What are Junk Bonds – Its Advantages and Disadvantages
Bonds are debt securities that borrowers issue to raise money from investors. Although they are considered to be less risky than equity investments, junk bonds, in particular, are considered to be highly risky. They have the potential to perform aggressively in the market, with distinctly higher returns than other bonds. This gives an edge to an investor to sweep maximum returns and lock profits.
However, junk bonds also carry a high risk of default. New start-ups and financially unsecured companies issue these bonds to navigate through monetary hurdles. They are issued by companies that have a low credit rating. They are rated below the investment grade by the rating agencies in our country.
If you are an investor with a high risk appetite, here’s everything you need to know about junk bonds before you start investing. Read on!
How Do Junk Bonds Work?
Junk bonds have a much higher risk of defaulting than other bonds in the market. Companies that are comparatively new in the market issue high-yield bonds to collect funds for their working capital. Usually, such companies are financially struggling or have bad credit ratings due to past defaults.
As these bonds are rated as high-risk grade investments, the companies promise high returns to the investors as their unique selling point. Investors with a high-risk appetite tend to prefer such bonds as there are chances of generating high returns if the companies succeed in their endeavours.
What Are the Examples of Junk Bonds?
Some Indian companies that have issued junk bonds in India are as follows:
- SREI Equipment Finance Limited
- Vedanta Resources Finance
- Shriram Transport Finance Company Ltd.
All of these companies have a low credit rating (Category B) when compared to the other stable and well-established companies in their respective sectors.
What Are the Reasons to Buy Junk Bonds?
There are many benefits of investing in junk bonds. First, for a strategic investor, such bonds can improve returns on investment. Other reasons include:
- Junk bonds have the potential to offer returns that can be compared to equity-based returns.
- As debt securities, junk bonds are safer than individual stocks.
- Junk bonds have a fixed rate of return, unlike equity investments.
How to Buy Junk Bonds?
All market instruments, including junk bonds, can be bought and sold via an investment account. All you need to do is have a Demat account and a trading account with a broker or bond trader.
Junk bonds can be purchased in three forms:
• Trade in ETFs
You can invest in an exchange-traded fund (ETF) that has a portfolio of several high-yielding bonds. Units of ETFs are like stocks and can be traded on the stock markets. This method provides the investor with easy exposure to several junk bonds at once.
• Purchase individual bonds
These bonds can also be purchased directly, but it requires a larger amount of funds, and the exposure is limited to just one bond. Therefore, it is not a convenient option for most buyers unless you have a monetary surplus parked in your account.
• Invest in thematic mutual funds
Several thematic mutual funds invest exclusively in high-yield bonds. This gives exposure to multiple bonds at the same time and also allows expert control over your investment. This is a convenient option for new investors who wish to invest in junk bond funds.
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What Are the Interest Rates of Junk Bonds?
As junk bonds are perceived to be riskier than other investment options, companies typically offer them at higher rates of return. On average, the interest rate offered by junk bonds in India hovers around 10-12%. Some Indian junk bonds with their coupon rates have been mentioned below:
| Name of the bond | Allotment Date | Maturity Date | Interest Rate |
| 11% SREI Equipment 16 Mar 2025 | March 16, 2015 | March 16, 2025 | 11% |
| 10.75% SREI Equipment 13 Aug 2025 | August 13, 2015 | August 13, 2025 | 10.75% |
| 10.50% SREI Equipment 24 Jan 2024 | January 24, 2019 | January 24, 2024 | 10.50% |
| 9.80% Future Enterprises 26 Oct 2023 | October 26, 2016 | October 26, 2023 | 9.80% |
| 9.80% Future Enterprises 05 Dec 2023 | December 05, 2016 | December 05, 2023 | 9.80% |
Why Do Junk Bond Credit Ratings Matter?
Bond credit ratings act as a review parameter for investors to understand the risk associated with the bond. All bonds are audited, including junk bonds in India. Credit rating agencies like CRISIL and CIBIL prepare credit reports for the companies that issue junk bonds.
