High Yield Bonds Equal High-Risk Investments
Bonds are an investment in a company’s debt. They are loans. Companies issue bonds and investors purchase them. Like any loan, there is a principal amount, a date when it will be returned, and an interest rate. The date referred to as the bond’s maturity and its interest rate is called the coupon.
Bonds are fixed-income securities. They are considered predictable, stable investments preferred by people with low-risk tolerance. A junk bond is not for the faint of heart.
Junk bonds are loans as well. They are also called high yield bonds because they offer a higher coupon. For newcomers to investing, this sounds much more appealing than junk bonds. Junk bonds may offer a higher interest rate but they are not low-risk and not necessarily stable. Companies that issue junk bonds have a poor credit rating and more likely to default on the loan.
Corporate Credit Standing
Every publicly traded corporation receives a credit rating. Investors use the system to understand their financial status. Three agencies rank corporations: Moody’s, Standard & Poors, and Fitch Rating. They issue ratings on a company’s outlook, including debt status. Before investors buy a bond, they need to understand their own risk.
These ratings act the same way your personal credit score would when applying for a loan. The better your credit score, the less interest you pay. The same goes for bonds. Companies with a poor ranking have to pay more in interest.
Moody and S&P rank bonds as investment grade or junk. Fitch is less inclined to generalize so they go the issuers’ credit quality. They all offer some plus or minus signs to their rankings. They indicate the potential direction of the bond. Everything in the rankings is about the risk to the investor.
Investors still look at rankings from the big three rating firms. But their credibility was damaged during the sub-prime mortgage scandal of 2008. None of the agencies warned investors of the coming financial disaster. S&P was sued by the U.S. Department of Justice. All three faced legitimate accusations about pushing a narrative they knew to be faulty.
Though corporations value their higher ratings, most financial advisors look beyond their credit standings. Before encouraging the purchase of any bond, junk bonds, in particular, firms do their own research.
Who issues Junk Bonds?
Companies issue junk bonds for different reasons.
Rising Stars: Emerging companies with a public profile sometimes use bonds for seed money. They don’t have a long enough operation history or capitalization to merit a credit rating. Startups are risky but research will determine their viability. Investors should consider the industry, potential market growth, and their leadership.
Fallen Angels: These are companies that had a good credit ranking but lost it. The loss may be the result of poor management or external circumstances- or both. The best example is Ford Motor Company, which lost its credit standing in 2019.
Ford CEO Jim Hackett promoted a new plan to improve the company’s performance but it was widely panned. When COVID hit the situation got worse. They had to close factories and sales dropped dramatically. Their credit status went from investment to junk. Ford issued three series of junk bonds to finance debt of $2 billion. The interest rates ranged from 8% for the first in the series to 9.65% in the last. The company raised $8 billion. In 2021, Fitch gave Ford a BB+ rating – speculative, but they note the company seems to be stable.
How to Get High Yield Bonds
Some investors see junk bonds as the middle ground between the stock and bond markets. They want a fixed income asset, like bonds, with a high return like stocks. If you can tolerant the risk, junk bonds are a solution. They tend to earn a lower return than stocks, but over time the return leans the same way.
Meanwhile, a 9.65% coupon on a $1B bond from Ford is a decent chunk of change. As long as they’re around to pay up. Investors with a strong risk tolerance are willing to bet they will be.
The average rate of default historically sits around 5%. But external factors can quickly change the average. To state the obvious, junk bonds do better during periods of economic growth. During the subprime mortgage crisis of 2008, the junk bond default rate rose to 25%. Due to the potential for volatility, investors with a short-term time frame.
Michael Milken was the mastermind of high yield bonds and leveraged buyouts. Milken was implicated by Ivan Boesky in many illegal financial transactions. He pled guilty to six charges, one of which included overcharging mutual funds for junk bonds. Milken, labeled the junk bond king, received a $600M fine and a prison sentence. He is allegedly behind the inspiration behind the Gordon Gecko character in the movie Wall Street.
Crooked financiers are not a new story. Neither is the mess Moody’s, S&P and Fitch helped to perpetuate in 2008. Moral of the story? If you want to invest in junk bonds – and make your money back – due diligence is key.
