A Junk Bond by Any Other Name Would Smell As Risky

Today in class we briefly talked about junk bonds.

Bonds are fixed-income debt instruments that corporations and governments issue to investors to raise capital. When investors buy bonds, they’re effectively loaning money to the issuer who promises to repay the money on a specific date called the maturity date. At maturity, the investor is repaid the principal amount invested. Most bonds also pay investors an annual interest rate during the life of the bond, called a coupon rate. (investopedia)

Junk bonds are one type of bond that carry a higher risk than “regular” bonds. The higher risk is that the company may not pay the interest when it is due, and/or they may not repay the bond when it reaches its maturity date.

In the table below, the first four rows of ratings are referred to as investment grade bonds, meaning there is not much risk associated with such bonds. (Fun fact: only two companies have a AAA rating – Microsoft and Johnson & Johnson).

Moody’s S&P
Aaa AAA Highest Rating Available
Aa AA Very High Quality
A A High Quality
Baa BBB Minimum Investment Grade
Ba BB Low grade
B B Very speculative
Caa CCC Substantial Risk
Ca CC Very Poor Quality
C D Imminent Default or In Default

After these first four rows we move into junk bond status.

Since that name does not sound very appealing, other names have been suggested. Such names include:

  • below investment grade
  • speculative
  • high yield

Shakespeare would have been impressed by these alternative names.

The one that seems a bit deceptive to me is the high yield moniker. It seems to suggest that it offers a great return on your investment. But there’s a catch.

The high yield name come from the fact that because these bonds carry higher risk than investment grade bonds, the only way a company is going to entice an investor to lend the company money is by offering a higher return (interest payment) in exchange for the investor’s willingness to take on the higher risk. Thus, high-yield is just another name for high interest rates. These higher rates cause the company to have lower profits.

So no matter what you call these bonds – junk, below investment grade, speculative, or high yield, they all mean the same thing.

It’s a risker investment because of the chance the company will not be able to make its obligations related to the borrowing of money.

In many ways, bond ratings are like our credit score. The higher the credit score, the more likely we are to get approved a for a loan, and the more likely we are to get a more favorable rate when we borrow.

Today’s class also gives me the chance to tell my only joke of the semester, which I may have told here on WordPress before:

What’s the difference between a bond and a man?

Bonds mature…

32 thoughts on “A Junk Bond by Any Other Name Would Smell As Risky

  1. I assume the enticement of a higher yield is the only thing that keeps these bonds a reality. I can’t believe you do an entire lecture just to set-up your one and only joke. And here I thought they were investments in a Chinese boat building company. Who knew. One question, professor, can the rating of a bond change over its time to maturity? Asking for a friend….๐Ÿ˜

    Liked by 1 person

    1. it’s like a 45 minute joke. well maybe that describes most of my lectures…

      I think I’d rather invest in a Chinese boat building company…

      and yes, the ratings can change over time…

      Liked by 1 person

  2. I think that’s a good explanation about junk bonds, which brokers are expected to provide to their clients. Unfortunately, there are some unethical ones who do not. I see nothing wrong with investing in junk bonds, as long as the investor goes into it with their eyes open, understanding the risk.

    Now, is a man who doesn’t mature, of any interest?

    Liked by 2 people

      1. Yes, indeed. I think one of the best fundamental lessons any investor can learn is the value of diversification. Never put all your eggs in one basket.

        Like

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