These ratings certify if a bond is investment grade or speculative in terms of returns and default. Any bonds that are rated below investment grade are considered junk bonds or of speculative grade.
High investment-grade bonds are ideal and preferable for low-risk investors; however, they yield lower returns comparatively. As a result, investors with a high-risk appetite often look for low-investment grade junk bonds that have the potential to offer exponential returns.
What Are the Risks Associated with Junk Bonds?
As these bonds are issued by companies with scarce funds or new start-ups with no prior records, they possess certain risks as an instrument in the market. Some of the associated risks have been discussed below:
- There’s a risk of bankruptcy with low-rated companies. Hence, junk bonds have a much higher risk of default than other bonds in the market.
- These bonds are long-term investments and thus have low liquidity.
- A negative economic situation will gravely impact high-yield bonds.
What Are the Pros and Cons of Buying Junk Bonds?
Preference for buying a junk bond is very subjective to individual investors. Aggressive investors find high-yielding bonds very attractive as investment options and generate satisfactory returns from those bonds. On the other hand, several investors with a shallow appetite for risk find investing in such speculative bonds challenging.
There are several advantages and disadvantages associated with junk bonds, some of which have been discussed below:
Pros
- Lower risk than equity: Speculative bonds have a fixed interest rate, making them lower in risk than individual equity. In case of bankruptcy, bondholders are given preference before shareholders.
- Higher returns: These bonds assure higher returns than other debt securities to balance out the high-risk factor for investors.
- Preferable purchase in falling markets: Investing in junk bonds in a falling market trend can turn out to be a smart decision. In the rising market, they can yield very high profits.
- Fixed income source: They are long-term investments with a fixed interest rate; hence, they can be a steady income source for your future.
- Lower default risk than stocks: Although they are considered junk bonds, they are still considered safer than equity investments that depend heavily on market fluctuations.
Cons
- Poor returns in the short-term: Speculative bonds can offer satisfactory returns over the long term but are highly unpredictable investments in the short run.
- High risk of default: Junk bond schemes have a comparatively high risk of default than other bonds.
- Low liquidity: They are long-term investment schemes that are usually locked for years.
- Credibility: Junk bonds have low credibility and are hence not a popular investment choice.
Things to Consider Before Buying Junk Bonds
Investing in a high-yield bond can be a strategic move for an investor; it is crucial to consider all aspects before buying a junk bond.
• Check All Options
Different investors have different goals; hence, they should choose an investment option that best suits their needs while buying junk bonds.
• Use the Cons as an Advantage
It is important to understand the positive and negative features of junk bonds; use the cons as an opportunity, and invest wisely.
• Follow Credit Ratings
It is best to invest in junk bonds after assessing the ratings available for each bond. The higher the rating, the lesser the chances of defaulting.
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Final Word
Junk Bonds are rated low by credit rating agencies as they are issued by comparatively new or financially unstable companies posing a high risk of default. These bonds are an attractive opportunity to maximise profits for active investors; however, they have several risks. Investing in these bonds is speculative but profitable and should be closely monitored.
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FAQs
Ans: Based on the credit ratings offered by rating agencies, companies with a rating of BBB or lower are generally considered to be junk-rated companies. The bonds issued by them have a moderate to very high default risk.
Ans: Junk bonds are high risk investments that yield high returns and are legally regulated schemes under SEBI and AMFI. The bond issuers can easily default and declare bankruptcy in a low market; however, they are comparatively safer than stocks.
Ans: High-yield bond schemes have approximately a 3.5- 5% median default rate which may vary in different market situations based on several parameters and investor behaviours.
Ans: In case of a default, a junk bond issuing entity either files for bankruptcy or is forced into bankruptcy by the investors. Therefore, the investors or bondholders have a serious chance of losing their principal amount if a bond defaults.
Ans: Some of the renowned rating agencies of India are:
• Credit Rating Information Services of India Limited (CRISIL),
• Investment Information and Credit Rating Agency of India Limited (ICRA),
• Credit Analysis & Research (CARE)
• Onida Individual Credit Rating Agency of India (ONICRA)
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