Bonds are considered one of the most popular forms of fixed-income debt instruments available for purchase today. When a company issues a bond, they are essentially selling debt that they promise to repay at a specific point in the future with a guaranteed rate of interest attached to the principal. Understanding junk bond advantages and disadvantages will ensure that you have the information you need to make the right investment decisions for your personal portfolio.
Junk bonds are often considered a high-risk investment due to uncertain financial circumstances involving the company that has issued them. Although a variety of advantages may exist when it comes to investing in these bonds, leveraging this investment could add an extremely high degree of risk.
Understanding Junk Bonds
As mentioned previously, a bond is labeled as "junk" in situations where the company that has issued it is not considered to be financially stable or not stable enough to legitimize its assets as a long-term investment vehicle. If a company has been noticeably struggling to meet its financial obligations, the bonds they sell may be classified as junk. These bonds are generally considered to have a higher risk of default and may result in the bond investor not receiving either their principal or interest back. That being said, the risk associated with these bonds can also create unique opportunities not present in more secure bonds.
In some situations, a company may be in reasonable financial health and then decline sharply due to issues such as corporate scandals, product recalls, market downturns and a myriad of other factors. If a company turns to bonds in order to help finance their way out of debt issues, these bonds will most likely be labeled as "junk" by national credit rating agencies. This does not mean that these bonds cannot be purchased, but rather that there is a higher risk of losing your original investment compared to all other bonds that have not been designated with this term.
Advantages of Junk Bond Investments
The inherent risk of default attached to junk bonds does provide certain distinct advantages for investors, however. One of the most noticeable advantages is the fact that the interest rates attached to junk bonds are considerably higher than those paired with standard bonds. These higher interest rates act as a form of "compromise" for investors who are willing to take on the risk attached to junk bonds. In exchange for shouldering the potential burden of default, investors are rewarded with larger interest payments over the bond maturation period.
With this idea in mind, it can generally be stated that junk bonds offer higher interest rates and yield potential than the vast majority of fixed-income securities available on the market today. As the old saying goes, "without risk, there is no reward." This quotation certainly applies to the junk bond marketplace.
With any form of bond, particular those that offer higher degrees of yield, the income derived from these interest payments will likely be far more consistent and predictable than stocks. With that in mind, some investors consider bonds – even those labeled as "junk" status – a routine form of income.
Junk Bonds Examples as a Market Indicator
Given the fact that junk bonds are a risky investment vehicle, the number of investors who choose to purchase these debt instruments also acts as a generalized measure of market sentiment. If a large number of investors are willing to shoulder the risks of junk bonds, this could be a good sign that the market is healthy and that investors are predicting sustained growth over a period of time. Similarly, if investors are fleeing junk bonds, this could represent negative market sentiment and simultaneously indicate that investors expect the financial markets to experience a correction or other form of downward price momentum in the near future.
Disadvantages of Junk Bond Investments
Just as the risk associated with these bonds can raise interest rates, it is also important to mention that there is a very real risk of default by the company that has issued the bond. This, in turn, can dramatically limit the number of options available to investors as they seek to obtain the principal they invested in the bond, let alone the interest. It is also important to remember that the risk associated with these bonds will often make them less liquid compared to more secure fixed-income debt instruments.
As an example, consider the following situation. If a company offers junk bonds (which are often labeled as high-yield bonds) to investors, there may be a healthy amount of initial interest. However, if the company in question does indeed default on their financial obligations or experience additional financial hardship, the value of these bonds will plummet. In this situation, it will be virtually impossible for the bondholder to resell these instruments for any price that is remotely close to their original investment.
External Economic Conditions and Junk Bonds
Finally, it is worth mentioning that junk bonds are impacted far greater than higher-rated bonds during an economic recession. In times of market downturn, individuals will often rapidly liquidate riskier investments in favor of a "sure bet," an investment that is guaranteed to maintain a relatively stable degree of value. These often include precious metals, cash or bonds that have been labeled as "investment grade." Because of this, investors should carefully assess the current health of the marketplace, as well as current investor sentiment, before making the decision to invest a significant sum of money in junk bonds.
Leverage and Junk Bond Returns
A leveraged bond fund will typically involve the use of borrowed funds to magnify the scope of the original investment. In theory, using borrowed funds to purchase bonds will magnify the size of interest yield, thus providing the original investors with a high degree of profit. When the bond reaches maturity, the investor simply "gives back" the borrowed funds alongside any interest premium attached to it.
Leveraging has always been considered a "high risk" strategy, which makes the use of leveraged junk bonds even more hazardous for investors. In the event that a high-risk investment platform such as a junk bond were to lose value rapidly, the act of leveraging would dramatically increase the amount of money that the original investor would not only lose but also be forced to pay back to the individual they borrowed money from. With that idea in mind, investors should carefully explore all available options before making the deliberate choice to leverage a junk bond investment.
Keep in mind that leveraging an investment will often expose the investor to what is known as a "margin call," a term which is used to define the specific price point at which the individual or organization loaning the funds can request an immediate return of their principal. With volatile assets such as these, investors may find themselves unable to meet a margin call in this situation.
Ryan Cockerham is a nationally recognized author specializing in all things business and finance. His work has served the business, nonprofit and political community. Ryan's work has been featured on PocketSense, Zacks Investment Research, SFGate Home Guides, Bloomberg, HuffPost and more.