The 30 second intro to Junk Bonds
Junk Bonds, also known as High Yield Bonds, are debt instruments issued by companies with poor credit ratings, or are the debt instruments of companies that were issued as high quality bonds from strong companies that have since fallen on hard times (“Fallen Angels”).
Typically these are any bonds that are not classified as Investment Grade (BBB rated or better).
Junk Bonds behave very differently from Investment Grade bonds. Their value depends only marginally on market interest rates and far more on the underlying economic strength and operational performance of the issuing company.
Junk Bond return characteristics
They don’t often the unlimited upside of ordinary equity, but with the high starting yield (10% to 25% depending on the circumstances) it can provide a very healthy return if the company doesn’t default. There is also a chance for rerating where if the strength of the company improves dramatically, the bond may be repriced to a lower market yield, resulting in a significant capital gain.
Founders keeping control
So company founders can issue junk bonds rather than diluting themselves by issuing equity and still provide attractive returns to investors and an opportunity for savvy investors (and those who just think they are savvy) to “pick” their company with the prospect of fantastic returns if it performs really well.
Did I mention the interest payments on the issued junk bonds are tax deductible for the business?
Why would investors be happy to invest in junk bonds?
Aside from the attractive returns possible, now is a particularly good time for investors to consider junk bonds. With low interest rates (particularly in the US, Europe, Japan sphere of the world) investors are looking for instruments to boost their yield. Junk Bonds can do just that.
Further, with the Fed (and to a lesser extent, other central banks) promising to keep interest rates low and therefore debt cheap for an extended period, the risks to investors are fairly low. Certainly, the perception is that the risk is lower in bonds than equities as an asset class – this is probably at least partly a mirage given the equity-like characteristics of junk bonds.
Moody’s has also shrunk it’s list of companies most likely to default, further encouraging views of low default probabilities.
I’ll be writing a few more posts related to bonds and junk bonds over the next few weeks so keep an eye out for those if you’re interested.