Why would investors buy a poorly rated bond?
The junk bond rating means that there is a greater risk that the issuer will default on the debt, relative to investment-grade bonds. As a result of this increased risk, junk bonds offer a higher interest rate than investment-grade bonds, all else equal.
An issuer with a high credit rating will pay a lower interest rate than one with a low credit rating. Again, investors who purchase bonds with low credit ratings can potentially earn higher returns, but they must bear the additional risk of default by the bond issuer.
The simple reason to buy a junk bond is for higher returns. Junk bonds are risky assets but due to their high risk, they come with returns that are higher than safer, investment-grade bonds. Investors willing to take on higher risk for higher returns would buy junk bonds.
If a bond's credit rating is downgraded, the bond becomes less attractive to investors and its price will likely fall. The age of a bond relative to its maturity date can affect pricing.
What circ*mstances might motivate a company to issue a bond that will be rated poorly? That they may not be able to pay back the loans that they issue therefore taking the money from the consumer.
Bonds with a rating of BBB- (on the Standard & Poor's and Fitch scale) or Baa3 (on Moody's) or better are considered "investment-grade." Bonds with lower ratings are considered "speculative" and often referred to as "high-yield" or "junk" bonds.
Obligations rated Ca are highly speculative and are likely in, or very near, default, with some prospect of recovery in principal and interest. Obligations rated C are the lowest-rated class of bonds and are typical- ly in default, with little prospect for recovery of principal and interest.
If junk bonds are "junk," then why do investors buy them? junk bonds contain higher yields to compensate investors for the higher default risk. Although the risk of default is higher, the investor will see a higher payoff than safer bonds as long as the bond doesn't default.
A strong economy can also lower default rates because bond issuers are operating in a more benign environment. On the other hand, when the economy is weak the rates of returns on junk bonds often rise. That's because their yield, another key component of the rate of return, soars.
Disadvantages. Junk bonds have a higher likelihood of default than other types of bonds. In the event that a company defaults, the bondholders are at risk of losing 100% of their investment. If a company's credit rating deteriorates further, the value of the bonds declines.
Why are bonds doing so poorly?
It's all about the Fed
In 2022, the focus of their policies shifted from supporting markets to trying to fight inflation, and bond markets have reacted badly as the battle against inflation has continued longer than initially expected. The Fed's rate hikes ended the bull market in bond prices that had run since 1982.
Historically, bonds have provided lower long-term returns than stocks. Bond prices fall when interest rates go up. Long-term bonds, especially, suffer from price fluctuations as interest rates rise and fall.
Disadvantages of Corporate Bonds
If the issuer goes out of business, the investor may never get the promised interest payments or even get their principal back. Corporate bonds are generally considered riskier than government bonds because governments have the option of raising taxes to meet their obligations.
- THE LINK BETWEEN INTEREST RATES AND MATURITY.
- DEFAULT.
- CREDIT QUALITY.
- CREDIT RATINGS.
- BOND INSURANCE.
- TAX STATUS.
- Raising Capital: ...
- Lower Cost of Capital: ...
- Capital Structure Optimization: ...
- Financing Specific Projects: ...
- Refinancing Existing Debt: ...
- Financial Flexibility: ...
- Maturity Matching: ...
- Investor Relations:
The ability to borrow large sums at low interest rates gives corporations the ability to invest in growth and other projects. Issuing bonds also gives companies significantly greater freedom to operate as they see fit. Bonds release firms from the restrictions that are often attached to bank loans.
The bond rating alerts investors to the quality and stability of the bond. The rating influences interest rates, investment appetite, and bond pricing.
Bonds rated lower than BBB- are considered speculative, which is another way of saying, "Invest at your own risk." Bonds with speculative ratings typically have issuers with questionable liquidity and solvency measures.
Credit Ratings
The safest bonds—AAA, AA, A, and BBB—have a one-year probability of default that is less than 0.1 percent. 4 Speculative-grade bonds—BB, B, and CCC—are considerably riskier.
Moving from a "BBB" rating, which is investment grade, to "BB," which is below investment grade, can have severe effects on the price and prospects of a company or government that issued the bonds. A rating below investment grade indicates deteriorating fundamentals in the issuing company or government.
Why do companies that issue junk bonds have to pay relatively high interest rates?
That is the official name, because bonds from these companies pay out more — sometimes a lot more — than treasury bonds or investment grade bonds. They pay out more because they do carry a higher risk of default. Like if something goes wrong, they might never pay back the bond.
Companies issue corporate bonds to raise money for a variety of purposes, such as building a new plant, purchasing equipment, or growing the business. Corporate bonds are debt obligations of the issuer—the company that issued the bond.
The big deal with high-yield corporate bonds is that when a recession hits, the companies issuing these are the first to go. However, some companies that don't have an investment-grade rating on their bonds are recession-resistant because they boom at such times.
By Glenn Yago. POST: Junk bonds, also known less pejoratively as high-yield bonds, are bonds that are rated as “speculative” or “below investment” grade issues: below BBB for bonds rated by Moody's and below Baa for bonds rated by Standard and Poor's (the two main debt-rating agencies).
High-yield bonds offer higher long-term returns than investment-grade bonds, better bankruptcy protections than stocks, and portfolio diversification benefits. Unfortunately, the high-profile fall of "Junk Bond King" Michael Milken damaged the reputation of high-yield bonds as an asset class.
