In the financial world, those high yield bonds or bonds that are rated below “investment grade” are known as Junk Bonds. Although the risk of such bonds defaulting is higher as compared to other types of securities, they are still preferred by experienced investors, as the returns are typically high as well.
There are two types of risks that come attached to Junk Bonds. These are interest rate risk and credit risk. The first type refers to the rise and fall in value due to changes in the level of interest rates or their structure. The latter indicates the probability of a debtor defaulting in combination with the chances of not receiving principal and interest in arrears after a default.
It is the job of a credit rating agency to analyze and identify the risk with a credit rating such as AAA, AA, A BBB, BB, B, CCC, CC, or C. An additional rating D is used to rate debt already in arrears. Usually, government bonds are placed in the zero-risk category above the credit rating AAA.
All bonds that are rated above BBB are defined as Investment grade bonds. Bonds that are rated below the investment grade are colloquially defined as Junk Bonds. Because of the risk factor that comes with these bonds, these bonds always invite investors by promising higher yields. This makes them attractive investment vehicles for certain categories of financial portfolios and strategies.
Despite the high yield tag, junk bonds often fail to sell well in the market. This is because certain by-laws prohibit many types of provident funds and other investors from investing in bonds that are rated below a particular level. In some cases, the limited market for junk bonds themselves also hinders investment in lower rated securities. As a result, a company with financial problems gets sucked into a vicious cycle where it’s bond rating is further lowered, making it even harder to generate funds.
This vicious cycle is one of the reasons why high profile companies such as Enron and WorldCom, whose bonds were initially rated above investment grade, have collapsed in a heap. Bonds that fall from being certified as having investment grade status to high yield status are termed as “fallen angels”. On the other hand, those bonds whose credit rating levels are on the rise are known as “rising stars”.
Only seasoned investors should try their hands at dealing in junk bonds. A company whose equity has a good value in the market is always a safer alternative investment.
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