How To Buy Junk Bonds
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Emerging companiesWhile many high yield bonds are issued by former investment grade companies in decline, the high yield market also provides financing opportunities for emerging companies seeking working capital for expansion or to fund acquisitions.
Higher coupon ratesIn general the issuers of high yield bonds are considered less likely to make interest payments than issuers of investment grade corporate debt. Because investors are being asked to assume this risk, high yield bonds tend to come with higher coupon rates, which can generate additional investment income.
Capital appreciation potentialCompanies issuing high yield bonds have the potential to turn around their financial standing, creating the opportunity for investors to realize capital gains as bond values increase, due to improving business conditions or improved credit ratings.
While it may seem appealing to look at bonds that offer higher yields, investors should consider those higher yields to be a sign of potentially greater risk. Below are some of the potential risks involved with high yield investing.
Default riskHistorically, the risk of default on principal, interest, or both, is greater for high yield bonds than for investment grade bonds. Moody's data shows that bonds rated Ba had a 2.64% probability of defaulting within a year, whereas more speculative bonds rated Caa-C, had a one-year default probability of more than 8%. Investment grade bonds meanwhile had a .03% probability of a default within a year.1
Make-whole callsSome bonds give the issuer the right to call a bond but stipulate that redemption occurs at par plus a premium. This feature is referred to as a make-whole call. The amount of the premium is determined by the yield of a comparable mature Treasury security, plus additional basis points. Because the cost to the issuer can often be significant, make-whole calls are rarely invoked.
Equity correlation riskThe perception that high yield issuers may have trouble generating sufficient cash flow to make interest payments could make them behave like equities. In some cases, high yield bonds may fall along with equities during an economic or stock market downturn. This is a concern for investors using fixed income as a hedge against equity volatility.
Liquidity riskHigh yield bonds that may have been easy to buy or sell when market conditions were calm can suddenly become very difficult to sell when volatility increases. Typically, the market for high yield bonds is less liquid than the market for investment grade or government bonds.
Interest rate riskAlthough high yield bonds have relatively low levels of interest rate risk for a given duration or maturity compared to other bond types, this risk can nevertheless be a factor. As with all bonds, a rise in interest rates causes prices of bonds and bond funds to decline. Because credit and default risk are the dominant drivers of valuations of high yield bonds, changes in market interest rates are relatively less important. At the same time, a tightening in monetary conditions that usually accompanies a rise in the general level of interest rates may cause a lagging reaction by weaker credits because of their inability to find sufficient funding, which in turn weakens the balance sheet of the high yield entity.
Higher transaction costsDue to a typically large spread between bid and offer prices, and higher transaction costs associated with less liquid securities, trading high yield bonds can be costly.
Research and monitoring demandsCurrent and accurate information can be more difficult to obtain for high yield bonds. Investors should conduct due diligence as they consider investment strategies and closely monitor the changing financial condition of the issuing company.
Foreign riskIn addition to the risks mentioned above, there are additional considerations for bonds issued by foreign governments and corporations. These bonds can experience greater volatility due to increased political, regulatory, market, or economic risks. These risks are usually more pronounced in emerging markets, which may be subject to greater social, economic, regulatory, and political uncertainties.
You may search for and purchase high yield bonds at Fidelity.com, where you can choose the credit rating levels appropriate for your portfolio and risk tolerance. You can also research recent ratings actions before you buy, and evaluate the liquidity risk based on real-time Trade Reporting and Compliance Engine (TRACE)2 data.
the date on which the principal amount of a fixed income security is scheduled to become due and payable, typically along with any final coupon payment. It is also a list of the maturity dates on which individual bonds issued as part of a new issue municipal bond offering will mature
an interest-bearing promise to pay a specified sum of money (the principal amount) on a specific date; bonds are a form of debt obligation; categories of bonds are corporate, municipal, treasury, agency/GSE
To attract investors, bonds of all types have to offer interest payments when they borrow money. Investment-grade bonds tend to have much lower interest rates because they pose less of a risk for investors. Junk bonds, meanwhile, have to really sweeten the proverbial pot to convince investors to risk their money. And over time, that can really pay off for certain investors.
