Junk bonds can be a good part of an investor’s portfolio, but they are not for everyone. These high-risk securities have a much higher probability of default than other fixed-income investments like U.S. Treasuries and investment-grade corporate bonds. However, with the right risk profile and expectations, junk bonds can be an appropriate addition to a diversified portfolio. In this blog post, we’ll cover what junk bonds are, why you would consider investing in them and how you should approach this unique asset class if you’re interested in including it in your portfolio.

What are Junk Bonds?

When you hear the term “junk bonds,” it’s likely that two types of bonds come to mind: high- and lower-quality bonds. They’re different pieces of the same investment puzzle, but they’re used interchangeably in the financial media. Junk bonds are low-quality bonds. They are generally issued by companies with a below-average credit rating from a major credit rating agency, like Standard & Poors or Moody’s. An investment-grade bond is a bond that has a relatively low risk of default. Lower-quality bonds have a higher risk of default, which means that investors are less likely to be repaid their principal. Investors are paid a higher interest rate in return for taking on the additional risk of default for these junk bonds. This is why junk bonds have a higher yield than investment-grade bonds.

Why Buy Junk Bonds?

Investing in high-yield, more commonly known as junk bonds, can provide higher returns than traditional fixed-income investments like U.S. Treasuries. Junk bonds are generally issued by corporations with below-average credit ratings, which means they are more likely to default on their debt repayments. While this is bad news for the bondholder, it can be great news for the equity investor, who can purchase the company’s shares at a discounted price. Junk bonds are a good fit for investors looking to add risk to their portfolios. When you buy junk bonds, you’re taking on more risk that the issuer won’t be able to repay the debt. While there’s a lower likelihood of default for bonds compared to stocks, the risk is still high.

However, they are less likely to default than corporate bonds. They are often issued by small and medium enterprises and certain real estate ventures. Due to their higher risk of default, they offer a higher return than traditional fixed-income investments. There is no standardized definition of “junk” in the investment community. The term is often used to describe bonds with comparatively higher risk and lower credit quality. In the United States, standardized risk-rating systems are often used to designate the risk level of a bond. The Standard & Poor’s (S&P) Investment Grade Corporate Bond Index and the S&P Global Ratings Corporate Non-Investment Grade Index are the most common indicators. An investment-grade bond has a 3% or greater probability of default. In comparison, a non-investment grade bond has a 20% or greater probability of default. The majority of junk bonds are in the non-investment grade category.

How to Research and Select Individual Junk Bonds

You should approach investing in junk bonds with a cautious mindset. There’s a reason these bonds have a below-average credit rating. However, if you follow a disciplined approach to researching individual bonds, you can increase your probability of earning a profit. And because you’re dealing with a high-yield investment, you stand to make a greater profit compared to other fixed-income securities like high-quality corporate bonds or U.S. Treasuries. You can approach your research in two different ways. You can either focus on a specific sector or select individual junk bonds based on their credit rating, maturity date, and coupon payment.

Pros of Investing in Junk Bonds

If you select high-quality junk bonds, you can build an above-average yield in your portfolio with a limited risk of default. Here are a few reasons why you may want to consider investing in junk bonds. The yield on junk bonds is typically around 100 basis points above investment-grade bonds. This means that you can earn a higher expected return on your investment by holding junk bonds over high-quality corporate bonds. A junk bond is held to maturity, and you’ll be paid the full principal of the bond investment. Even if the company defaults on the bond, you’ll likely receive the full amount of money you invested because the bond will trade at a discount. By comparison, if you own shares in a company and it goes bankrupt, you’ll earn nothing.

Cons of Investing in Junk Bonds

Junk bonds come with greater risk than traditional fixed-income investments like U.S. Treasuries. Here are a few reasons why you may want to consider investing in junk bonds. Compared to investment-grade bonds, junk bonds tend to be more volatile. While this may not seem appealing, the added price swing can be beneficial to an investor who is also expecting a higher return. The investor could suffer a loss if a junk bond issuer fails to repay the principal or interest payments. This risk may lead to a greater expected loss than other fixed-income securities.

Should You Add Junk Bonds to Your Portfolio?

Junk bonds can be a good part of an investor’s portfolio. Still, you’ll need to follow a disciplined approach to researching and selecting individual junk bonds. Suppose you’re willing to accept the added risk of default and the possibility of a greater loss. In that case, you may consider adding junk bonds to your portfolio. Remember that even though these bonds may have a higher expected yield than other fixed-income investments, they also have higher expected volatility. By choosing high-quality junk bonds, you can minimize the impact of these added risks on your portfolio. To avoid the pitfalls of this high-risk asset class. You can take several steps to increase the likelihood of success with junk bonds. Junk bonds are riskier than other types of fixed-income investments, so you may want to allocate a smaller amount of your portfolio to this asset class. Keep in mind that every investment has some degree of risk. Diversification can significantly reduce risk.

Even if you have a smaller amount of your portfolio in junk bonds, they can be volatile, so it’s important to stay disciplined. You should also keep an eye on interest rates: When interest rates go up, the value of existing fixed-income investments falls. Following that, stay up to date with current events. Junk bonds can be affected by economic factors such as changes in the interest rate environment and changes in the outlook for the economy. You can limit your exposure to risk by purchasing only high-quality junk bonds. The best way to evaluate a potential junk bond investment is to look at its credit rating. The higher the credit rating, the lower the risk. Credit ratings range from AAA (highest risk) to D (no credit). The average credit rating for junk bonds is below B. You can also look at the bond’s yield to determine its risk level. The higher the yield, the greater the risk. Most junk bonds have 10% or higher yields, making them a very risky investment.

Examples of Junk Bond Firms

Several firms have credit ratings that are below investment grade. Some important firms with credit ratings that give them the status of being junk include Netflix. It also falls into the sector of growth-oriented firms. The firm generated negative free cash flow for many years to pay for creating new content for their streaming service. They issued junk bonds as a strategy to fund the in-house production of their television shows and movies. The bonds of the firm also trade at a premium. They have gained some more value as the firm gets closer to positive free cash flow. The improving credit rating of the firm makes it very likely to finally get a status of investment grade.

Conclusion

Junk bonds are a major part of the financial markets. But that does not mean they should be a large portion of your financial portfolio. For many individual investors, it is alright not to invest in junk bonds in the financial markets. For the other investors, this kind of holding should represent only a small part of the portfolio and be purchased through ETFs. This type of junk is much more suitable for investors than typically found in your house. But you should invest with a lot of research and understand all the risks before purchasing them.