Bonds come in a range of shapes and sizes. You’ve got corporate bonds, government bonds, and even municipal bonds that are issued at a regional level. With that said, junk bonds are also a popular financial instrument in the online trading space.
They refer to bonds that carry a much higher risk, but this is reflected in the yield. Junk bonds usually come from the corporate space, meaning that they are issued by blue-chip companies that are publicly listed. In some cases, you can even buy government junk bonds from nations that have a weak economy.
In this in-depth junk bonds guide, we’re going to show you everything you need to know. Not only does this include a full breakdown of how junk bonds work, but we’ll also explain how you can make an investment today.
What are Junk Bonds?
In a nutshell, junk bonds operate much like any other bond instrument in the market. By investing in one, you are lending money to the issuer. In return, you will receive a fixed rate of interest until the bonds mature. At the end of the term, you will then receive your original investment back. However, junk bonds are perceived as high-risk by the financial markets.
By this, we mean that there is a much greater chance that the issuer will either default on their interest payments or worse, default on the principal. Although there are different rating systems that determine whether a bond should be classed as ‘junk’, this is usually based on the ratings issued by Standard & Poor’s. If the bond issuer in question carries a credit rating of less than BB, then Standard & Poor’s will classify the investment as a junk bond.
In order to set the scene, let’s look at a quick example of how a junk bond investment might work.
Example of a Junk Bond Investment
- You invest $10,000 in a corporate bond with a Standard & Poor’s rating of ‘C’
- This means that the bond is classified as a junk bond
- The junk bond has a yield of 8% and a term of 5 years
- At the end of each year, your 8% interest pays $800
- Over the course of 5 years, your total interest amounts to $4,000 (5 x $800)
- At the end of the term, you then get your original $10,000 back
As you can see from the above example, you made a juicy $4,000 from your junk bond investment over the 5-year term. Although the annual yield amounted to 8%, you actually got an ROI (Return-on-Investment) of 40%, which is very attractive. However, the reason that you were able to get such an attractive yield is that the bonds fall within the junk category.
As such, although in this example you received your interest and principal back in full, this might not always be the case. On the contrary, the issuer behind the junk bond could default if they run in to further financial difficulties.
Pros and Cons of Investing in Junk BondsPros
- The yields on junk bonds are much higher than the market average
- You will receive fixed interest payments
- You get to buy the junk bonds at a discounted price
- You might be able to sell them at a profit if the issuer improves its financial standing
- Ability to diversify by investing in hundreds of different junk bonds
- Junk bonds are very high-risk, so there’s always a chance that the issuer defaults
- No guarantee that you will receive your principal investment back
- Certain junk bonds, such as those issued by governments, can be difficult to invest in
- Junk bond yields are volatile
- You might struggle to sell your junk bonds before they mature
Junks Bonds: Yields and Maturity
The junk bond space is highly diverse. Much like the traditional bond arena, this covers a huge range of potential yields and terms. This allows you to choose a junk bond that best fits your appetite for risk. For those of you that are still new to the junk bond scene, below we’ve explained how the yield and maturity works, and why they are important metrics to consider prior to making an investment.
Junk Bond Yield
The yield of a bond simply refers to the amount of interest that you will make as an investor. Expressed as a percentage, you can calculate the yield against your investment amount to determine how much money the bonds will pay in interest.
- If the bond yield pays 10% in interest, this means that you will receive 10% of the amount that you originally invested per year
- If you held $5,000 worth of junk bonds, you would get $500 per year in interest
- Some junk bonds pay interest on a bi-annual basis, so you would get $250 every 6 months
It is also important to understand how the coupon rate works, and how this differs to the yield. Once a junk bond has been issued, the specific yield can change. This is based on market forces. For example, if the company that has issued the bond is performing poorly, then this means that the risk of default increases.
This would mean that the yield would increase, as investors need a higher interest rate to counter the risks. Similarly, if the company behind the bonds published a strong earnings report, then the yield of the bond would go down. This is because the risks of default are lower, so the bonds are worth more.
Junk Bond Coupon Rate
Although the yield of a bond can change at any time, this is only relevant if you plan to sell the junk bonds on the open marketplace before they mature. For example, if you’re holding a junk bond with a 10-year maturity date, but you want to sell them part-way through the term, then the amount that you would be able to sell them for would be based on the current yield. Again, this is determined by market forces.
