Junk Bonds

Definition

Junk bonds are high-yield, high-risk debt securities issued by companies with poor credit ratings or a high risk of default. They offer higher returns than investment-grade bonds, but also carry a greater chance of the issuer being unable to repay the debt.

5 Must Know Facts For Your Next Test

1. Junk bonds typically have credit ratings below investment-grade, such as BB or lower from rating agencies like S&P and Moody's.
2. The higher yields of junk bonds are meant to compensate investors for the increased risk of default or bankruptcy of the issuing company.
3. Junk bonds can be used by companies to raise capital for expansion, acquisitions, or to refinance existing debt when they have limited access to traditional financing.
4. The junk bond market experienced significant growth in the 1980s, led by financier Michael Milken, but also faced volatility and high-profile defaults.
5. Investors in junk bonds must conduct thorough research and due diligence to assess the risk-reward tradeoff, as the potential for higher returns comes with greater uncertainty.

Review Questions

• Explain how junk bonds are used by companies to raise capital and the associated risks.
  • Junk bonds allow companies with poor credit ratings or high default risk to raise capital by offering higher yields to investors. This helps companies finance expansion, acquisitions, or refinance existing debt when they have limited access to traditional financing. However, the higher yields of junk bonds compensate investors for the increased risk of default or bankruptcy of the issuing company. Investors must carefully assess this risk-reward tradeoff when considering investing in junk bonds.
• Describe the role of credit ratings in the junk bond market and how they impact the yields and risk of these securities.
  • Credit ratings play a crucial role in the junk bond market, as they determine whether a bond is considered investment-grade or speculative-grade (junk). Bonds with credit ratings below investment-grade, such as BB or lower, are classified as junk bonds. The lower credit ratings of junk bonds indicate a higher risk of default, which is why they offer higher yields to compensate investors for this increased risk. The yield spread between junk bonds and investment-grade bonds reflects the market's assessment of the additional default risk associated with junk bonds.
• Analyze the historical growth and volatility of the junk bond market, and discuss the potential implications for households supplying financial capital.
  • The junk bond market experienced significant growth in the 1980s, led by financier Michael Milken, but also faced periods of high volatility and high-profile defaults. This volatility can have important implications for households supplying financial capital. Investors in junk bonds must conduct thorough research and due diligence to assess the risk-reward tradeoff, as the potential for higher returns comes with greater uncertainty. Households must carefully consider their risk tolerance and investment objectives when allocating capital to the junk bond market, as the higher yields may not always compensate for the increased default risk.

Related terms

Speculative-Grade Bonds: Another term for junk bonds, referring to their speculative and high-risk nature compared to investment-grade bonds.

Default Risk: The risk that the bond issuer will be unable to make the required interest or principal payments, resulting in default.

Yield Spread: The difference in yield between junk bonds and investment-grade bonds, which compensates investors for the higher risk of junk bonds.