By Matthew Haan, Fall 2018 IAC Student Intern
Get that junk outta here! Oh wait, actually, if you understand the risks, this trash might be your treasure. I am not talking about the trash you are likely to find at the salvage yard or your neighborhood garage sale—I am talking about junk bonds.
Junk bonds, also known as high-yield corporate bonds, are corporate bonds that offer a higher rate of interest, but carry with them a very high level of risk, including a much higher risk of default. Companies who issue secured bonds post specific assets as collateral in the event that bond payments are missed, but not all companies have the assets to help them obtain the credit rating associated with secured bonds. To attract investors and acquire capital, smaller companies or startups often issue junk bonds to offset any uncertainty or lack of operating history.
All of this might sound scary at first glance, but while only five to ten percent of companies that issue junk bonds end up in default, in the event that these companies do go belly up, many junk bonds retain some sort of recovery value. This means that junk bonds that have defaulted are not necessarily worthless, though there is always the risk that they could be. Junk bonds are not also limited to unknown startups in California. Popular publicly-traded companies like Tesla and Netflix have offered junk bonds in the past. And, some companies are even using junk bonds to finance the acquisition of other companies.
In this bull market, with new record highs happening almost every week, more and more investors are drawn to riskier investments. If you choose to invest in junk bonds, either directly or via a mutual fund or ETF, you should be aware of exactly what risks you are taking on. As mentioned before, one key risk is default. Another important risk to be aware of is the interest rate risk. All bonds, from secured to junk, see their prices move in the opposite direction of interest rates. If interest rates go up, your junk bond might not be worth as much as you hoped it would. Another factor that can affect the bond’s price is the economy. If the economy declines, the market for junk bonds may become flooded with more sellers than buyers. Simple economics tells us that when supply is greater than demand, price goes down. Finally, junk bonds carry with them liquidity risks. Even though more investors are beginning to seek junk bonds, they are still traded less frequently than investment-grade bonds. This means that those holding junk bonds might not be able to sell their bonds at a price that accurately reflects the value.
So, if you are aware of the risk and can afford to take a total loss, you might be the right person to throw that junk in your trunk portfolio (with proper advice).