No matter what your risk profile, ask yourself how much you could afford to lose. Three years after Ford’s last junk bond release, Fitch is still rating the company as speculative.
Buying Junk Bonds
Experienced investors looking for individual high-yield bonds can buy them from their broker. This involves a good deal of time and research to source the opportunities. These investors use yield spread to help identify the best coupon and risk level. Buying junk bonds directly is not advisable for new investors.
The common way investors buy junk bonds is through funds set up to sell them. There are mutual funds and EFT’s grounded in high yield bonds. There are many credible funds from well-known financial firms, including Barclays and Invesco.
Some facts to consider:
- No matter what the fund is called or rated, the risk of every high yield bond is based on the issuer.
- Bond prices are governed by the market. Fund managers buy and sell bonds regularly. If they sell a bond before it reaches maturity, you may lose money
- If the fund itself performs poorly, so might your investment.
This is not to suggest how you should invest, but to offer some considerations for making your choice. Investors rarely look at what bonds are in the fund. You may want to do otherwise.
Covid Propels Jump in Junk Bonds
During the height of the pandemic, the junk bond industry jumped. Between January and August 2020, over $274 billion in high yield bonds were issued in the US. That amount exceeded the entire year of 2019. The EU reported an increase as well, despite a less developed financial infrastructure for their sale.
The pricing went up and down as the pandemic continues to recede and surge. Sell-offs were not uncommon and funds’ performances tanked. Though investors quickly bought initial junk bond offerings, there was a growing concern. Zombie companies had been kept alive by low-cost borrowing. This despite the fact their interest costs were greater than their annual earnings.
The Federal Reserve stepped in to protect the credit market. Their efforts helped to stabilize the markets and stave off defaults.
What Happens in Case of Default
A bond is in default when the issuer can’t make their principal or interest payments as required. Companies that issue junk bonds are already under financial duress. They have limited options for financing. If they can’t pay, they don’t have a way to pull the money together.
If a bond you invested in defaults, you lose the majority of the principal. Based on the historical average, you can expect to see about 42%. On a $10,000 investment, you get back $4200. Don’t expect it immediately. The company will likely need to dissolve and sell its assets. One minor advantage, bondholders get paid before shareholders
The chance for default increase during periods of slow or declining economic conditions. Junk bonds are a company’s last option. If sales and revenue drop and expenses rise, they’re trapped. The default is the death knoll.
But not necessarily for the bond itself. Even after default, distressed debt investors might pick up. If they think the amount from the dispersal of the assets is greater than the price of the bond, they might snap it up.
Junk Bond Pros & Cons
The positives and negatives of high-yield bonds are pretty straightforward:
- High return on investment: Junk bonds are called high yield because they pay higher interest rates
- Recurring payments: Junk bonds are loans. They make monthly payments on the interest and principal.
- Less risky than stocks: In the event of default, bondholders are paid before shareholders.
- Diversification: Some claim that holding only investment-grade assets can be risky. We note there are many ways to diversify a portfolio without turning to high-risk assets.
- High Risk: Junk bonds pay a higher because they pose a greater risk.
- Price Risk: When the bond rating is lowered, it can force down its market price from what was originally offered.
- Stock Risk: This only matters if the issuer defaults.
- Diversification: There are many ways to diversify a portfolio without turning to high-risk assets.
What is the Junk Bonds Outlook?
As America ventures out from the pandemic, Moody declares a positive outlook in April 2021.
The number of defaults from Ba and B rated firms dropped by 60% from the previous month. Two of the six corporate defaults in the first quarter were from the Services sector. The largest default came from Belk, Inc. with $2.5 billion in debt, a private equity-owned department store chain.
But over a year, the most defaults occurred in the oil and gas sector. They accounted for 28% from April 2020 to April 2021. That is expected to improve in the coming year. Defaults in the hospitality industry are estimated to remain at 8%, at least until public health restrictions are waived.
In 2020, over $329 billion in high yield bonds were issued. There have since been concerns that low-interest rates are driving bond values down. Companies can refinance debt, reducing the dependence on high yield bonds.
But economists agree, as the pandemic slows and vaccinations grow, 2021 will be a period of recovery for all markets. Junk bonds included.
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