Investing in Junk Bonds: What Are the Pros and Cons?

Many investors are attracted to the potential for high returns. But a potentially higher yield also comes with much higher risk. Still, high-risk investments can have a place in a well-balanced portfolio. Junk bonds are one example of these risky investments.

But what are junk bonds? They’re a high-risk, high-yield investment that could either provide soaring returns or cause an investor to lose money. However, they can still be a good addition to some portfolios if approached correctly and in the right financial situations. Learn more about junk bonds and see if they’re a good investment for you.

What Are Junk Bonds?

Junk bonds are a form of corporate bond. When a company needs to raise capital, it will send bonds to investors. In return, companies will pay investors a fixed income of interest payments and the principal when the bond matures.

Junk bonds are issued by companies with poor credit ratings. This factor means they are more likely to default on their payments, which is why they are such a risky investment. However, to attract investors to their bonds, these companies offer a high yield. So if the company can make their payments, investors could receive higher-than-average interest payments. If the company defaults, then investors won’t get their payments at all. This is why they are called junk bonds because there is the possibility that the investment is worthless.

What’s the Difference Between Junk Bonds vs. Investment-Grade Bonds?

Investment-grade bonds come from companies with good credit ratings that will most likely be able to make their interest payments to investors. Their credit rating and history make these bonds a fairly safe investment since there is little risk of them defaulting. Junk bonds come from companies that might be struggling financially and don’t have a good credit rating, meaning they are more likely to default.

How Do Junk Bonds Work?

Junk bonds are corporate bonds that are issued by companies that are less likely to cover their payments. An example could be a startup company that doesn’t have a lot of cash flow. To expand its business and its reach, it may need to take out a loan. So it will sell bonds in hopes of using that capital to grow the business.

The company’s goal is to expand so that it can increase its cash flow. If it succeeds, it will be able to pay bond investors those high-yield interest payments. However, if it doesn’t work, then it will default on their payments and investors could lose money.

How to Buy Junk Bonds

There are two main ways investors can incorporate junk bonds into their portfolios. They could purchase an individual bond or invest in bond funds.

Buy Individual Bonds

The first option is to buy an individual bond straight from the company using brokerage accounts. Investors will first want to research high-yield bonds and do some research on the company to assess the risk associated with the bond. Individual junk bonds can lead to high rewards but are very risky and not a good option for diversification. 

Invest in Bond Funds

The other option is to invest in junk bond funds, such as an exchange-traded fund (ETF). These funds create a portfolio of junk bonds and allow investors to buy shares of the entire portfolio. Investors can purchase shares of these ETFs through their brokerage account. This option can diversify your portfolio and mitigate some of the risks associated with junk bonds. The bonds within a fund can balance each other out. For example, if one bond defaults but another is providing fantastic returns, there’s less loss for the investor. 

Pros of Investing in Junk Bonds

Junk bonds are risky, but they can still provide a lot of value to certain portfolios and investors. