Understanding Corporate Junk Bonds and Their Risks

Corporate junk bonds are a type of high-risk, high-yield debt issued by companies with poor credit ratings. These bonds are often used by businesses to raise capital for expansion or refinancing.

Issuers of junk bonds typically have a low credit rating, which makes it harder for them to borrow money at a low interest rate. In 2019, for example, the total outstanding amount of junk bonds in the US reached $1.2 trillion.

Investors who buy junk bonds are essentially lending money to these companies, which can be a gamble. If the issuer defaults on the bond, the investor may lose some or all of their investment.

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A junk bond is debt issued by a company that doesn't have an investment-grade credit rating, making it riskier for investors.

These bonds are also known as high-yield bonds because they pay higher interest rates to compensate for the increased risk.

Companies that issue junk bonds have credit ratings below what's considered "investment grade" by at least one of the three major ratings agencies: Standard & Poor's, Moody's Investors Service, and Fitch Ratings.

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Here are the credit ratings that determine whether a bond is considered junk:

A "fallen angel" bond is debt originally issued by an investment-grade company that's since been downgraded to junk status by a credit rating agency, often due to financial struggles or industry decline.

Junk bonds are generally unsecured debt instruments with fixed interest rates and limited covenants, making them attractive to investors seeking higher returns.

Corporate junk bonds are a type of high-yield bond that offers investors a higher coupon rate in exchange for taking on a higher risk. This risk is due to the issuer's poor credit rating, which is often visible to investors before they invest.

Bonds are issued at a face value, which is the amount that the issuer promises to repay at maturity. However, the price at which a bond trades is influenced by the outlook for the business, average interest rates in the market, and a company's financial results.

Investors in junk bonds typically have a high-risk appetite and are comfortable with the possibility of incurring losses amounting to the invested capital. This is because junk bonds are issued by companies that are not financially strong and carry a high possibility of default.

The price of a junk bond can indicate the health of the economy. Rising junk bond prices tend to indicate an improving economy, while declining junk bond prices are generally a sign of poor or worsening economic conditions.

Junk bonds can be structured in various ways, including PIK bonds, step-up bonds, zero-coupon bonds, convertible bonds, and tax-exempt bonds. These different structures offer varying benefits and risks to investors.

Here are some key characteristics of junk bonds:

Bonds are fixed tenure debt instruments that are issued to finance specific projects by the issuer. The interest is paid in pre-defined instalments to the bondholder until maturity.

Investing in corporate junk bonds can be a high-risk, high-reward proposition. Junk bonds offer the potential to earn more money than investment-grade corporate bonds or bonds issued by the federal government and other government agencies.

To put this into perspective, the interest rate paid by the PIMCO High Yield Fund is almost two-thirds higher than the investment-grade bond fund rate. That's a lot of extra income potential.

However, investors must be aware of the risks involved, particularly the credit risk profile of the borrower. This estimates the potential loss incurred if the borrower's financial state were to deteriorate, resulting in a potential default.

High yield bonds (HYBs) tend to exhibit more volatility compared to investment-grade bonds, due to the higher default risk found among the underlying issuers and the longer borrowing terms. In times of economic contractions, the HYB asset class is less stable relative to the investment-grade debt and fixed-income market.

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Investors can invest in HYBs indirectly through mutual funds and exchange-traded funds (ETFs), as well as through direct ownership. The most active HYB market participants include mutual funds, exchange-traded funds, institutional investors, insurance companies, pension funds, and individual investors.

Here are some incentives for investors to purchase HYBs:

Ultimately, the credit rating of the company and subsequently of the issued bonds is what makes a bond termed a junk bond.

Examples of junk bond companies include Ford, which lost its investment-grade ratings in 2020 due to the COVID-19 pandemic and global economic collapse, but still trades at a premium reflecting its legacy status.

Ford's credit rating has a positive outlook, which may lead to it regaining investment-grade status in the future.

Coinbase, a cryptocurrency exchange, has speculative debt due to decreased interest in cryptocurrency and an ongoing SEC lawsuit.

Carvana, an online used car retailer, is struggling with debt and has bonds trading at distressed levels as it searches for a solution to its debt crisis.

Here are some examples of high-yield bond structures:

Let's take a look at some examples of companies that have struggled with junk bond debt. Ford, for instance, lost its investment-grade ratings in 2020 due to the COVID-19 pandemic and global economic collapse.

Ford's junk bonds still trade at a premium, reflecting the company's legacy status. Fitch has a positive outlook on Ford's credit rating, so it's possible that the automaker may eventually find itself back in investment-grade territory.

Another company that's facing debt issues is Coinbase. Its debt is rated as speculative due to decreased interest in cryptocurrency and a Securities and Exchange Commission (SEC) lawsuit that could threaten its business model.

Carvana is also struggling with debt, with its bonds trading at distressed levels as the company searches for a solution to its debt crisis.

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One of the most interesting types of high-yield bonds is the PIK bond. This type of bond allows the issuer to accrue interest to the principal as opposed to paying it in cash during the period due.

PIK bonds are a variation of high-yield bonds that offer the issuer some flexibility in their payment schedule. This can be beneficial for issuers with cash flow issues, but it also means that bondholders may not receive their interest payments on time.

Another type of bond structure is the step-up bond, also known as a "step-up". These bonds have coupon payments that gradually increase across the bond's borrowing term in accordance with a predetermined schedule.

Step-up bonds can be attractive to investors looking for a steady increase in income over time. However, they may also come with higher interest rates and more complex repayment terms.

Zero-coupon bonds, or "zeros", are a type of bond that is issued at a steep discount from the stated face value and pay no interest to the bondholder. Instead, the source of the return is the difference between the face value of the bond and the initial purchase price.

Zero-coupon bonds can be a good option for investors who want to avoid regular interest payments and instead focus on the potential for long-term appreciation in the bond's value.

Convertible bonds are a type of mezzanine financing that can provide the holder with the right to convert the bonds into shares of common stock per agreed-upon terms.

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Convertible bonds can be a good option for investors who want to participate in the potential upside of a company's stock price while also receiving regular interest payments.

Tax-exempt bonds are a type of bond that is issued by governments, municipalities, or related agencies with lower credit ratings. These bonds often come with the added benefit of being tax-exempt.

Tax-exempt bonds can be a good option for investors who are looking for a tax-free source of income, but they may also come with higher interest rates and more complex repayment terms.

Here's a summary of the different types of bond structures we've discussed:

High-yield bonds, also known as junk bonds, come with significant risks that investors should carefully consider.

The credit risk profile of the borrower is a crucial factor to understand before investing in a high-yield bond. This risk estimates the potential loss incurred if the borrower's financial state were to deteriorate, resulting in a potential default.

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High-yield bonds exhibit more volatility compared to investment-grade bonds, largely due to the higher default risk among underlying issuers and longer borrowing terms.

In times of economic contractions, the high-yield bond asset class is less stable than investment-grade debt and fixed-income markets. This is evident when the total number of corporate defaults and demand for restructuring spike.

Investors who are willing to take on this higher risk may be rewarded with higher interest rates, as junk bonds pay significantly more than investment-grade corporate bonds or government-issued bonds.

The interest rate risk, or market risk, is another consideration for high-yield bond investors, as movements in interest rates can negatively affect bond investments.

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