You may think of junk bonds as being issued by smaller corporations or very troubled companies. But just as often they are issued by well-known companies with long histories, or new companies without an established track record. Some recent examples include Coinbase and Crocs.
Coinbase is a cryptocurrency exchange that experienced massive demand in 2020 and 2021 as more consumers bought crypto, like Bitcoin and Dogecoin. Coinbase went public in April 2021, and in September it saw huge demand for a big junk bond offering. Its initial offer was $1.5 billion in seven- and 10-year bonds, but demand was so strong that Coinbase expanded the issue to $2 billion.
This chart reveals how much high-yield bonds have been hit; it shows how the spreads between junk debt and safer Treasurys TMUBMUSD10Y, 3.560% have widened this year because of recession and default fears. Bond prices fall as yields rise.
This chart from the St. Louis Fed shows that junk-bond prices can sink a lot more from here if a serious recession develops. Yields rise when bond prices sink as investors sell bonds due to worries about recessions and nonpayment.
But any recession that develops here will be shallow, believes Loome, and not like the recessions during 2020, the financial crisis and the early 2000s. As the chart above shows, those recessions sent junk yields spiraling as investors sold them off.
Investors have been pouring money into high-yield bonds, which typically pay more interest for taking on greater risk. But these investments are also known as \"junk bonds,\" and financial experts urge caution before piling in.
At the margin, rising interest rates may make it more difficult for some bond issuers to cover their debt, especially those with maturing bonds that need to refinance, said Matthew Gelfand, a CFP and executive director of Tricolor Capital Advisors in Bethesda, Maryland.
When assessing high-yield bonds, advisors may compare the \"spread\" in coupon rates between a junk bond and a less risky asset, such as U.S. Treasurys. Generally, the wider the spread, the more attractive high-yield bonds become.
With high-yield bonds paying 7.29% as of Aug. 10, an investor may receive $72.90 per year on a $1,000 face value bond, whereas the 7-year Treasury, offering about 2.86%, provides $28.60 annually for the same $1,000 bond.
Economic risk: When the economy gets shaky, investors might rush to shed their high-yield bonds and replace them with safer ones, such as U.S. Treasury bonds. This can lead to a drop in high-yield bond prices if the market supply exceeds the demand.
Liquidity risk: Liquidity is the level of ease an investor might have if they want to sell an investment. High-yield bonds can be less liquid than investment grade bonds. You can check corporate bond trading activity, and thus liquidity, with FINRA's Market Data Center.
Some well-known and many lesser-known companies issue high-yield bonds. Investors can buy individual high-yield bonds or, alternatively, you can purchase shares in a high-yield mutual fund or a high-yield exchange-traded fund (ETF).
But high-yield mutual funds and ETFs also come with risks. For instance, if a number of investors want to cash out their shares, the fund might have to sell assets to raise money for redemptions. The fund might have to sell bonds at a loss, causing its price to fall.
The Federal Reserve in July bought up more bonds from blue-chip companies including Microsoft and Coca-Cola, while it added to its positions in junk debt and made its biggest Main Street loan to a ski resort and casino in the Pocono Mountains.
In addition, the Fed stepped up its buying of junk bonds, purchasing $331 million worth of the iShares iBoxx High Yield Corporate Bond ETF, a move up from June's buying of $274.6 million. It also continued its purchases of bonds that were low-level investment-grade heading into the pandemic and then were downgraded. It bought $34.6 million of the VanEck Vectors Fallen Angel High Yield Bond fund.
Junk bonds are a high-risk investment, but they offer the potential for higher returns than investment-grade bonds. Junk bonds, also known as high-yield bonds, are best suited for investors who are willing to take on more risk in order to achieve higher returns. 59ce067264