How to invest in Junk Bonds

Investing in Junk Bonds

According to the International Capital Market Association, a global institution representing participants active in the world’s capital markets, the bond market holds an overall size of over $128 Trillion in value. This makes it one of the largest financial markets across the world, comprising of varied debt securities. Generally, the performance of a bond is dependent on the issuer’s ability to pay back the debt. Debt securities with a high credit rating and low risk of defaulting are commonly known as investment-grade bonds. However, where there is an increased risk of default, the securities are referred to as junk bonds.

This article explores the fundamentals of investing in junk bonds, what they are, and the alternatives to investing in junk bonds. Read on for a detailed guide.

What are Junk Bonds?

Junk bonds, also known as high-yield bonds, are debt securities that offer very high returns but are significantly defined by an extremely high risk of default. Ideally, bonds are issued as debts, with the promise from the issuer to pay back the invested principal along with interest payments after a defined duration. Unlike other bonds, junk bonds are accompanied by a very low credit rating, increasing their risk of not repaying the principal and interest payments. In an effort to cover for their risk of defaulting, junk bonds tend to pay high yields. Consequently, high-yield bonds are ideal for investors willing to take extremely high risks.

When investing in high-yield bonds, it is critical to evaluate the credit rating record of the issuer. An upward trend of the issuer’s credit ratings is a possible sign of future investment-grade bonds. On the other hand, a downward trend could signal increased risks should you invest in a given junk bond.

How Do Junk Bonds Work?

Like stocks, the bond market is significantly influenced by the price movements of the underlying bonds. A movement in the price of a bond induces a fluctuation in its returns in the opposite direction. For instance, a rise in demand for bonds triggers an increase in the market price. This consequently causes a decline in the yields. The opposite is also true. A decline in demand for a bond lowers its trading price, resulting in high yields.

Interestingly, the yield and returns of a bond are also dependent on the creditworthiness of the issuer. This implies that how low or high a bond will produce its yield is impacted by the credit rating of the issuing entity. Bonds issued by entities with strong credit ratings tend to make low yields. However, those with poor ratings offer significantly high yields. Junk bonds are associated with high yields, thanks to their low credit ratings.

The Pros and Cons of Investing in Junk Bonds

While junk bonds are known for offering high yields and returns, they equally pose significant threats to the investor. Here is a highlight of the advantages and disadvantages of investing in high-yield bonds.

Pros

High Yields – At the top of the most notable benefits of investing in junk bonds is the high yields associated with these debt securities. This is unlike investment-grade bonds, which come with low yields.

Less Risky Than Stocks – Interestingly, investing in junk bonds is less risky than venturing into the stock market. This is because, in the event of bankruptcy on the part of the issuing company, bondholders are prioritized over stockholders when repaying securities.

Less Volatile Than Stocks – The stock market is popular for its wild fluctuation in stock prices, a phenomenon best known as volatility. While bonds are also volatile, the rate of fluctuation of bond prices is not as severe as it is with stocks.

Diversification – Typically, the performance of junk bonds is not always congruous with stocks or other types of bonds. This is because junk bonds have higher yields and are less vulnerable to the interest rate risk than stocks and other bonds. As a result, adding a junk bond to your investment portfolio can go a long way in minimizing your exposure to risks.

Cons

Default Risk – Topping the list of the drawbacks of investing in junk bonds is the high risk of default associated with the debt securities. The implication is that you could lose your initial principal from a single investment. This explains why most investors are shy of investing in high-yield bonds.

Junk Bond Prices are Impacted by Multiple Factors – Generally, the price of a junk bond is affected by a wide range of factors, including credit ratings and interest rates. While it is common in all bond types, junk bonds are more often impacted by these factors. For example, a decline in the credit rating of a junk bond consequently lowers its market price. This may lead to a significant reduction in the return on investment (ROI) of the bond.

Less Liquid – Due to the high rate of defaulting linked to junk bonds, most investors are hesitant to invest in this category of bonds. The consequence is that, unlike the other bond types, reselling a high-yield bond may be extremely difficult.

Financial Metrics Used to Analyze the Performance of a Junk Bond

Like any other market, junk bond investors rely on a range of metrics to evaluate the performance of a bond. Here is a brief guide on key metrics necessary when investing in high-yield bonds.

Debt/EBITDA Ratio

The Debt to Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) ratio is one of the most important metrics for evaluating junk bonds. The ratio determines the risk of default of a junk bond by establishing the issuer’s capacity to finance its debt obligations.

Ideally, a junk bond with a high Debt/EBITDA ratio signals the issuer’s lack of capacity to finance its debts. As a result, its credit ratings are downgraded, posing a high default risk on the part of the investor. On the other hand, a junk bond with a low Debt/EBITDA ratio is considered to be in a strong position to pay back its debts. Consequently, the issuer’s credit rating is upgraded, making the junk bonds more appealing to investors.

Leading Indicators

While they may not be a conventional statistic in analyzing the performance of a security, leading indicators help you anticipate various market trends. One of the leading indicators critical in evaluating junk bonds is the 2008/9 yield curve. After the 2008/9 Great Recession, investors in the bond market could quickly identify the best bond issuers.

