iQuanti: If you’re interested in investing, you may have come across the term “junk bonds.” But what exactly are junk bonds, how are they traded, and why are they considered riskier than other types of bonds?
Let’s look at what junk bonds are and how they work:
What are bonds?
To understand junk bonds, it’s important to understand how bonds work in general. A bond is essentially an IOU. When you buy a bond, you’re lending money to a government, municipality, corporation, federal agency or other entity known as the issuer. In return, the issuer promises to pay you interest over a specified term and to repay the loan when the bond matures or comes due. When you buy a bond, you become a creditor of the issuer. Of course, there are many different types of bonds with different features, but these are the basics.
Junk bonds explained
Junk bonds are corporate bonds that are rated below investment-grade by credit rating agencies. These agencies use letter grades to rate the creditworthiness of bonds. The ratings differ slightly between agencies but, in general, “AAA” is the highest rating and “D” is the lowest. The lower the rating, the more likely the company is to default. Bonds that are a certain B-level rating or below are considered junk bonds.
Junk bonds typically have higher interest rates than investment-grade bonds, which makes them more attractive to investors looking for higher yields. However, junk bonds also carry a higher risk of default, which means that investors could lose all or part of their investment. Overall, junk bonds do offer higher returns, but the risk that the issuer will file for bankruptcy and you’ll lose your original investment is considered much higher than investment-grade bonds.
How do you buy and sell junk bonds?
When it comes to investing in junk bonds, there are two main options: buying individual bonds or investing in funds, such as mutual funds and exchange-traded funds (ETFs). Buying individual bonds is riskier, as it concentrates your money in fewer investments. Investing in bond funds can provide diversification and professional expertise that can help reduce the overall risk. The best option for you will depend on your financial goals and risk tolerance.
Deciding whether to invest in junk bonds
Junk bonds are considered riskier than investment-grade bonds and can offer higher rewards. Ultimately, whether you invest in junk bonds at all will depend on your individual goals and risk tolerance. For this reason, it is important to research the investment carefully and weigh the risks and benefits of each option before deciding what is right for you.