Delving into bonds: What are junk bonds?

Julie Brownlee, Fsp Invest, 08 Aug. 2014

Tags: junk bond, junk bonds, what are junk bonds, junk, credit rating agencies, risk, investing in junk bonds

When governments and companies want to borrow money, they issue bonds. Bonds are a way to secure funding for a fixed period of time.

The more financially secure and sound a company or government is, the lower the interest rate they must pay on the bond. They attract less risk and as a result more bond buyers.

But what if a company or government is looking financially shaky? It might see its bonds downgraded to junk.

So what is a junk bond? Let’s take a closer look…

Bonds get a credit rating

When companies and governments issue bonds, a credit rating agency gives them a credit rating. Credit rating agencies include Standard & Poor, Fitch and Moody’s.

The credit rating agency looks at a number of thing to award the rating. This includes how likely the borrower is to repay the debt.

What is a junk bond?

When a credit agency award a bond ‘junk’ status, it means it has a credit rating of BB or lower. A junk bond is also known as a non-investment grade bond.

Junk bond status is the lowest bond credit rating. A company’s bonds might become junk bonds because it already has a lot of debt. Or it’s in a very cyclical sector and its profits aren’t very stable.

Junk bond status brings with it higher risk. So there’s higher risk attached to a company paying the interest payments on its bonds and the amount loaned at the end of the bond term.

Junk bonds are high risk

The credit agency believes there’s a risk the company might not be able to pay back the interest or the bond amount if trading conditions deteriorate. This is known as defaulting.

Junk bonds are also known as high yield bonds. That’s because they offer high interest payments compared to other safer companies and governments.

The higher interest rate rewards bond buyers for taking on the extra risk. But comes with a higher chance that the bond buyer won’t get their money back.

So there you have it, what junk bonds are.

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