Companies that are financially struggling and have a high risk of not paying their interest payments, defaulting, or repaying the principal to investors issue these bonds known as junk bonds. Since the higher yield is needed to help offset any risk of default, junk bonds are also known as high-yield bonds.
Junk bonds or High-yield bonds are very similar to the regular corporate bonds from a technical standpoint. Since, the promise to return the principal at maturity and to pay interest, is made by the debt issued by the firm in both the cases. Because of the issuer’s poorer credit quality, the junk bonds differ. Fixed income instruments which are issued by governments and corporations to investors in order to raise capital are known as junk bonds. Money is loaned to the issuer who promises to repay the money on a specific date (known as the maturity date), when investors are buying bonds. The principal amount invested is repaid to the investor at maturity. A coupon rate is paid to the investors during the life of the bond. A coupon rate is an annual interest during the life of the bond. For example – an investor who purchases the bonds earns 5 % per year if the bond that was bought has a 5 % annual coupon rate. So, a bond with Rs. 3000 face, or par-value will receive 5 % * 3000, which comes to Rs. 150 each year until the bond matures.
A junk bond is a bond hat has a high risk of the underlying company defaulting. Typically, companies who are struggling financially, or start-up companies issue these junk bonds. The risk of investors being unsure of whether they’ll be repaid their principal and ear regular interest is carried within the junk bonds. For this reason, compared to their safer counterparts to help compensate investors for the added level of risk, the junk bonds pay a higher yield. Since companies need to attract investors to fund their operations, they are wiling to pay the high yield.
The pros of junk bonds are –
- Compared to most other fixed income debt securities, junk bonds return higher yields.
- The potential of significant price increase is had by the junk bonds, if the company’s financial situation improves.
- When investors are willing to avoid a risk or take a risk can be indicated by the junk bonds.
The cons of junk bonds are –
- Compared to most bonds with better credit ratings, junk bonds have a higher risk of default.
- Due to the uncertainty that surrounds the issuer’s financial performance, junk bond prices can exhibit volatility.
- An overbought market can be indicated through active junk bonds. This means that the investors are too complacent with the risk and might lead to market downturns.
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