Junk bonds, or high-yield bonds, are risky investments that have higher rates of default but offer significantly higher returns. Unlike lower-risk,
junk bonds are not usually
ideal for long-term
investments, and can easily
cause the investor to lose
money if she’s not careful.
A bond is a way of lending money to a company. The company accepts the money for the bond with the agreement that it repays the initial loan with interest when the bond matures.
Junk bonds have low credit
ratings, meaning there’s a high
risk of default or the potential for
other adverse credit events. However, where long-term investors favor reliable, income-producing bonds, speculators may prefer to shoulder the risks of a high-yield, non-investment-grade bond.
Junk bonds also offer strong
during periods when
interest rates are low and
more reliable investment
options are offering poor
returns. This is because the high yields and short maturities of junk bonds are less affected by interest rates, an increase in the issuing company’s revenue may improve the health of a junk bond even when interest rates stay low.
Five years ago, Business Corporation, LLC, needed a little bit of cash flow, but it didn’t want to issue shares. Instead, it sold bonds with a set 2.5% interest rate that offered purchasers reliable, long-term income. This year, however, Business Corporation isn’t doing so hot: its industry is flagging and its revenue is falling.
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Investors may expect the bond issuer’s revenue to pick up, if, for example, it’s in an industry undergoing a temporary slump. In that case, there’s potential for a significant windfall on a high-yield investment. But, absent any information about the company’s financial prospects, it’s just as likely that it’ll miss a payment and the purchaser could lose money.
They usually have a credit rating from a financial services company like Standard & Poor’s that reflects the ability of the company to meet its payment obligations when the bond matures. A healthy rating means a bond is likely to generate a lot of revenue, which goes toward the bond
issuer’s payments on its
principal and interest.
These bonds are called
To raise money, it wants to sell bonds again, but Moody’s has rated them below investment grade, and they’re considered high-risk since it’s not clear that Business Corporation will be able to meet all its obligations. In order to entice investors, the bonds have a 10% interest rate.