & Poor. They use a credit rating scale ranging from AAA (the highest score) to D (the lowest score). When a bond is rated BB or lower by Standard & Poor, it is considered “speculative-grade”, i.e. a junk bond.
Standard & Poor´s rating above BB:
- AA—very good
Standard & Poor´s rating below BB:
- CCC—currently vulnerable to nonpayment
- C—highly vulnerable to nonpayment
- D—in default
A rating is not forever. Example: A company is struggling financially, and the rating for its bonds drops to CCC. Later, the company improved financially, and the rating was upgraded to BBB. This causes a significant uptick in the market price of the bonds because they are no longer considered speculative grade.
A real-world example of a famous junk bond
In 2014, Tesla Inc. Issued a fixed-rate bond with a semi-annual coupon rate of 1.25% and March 1, 2021, as the maturity date.
- When first issued, the bond was rated B- (B minus) by Standard & Poor. It was thus considered a speculative grade.
- Later, the rating was upgraded to B+.
- In October 2020, when there was less than half-a-year left before maturity, Standard & Poor changed the rating from B+ to BB-. That is still slightly below a BB rating, but not by much.
By October 2020, the bond was trading at $577 despite having a face value of just $100. Was this only because of the improved rating? No, in order to fully understand the appeal of the Tesla bond, we must take into account that this was a convertible bond – it could be converted into equity. As the market price of equity (shares) in Tesla soared, it pulled the market value of the bond up with it.
Using junk bond prices as a market indicator
Some investors and analysts use junk bond prices as a market indicator. If there is a general belief among market participants that economic conditions are about to improve (e.g. in the United States or in the Eurozone), it can translate into the market becoming more interested in purchasing junk bonds issued by companies in that region, as investors expect the credit worthiness of the issuer to improve as the economy improves.
Conversely, investors who believe that we are heading for worse economic times are likely to try and get rid of their junk bonds (and possibly also mid-rated bonds), or at the very least not buy any more because they expect companies that are already struggling to default in harsher economic times.
N.B! A surge in junk bond investing can also indicate too much optimism in the market. Junk bond investing is just one indicator and should not be utilized alone.