Junk Bond

10-K

What is an unwanted bond?

Unwanted bonds are bonds that carry a higher risk of default than most bonds issued by companies and governments. A bond is a debt or promises to pay interest to investors and the return of capital invested in exchange for the purchase of the bond. Unwanted bonds represent bonds issued by companies that are experiencing financial difficulties and present a high risk of default, non-payment of interest or repayment of principal to investors.

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Junk Bond

Explanation of unwanted obligations

Bonds are fixed income debt securities that companies and governments issue to investors to raise capital. When investors buy bonds, they actually lend money to the issuer who promises to pay the money back on a specific date called the maturity date. At maturity, the investor is reimbursed for the capital invested. Most bonds pay investors an annual interest rate over the life of the bond, called the nominal interest rate.

For example, a bond that has an annual coupon rate of 5% means that an investor who buys the bond earns 5% per year. Thus, a bond with a nominal or nominal value of $ 1,000 will receive 5% x $ 1,000, which amounts to $ 50 each year until the maturity of the bond.

Higher risk equals higher return

A bond that presents a high risk of default by the underlying company is called an undesirable bond. The companies that issue unwanted bonds are usually start-ups or companies that are experiencing financial difficulties. Unwanted bonds are risky because investors do not know if they will be paid their principal and will receive regular interest. As a result, junk bonds offer a higher return than their safer counterparts to help compensate investors for the additional level of risk. Companies are willing to pay high returns because they have to attract investors to finance their operations. Unwanted bonds are also called high-yield bonds because a higher yield is necessary to offset any risk of default.

Benefits

  • Unwanted bonds produce higher yields than most other fixed income debt securities.

  • Unwanted bonds have the potential to dramatically increase prices if the company’s financial condition improves.

  • Unwanted bonds serve as a risk indicator when investors are ready to take risks or avoid risks in the market.

The inconvenients

  • Unwanted bonds have a higher risk of default than most bonds with better credit ratings.

  • Unwanted bond prices can be volatile due to the uncertainty surrounding the issuer’s financial performance.

  • Active junk bond markets can indicate an overbought market, which means that investors are too complacent about risk and can lead to market downturns.

Unwanted bonds as a market indicator

Some investors buy junk bonds to take advantage of potential price increases as the financial security of the underlying company improves, and not necessarily for the return of interest income. In addition, investors who anticipate higher bond prices are betting that there will be an increase in buying interest for high-yield bonds, even those with a low rating, due to a change in sentiment. market risk. For example, if investors believe that economic conditions are improving in the United States or abroad, they could buy rotten corporate bonds that will show improvement with the economy.

As a result, the increased purchase interest in junk bonds serves as an indicator of market risk for some investors. If investors buy junk bonds, market participants are willing to take more risks due to an improving economy. Conversely, if junk bonds sell while prices fall, it generally means that investors are more averse to risk and opt for safer and more stable investments.

Even if a large increase in investments in junk bonds generally translates into increased optimism in the market, it could also indicate overly optimism in the market.

It is important to note that unwanted bonds have much larger price fluctuations than higher quality bonds. Investors wishing to buy unwanted bonds can either buy the bonds individually through a broker or invest in an unwanted bond fund managed by a professional portfolio manager.

Improved financial conditions affect unwanted bonds

If the underlying company is doing well financially, its bonds will have a better credit rating and will generally attract buying interest from investors. As a result, the price of the bond increases as investors flock, willing to pay for the financially viable issuer. Conversely, companies with poor performance will likely have low or reduced credit ratings. These falling opinions could cause buyers to retreat. Companies with poor credit ratings generally offer high returns to attract investors and compensate them for the additional level of risk.

The result is that bonds issued by companies with positive credit ratings generally pay lower interest rates on their debt instruments compared to companies with poor credit ratings. Many bond investors monitor the credit ratings of bonds.

Assessment of unwanted obligations

Although junk bonds are considered risky investments, investors can monitor the risk level of a bond by examining the bond’s credit rating. A credit rating is an assessment of the credit worthiness of an issuer and its outstanding debt in the form of bonds. The company’s credit rating, and ultimately the bond’s credit rating, affects the market price of a bond and its supply interest rate.

Credit rating agencies measure the creditworthiness of all corporate and government bonds, providing investors with an overview of the risks associated with debt securities. Credit rating agencies assign ratings for their opinion on the matter.

For example, Standard & Poor’s has a credit rating scale from AAA – excellent – to lower ratings of C and D. Any bond rated below BB is said to be speculative or bond grade. This status should be a floating red flag for investors unwilling to take risks. The different ratings of the credit agencies represent the financial viability of the company and the probability that the contractual conditions of the conditions of the obligations are respected.

Investment Grade

Investment grade bonds come from companies that have a high probability of paying regular coupons and returning capital to investors. For example, Standard & Poor’s notes include:

  • AAA – excellent
  • AA – very good
  • A good
  • BBB – adequate

Speculative

As mentioned earlier, once the rating of a bond falls into the double B category, it falls into the territory of unwanted bonds. This area can be a scary place for investors who would be harmed by a total loss of their investment in the event of default.

Some speculative valuations include:

  • CCC – currently vulnerable to non-payment
  • C – very vulnerable to non-payment
  • D – default

Companies with bonds with these low credit ratings may find it difficult to raise the capital necessary to finance ongoing business operations. However, if a company manages to improve its financial performance and the credit rating of its bond is improved, a substantial appreciation in the price of the bond could occur. Conversely, if a company’s financial situation deteriorates, the credit rating of the company and its obligations could be downgraded by the rating agencies. It is crucial for investors in unwanted debt to thoroughly study the underlying business and all available financial documents before purchasing.

Default values ​​of bonds

If a bond misses a principal and interest payment, the bond is considered to be in default. The default is the non-repayment of a debt, including interest or principal on a loan or guarantee. Unwanted bonds have a higher risk of default due to an uncertain income stream or a lack of sufficient collateral. The risk of bond default increases during economic downturns, making these lower-level debts even more risky.

Real example of an unwanted obligation

Tesla Inc. (TSLA) has a fixed rate bond, which matures on March 1, 2021 and has a semi-annual coupon of 1.25%. The debt received an S&P rating from B- in 2020.

As of April 10, 2019, the current yield offered on the bond is more than 7%. The reason for this disparity is that the bond is rated B- by the Standard & Poor’s rating agency. Note B means that the bond or the company has unfavorable conditions which could adversely affect the ability to pay. As a result, the higher return compensates investors for the additional level of risk.

In addition, the current price of the Tesla offer is $ 103, slightly higher than its face value of $ 100 in 2020, which represents the additional return that investors get above the coupon payment. In other words, despite the B rating, the bond trades at a premium of $ 3 over its face value, which is likely due to the high yield of 7% offered.

However, Tesla has had financial difficulties in recent years, which has made borrowing risky as we can see from Standard & Poor’s B rating.

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