Companies and entities that survived the recession well provide fundamentally useful statistics for any bond investor today. Any entity that stood the impact of the recession and still thriving today reflects the issuer’s strategic ability to navigate any other market downturn. Generally, junk bonds are a risky investment. However, a good analysis of leading indicators like the 2008/9 yield will help you anticipate future results in your bond investment.

Debt to Total Capitalization Ratio

The total debt-to-capitalization metric analyses the financial leverage of a bond issuer by measuring the entity’s total debt as a ratio of its total capital. The ratio informs investors on the suitability of investing in an issuer’s bond by looking into its financial structure. The higher the debt to total capitalization ratio, the higher the risk of investing in the company’s bonds.

Generally, the ratio is an indication of the value of the company financed by debt over equity. Therefore, the higher the ratio, the greater the risk of defaulting the debt.

Alternatives to Investing in Junk Bonds

Today, junk bonds bear higher returns on investment than traditional Treasury bills. So, where does a high-yield bond investor turn to when they cannot earn high yields as projected? Here are some potential alternatives to junk bonds.

Convertible Bonds

Convertible bonds are a category of bonds that allow investors to convert their bond value into a specified number of shares in the issuing entity. Investors can diversify their portfolios using convertible bonds, thanks to their capacity to lower risks while maintaining high yields.

Generally, convertible bonds present an opportunity to make some gains from the stock market by changing the bonds into shares when there is a favourable movement in stock prices.

However, convertible bonds can also be a risky investment considering that the issuer reserves the right to forcibly convert the bonds into stocks. This happens when share prices rise higher than the value for which the convertible bond would have been redeemed

EMD Bonds

Emerging Market Debt (EMD), also known as emerging market bonds, are a category of bonds made available by entities and governments from developing economies. In recent years, EMD bonds have become increasingly popular among bond investors. This is because of the high yields and high credit quality associated with the bonds. Again, developing economies tend to grow rapidly, increasing the chances for high returns on particular EMD bonds.

However, emerging market bonds come with higher risks than domestic debt securities. These risks are often hyped by the economic and political tensions instability experienced in developing economies. The good news is that most countries within the emerging markets have taken strides in enhancing socio-economic stability. This way, the benefits of investing in EMD bonds outweigh the risks.

Warrants

Warrants offer a great investment opportunity to individuals interested in high yields in the long term. A warrant provides you with the right to buy and sell shares of an issuing company at a predetermined price and over a defined timeframe. Since warrant prices are relatively, the capital gains generated tend to be significantly high. However, the disadvantage of investing in a warrant is that you are likely to make relatively high capital losses. This is common when the gearing and leverage associated with a warrant works to your disadvantage.

How to Buy Junk Bonds

Buying junk bonds is more or less the same as purchasing stocks. There are plenty of full-service brokerage services available to buy and sell junk bonds on your behalf. Some of these online brokerage platforms include the following;

[1] Charles Schwab

The Charles Schwab brokerage site offers a wide range of investment options, including bond funds, high-yield bonds, and other traditional bonds. This trading tool allows you to open an account to buy and sell junk bonds at minimal rates. Investors can also enjoy professional services to have their accounts managed, in addition to a set of trading tools and resources.

[2] Robinhood

Robinhood is a commission-free investing tool for your junk bond investments. The educational tools made available on Robinhood are designed to keep you informed on the fundamentals of investing in bonds and other securities. You can also buy and sell high-yield bonds via your smartphone using the Robinhood app.

[3] Ally Invest

If you are looking for a platform where your investment accounts are integrated with your bank, then Ally Invest is your ideal brokerage platform. With Ally, you can invest in individual, corporate, and treasury bonds with a click of a button. You can also get high-yield bonds while enjoying the lowest standard fund commission in the brokerage industry.

[4] TD Ameritrade

TD Ameritrade holds the reputation of providing investors with a full spectrum of features and services. The company offers you a range of bond offerings, including high-yield bonds, zero-coupon bonds, treasury bonds, and corporate bonds. Generally, you become the licensed owner of a bond every time you buy bonds via TD Ameritrade. This way, you can mitigate risks by managing your portfolio at costs and fees.

[5] Betterment

Betterment is a Robo-advising brokerage company that invests your money in a mix of a diversified portfolio of such securities as bonds, stocks, and ETFs. It is a cost-effective platform where you can invest in high-yield bonds at different levels of risk. Betterment’s fees are affordable, and you do not require a minimum investment to get started with junk bonds.

Once you have identified your ideal brokerage platform, you can buy junk bonds in either of the following ways;

Exchange-Traded Funds (ETFs) – These funds give you access to a mix of multiple bonds at go. You will need to analyze the credit rating, historical performance, and trading rates before investing in junk bonds using ETFs.
• Mutual Funds – They are similar to ETFs but are traded in overnight batches.
• Individual Bonds – These allow you to buy bonds directly from an issuing authority or through a broker.

Wrap up

Junk bonds are a higher yielding alternative to higher-graded bonds or treasuries. Junk bond investors should be mindful of the creditworthiness of the entities issuing the junk bonds. As always, a balanced portfolio of different bond risk levels or grades helps weather volatility for investors.

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