What are junk bonds?
Junk bonds are bonds that offer higher interest rates but have a lower credit rating than other types of bonds.
You may hear the term “high yield” when talking about junk bonds but there is low security compared to other types of bonds like treasury bills.
High yield means high risk!
Although it sounds like an obviously bad idea to invest in something so risky, some people still do it because they want the high return that junk bonds provide.
In this article:
- What is a junk bond rating?
- Investment-grade and high-yield bonds
- Advantages of junk bonds
- Disadvantages of junk bonds
What is a junk bond rating?
Junk bond ratings indicate the credit quality of the issuer and its likelihood to default.
Credit ratings are used to determine how much risk an investor is taking on when buying certain bonds, as well as other factors such as interest rate payments, liquidity and maturity date.
The rate of return on junk bonds is dependent on the credit quality of the issuer.
A bond issued by a highly-rated company (AAA or AA rating) will generally have a lower risk than one issued by a lower-rated company (BBB or below).
Learn more about the AA, BB, etc ratings.
Investment-grade and high-yield bonds
Investment-grade bonds are issued by companies with good credit ratings.
On the other hand, companies with low credit ratings (below BB) issue junk bonds.
These companies may have a history of defaulting on their debt obligations, making them risky investments for individual investors.
However, they can be very lucrative for professional traders who make their living buying and selling financial instruments on the secondary market.
Secondary market is where investors buy and sell securities they already own.
In general, investment-grade bonds tend to offer lower rates of return than junk bonds.
They are also safer because the companies that issue them are less likely to default on their debt payments.
What are the advantages of junk bonds?
- Junk bonds have a higher yield than investment-grade bonds.
- They can be a good way to diversify your portfolio, especially if you are looking for higher returns.
- In a low-interest rate environment, junk bond funds often generate greater absolute returns than other types of fixed-income instruments such as short-term treasury bills or bank deposits.
What are the disadvantages of junk bonds?
- Junk bonds have a high degree of risk, meaning you will likely see defaults.
- While some will outperform their expected return, there is no guarantee that this will happen with your chosen bond.
- Less stable earnings.
- They’re not as safe as other investments.
How do I buy junk bonds?
You can invest in them directly through a broker or online exchange, as part of a mutual fund, or through banks and private investors.
Junk bonds have the potential to be rewarding, but can end up being a bad investment.
Conclusion
Junk bonds can be an exciting way to invest, but they are risky.
If you have a high risk tolerance and want to diversify your portfolio with some extra income, junk bonds may be worth considering. Just make sure you understand how they work before making any decisions.
However, if you’re just starting out and don’t have much money to invest, then there are other lower-risk investments that will provide stable returns.
This article is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It does not purport to be complete and is not a substitute for seeking the advice of a qualified professional for your individual financial situation.
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