At first glance, the label ‘junk bond’ appears to look like a warning.
“Stay away! This bond is a load of junk!”
You might be surprised to hear that junk bonds are actually becoming very popular investments. But, like other risky investments like shares, they’re not suitable for everyone.
Definition of a junk bond
A junk bond is a type of investment bond (see definition).
Specifically, a junk bond is a corporate bond (see definition) with a higher risk of default. Default is when a company fails to meet their obligations due to bankruptcy or similar problems.
When a bond issuer’s credit rating slips below a minimum threshold, its bonds are described as junk. You won’t see the term ‘junk bond’ on any prospectus or Google finance information page, but it’s a widely recognised term used across the investment community.
A quality company can issue junk bonds
The bonds of many companies that you might think are reputable are actually classed as ‘junk’. Often this is because the financial stability of a company is far worse than you might realise as a customer of their brand.
A junk bond is often written to give little protection in the event of a default – this makes the bond itself riskier, even if the company itself is relatively stable.
For example, a junk bond might include a clause that all other bondholders and lenders will receive priority payment in the event of bankruptcy before the junk bondholders will see a penny.
Why would a company insert this clause? Well, they may be forced by a clause in an earlier loan taken from a bank.
Tesla Inc is an excellent example of this. In 2017 it raised debt for the umpteenth time via a bond issue, and these were quickly labelled as junk.
Tesla may have been the darling of electric vehicle enthusiasts at the time. But its ability to remain solvent was unclear, and the bonds offered little protection in the event of Tesla running out of cash, so its bonds were consigned to the ‘junk’ pile.
Why do investors put money into junk bonds?
One word: yield.
Junk bonds are a sub-asset class of bonds in general. They represent a ‘high-risk, high return’ opportunity. Some junk bonds actually provide higher returns than buying shares!
In a world of low official interest rates and poor returns on bank accounts, yield-hungry investors have chased after opportunities offering yields in excess of 5%. This has led them down the quality spectrum into riskier propositions such as junk bonds.
If my investor risk appetite questionnaire places you at the adventurous end, you might want to consider including junk bonds in your portfolio too.
On the other hand, more cautious investors might prefer the security offered by government and investment-grade corporate bonds issued by institutions such as the UK Government or Disney instead. However, their safety means they offer a poor return, which may struggle to beat inflation.
Junk bonds, on the other hand, offer returns between 5% – 10% after defaults are factored in. And you’ll need to do just that – when investing in junk bonds, it isn’t a matter of ‘if’ you will experience a default, but ‘when’.
This makes diversification very important – you should aim to spread your money across as many junk bonds as possible, to keep your default rate as consistent and predictable as possible. You could use junk bond Exchange Traded Funds (ETFs) to help you do this efficiently.
Are junk bonds bad?
After reading this article, you might be arriving at the conclusion that junk bonds don’t sound that bad.
That’s probably a sound position to reach. Junk bonds aren’t inherently bad – they’re not written to be poor investments.
After all, if the rate of return they offered was not sufficient to compensate bondholders for the risk, then investors would never snap up the bond issue in the first place.
Junk bonds are simply higher risk bonds. As we explain in our online investment training; so long as you take this into account when building your investment portfolio, junk bonds can be a very successful investment.
Interested in other bond definitions?
- Definition of a bond
- Definition of a corporate bond
- Definition of a junk bond
- What is the coupon rate of a bond?