However, if you were to keep hold of the bonds until they mature, the yield would never change. This is referred to as the coupon rate. As such, if you were to buy bonds that have already been issued from the financial markets, you would need to take both the yield and the coupon rate into account.
Let’s look at a quick example to make sure we know the difference between the yield and coupon rate on junk bonds.
Yield vs Coupon Rate on Junk Bonds
- Let’s say that you invest $10,000 into some junk bonds with a 12-year term
- The junk bonds were issued 3 years ago, so there are 9 years left before they mature
- When the junk bonds were originally issued, they came with a yield of 9%
- However, as the company has since run into further financial difficulties, the bonds can be purchased at a cheaper rate
- As such, although the junk bonds originally paid 9%, they now yield 13%
- This means that the coupon rate is 9%, and the current yield is 13%
As per the above example, the yield on your junk bonds for the remainder of the 9-year term amounts to 13%. However, the coupon rate is only 9%. This means that the company behind the bonds will still pay 9%, as this is what was agreed upon when they were issued. With that said, as you will be purchasing the junk bonds from the financial markets for a much lower price, the actual yield will amount to 13%.
Junk Bond Maturity Date
The maturity date of a junk bond refers to the length of the term. This operates in a similar nature to a loan agreement, as the maturity is the amount of time that the bond issuer has to repay its investors. The maturity date will be decided by the issuer before the bonds are raised, and can vary from a couple of years to a number of decades.
The bond term will never change, although in rare cases the issuer might decide to repay the funds back early. The terms of the junk bond will also stipulate when your interest payments should be paid. This is usually on an annual or bi-annual basis. If it’s the latter, this is slightly more beneficial for you as a bondholder, as it allows you to re-invest the interest as soon as it is paid.
Different Types of Junk Bond Investments
Although much of our article has discussed junk bonds in the context of corporate bonds, this isn’t the only investment option that you have at your disposal. You can also invest in junk bonds that were issued by governments, as well as via a junk bond fund.
Let’s explore how each investment type works.
Corporate Junk Bonds
As we have discussed throughout our guide, corporate junk bonds are bonds that were issued by publicly listed companies. Think along the lines of Tesla. In fact, although Tesla is now one of the largest companies in the world, it recently had junk bonds active in the financial markets. When the bonds were originally issued, they paid a very low yield of 1.25%. A yield as low as this indicated at the time that the bonds were low-risk.
However, as Tesla ran into financial difficulties for a number of years, the bonds were downgraded by Standard & Poor’s to a junk rating. This meant that the bonds yielded 7% – which is significantly higher than the original yield of 1.25%. The key point is that when the bonds were originally issued, they were not junk bonds. However, when companies experience poor financial results, the bonds can move into the junk bond threshold.
Government Junk Bonds
In a similar nature to the corporate lending scene, government junk bonds refer to high-risk bonds, but they are issued by nation-states. A prime example of this would be Venezuela junks bonds that are currently in circulation. With Venezuela experiencing severe economic woes and a currency that has hyper-inflated by more than a million per cent, the yield on its bonds has gone through the roof.
For example, a 5-year Venezuela junk bond is now yielding 81.7%, which is staggering. Ultimately, just because the bonds are backed by a nation-state, this doesn’t mean that the issuer won’t default. In fact, Venezuela has already defaulted on an interest repayment, which is why the yield is so high.
Junk Bonds Funds
If you’ve got a higher appetite for risk and you want to gain exposure to the multi-trillion-dollar junk bond arena, it might be worth considering a fund. This is where a large fund provider will purchase thousands of junk bonds from a range of different sectors. This might focus on corporate bonds, municipal bonds, government bonds, or possibly a combination of all three. The fund manager will be tasked with buying and selling the bonds on your behalf.
As and when profits are realized, you will receive interest payments – proportionate to the amount you invest. There is no fixed coupon rate when you invest money with a junk bond fund, as the fund manager will constantly buy and sell new instruments. As such, the monthly interest that you receive can vary wildly. You will need to pay an annual maintenance fee when using a junk bond fund, which covers the costs of managing your money.
How do I Make Money From Junk Bonds?
When it comes to making money through a junk bond investment, this can come via two different revenue streams. Firstly, you will make money through the coupon payments that you receive from the bond issuer until the bond matures. Secondly, you stand the chance of selling the bonds at a profit in the secondary marketplace if the issuer improves its financial standing.
Let’s explore these two revenue streams in more detail so that you have a firm understanding of how you can make money from junk bonds.
Junk Bond Revenue Stream 1: Fixed Coupon Payments
First and foremost, when you invest in junk bonds you will be doing so to receive fixed coupon payments. This is the interest that the issuer pays to all bondholders. You will receive a fixed yield until the bonds mature, which allows you to earn a steady flow of passive income.
However, this is on the proviso that the junk bond issuer always meets its repayments. Even if the issuer does meet its annual or bi-annual coupon payments throughout the term of the junk bonds, you then to think about the principal.
This is the greatest risk of investing in junk bonds, as the issuer will need to outlay millions of dollars to all bondholders when the instrument matures. For example, let’s say that the company issued $200 million worth of bonds at a coupon rate of 7%.
This means that the issuer would need to pay out $14 million per year in interest, which is manageable. However, when the bonds eventually mature, the issuer would then need to repay the entire $200 million that it borrowed.
Junk Bond Revenue Stream 2: The Secondary Market
On top of your fixed coupon payments, you might be able to make money if you sell your bonds in the secondary market. As we have discussed throughout our guide, if the bond issuer improves its financial standing, then the market value of the bonds will increase, and the yield will decrease. This won’t matter if you plan to simply hold on to the junk bonds until they mature.
However, if you want to lock-in some early profits on your investment when the value of the bonds increases, then you will be able to sell them at a premium. Although you will get less than what you would have got if you held on to the bonds until maturity, this allows you to avoid the risks of the issuer defaulting further down the line.
How do I buy Junk Bonds?
Have a slightly higher appetite for risk, and want to make a junk bond investment today? If so, follow the step-by-step guidelines that we have outlined below.
Step 1: Choose a broker that sells junk bonds
Step 2: Open an account with the broker and verify your identity
Step 3: Deposit funds to your chosen broker
Step 4: Browse the junk bonds listed for sale with the broker
Step 5: Perform plenty of research on the junk bond prior to making an investment
Step 6: Enter the number of junk bonds that you want to buy and complete the trade
In summary, we hope you now have a good understanding of what junk bonds are, how they work, and whether or not they meet your long-term investment goals. On the one hand, junk bonds allow you to amplify your annual yields, not least because they typically pay well above average market rates. Moreover, they allow you to earn passive income, as once the junk bonds have been purchased there nothing more to do.
However, you also need to consider the risks of investing in junk bonds. While at first glance you might be attracted to the high yields on offer, there is always a chance that the underlying issuer will default. While coupon payment defaults are somewhat manageable, it is a default of your principal investment that would be highly determinantal. Ultimately, just make sure that you perform heaps of research on the junk bonds prior to making an investment.
How do I make money with junk bonds?You can make money from junk bonds on two fronts. Firstly, you will receive a fixed rate of interest on your investment, which is known as coupon payments. Secondly, you might be able to sell your junk bonds at a premium if the financial health of issuer improves.
Are junk bonds risky?Yes, junk bonds can be extremely risky, which is why credit rating agencies classify them as 'junk'. This is also why junk bonds pay such a high rate of return.
What is the minimum amount I can invest in junk bonds?This depends on the type of junk bond that you wish to buy, as well as the broker that you buy them from. If you're looking to buy government junk bonds, you will usually need to invest a 6-figure sum. Alternatively, some corporate junk bonds can be purchased in increments of $100.
Can I buy junk bonds directly from the issuer?In most cases, bonds won't be classified as junk when they are first issued. Instead, they obtain a junk status after the bonds have been issued, meaning that you will need to buy them from a broker.
Do junk bonds have a maturity date?Yes, junk bonds operate much the same as any other bond in the market, so they will always come with a maturity date..
Are junk bond yields fixed?Junk bonds will always come with a fixed rate of interest. However, if you decide to sell them before they mature, you will likely need to do so at a different price to what you paid.
How do I diversify my junk bond investment?You can diversify your junk bond investment in a number of different ways. For example, you can fill your portfolio with hundreds of different junk bonds, or invest in a junk bond fund.
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David WaringView all posts by David Waring
David Waring was the founder of LearnBonds.com and has been a major contributor to the extensive library of investing news and information available on the site. Until the launch of Learnbonds.com in late 2011 there was no single site on the internet catering exclusively to the individual bond investor. This was true even though more individuals own stocks than bonds. Learn Bonds was launched to fill that gap.Scroll Up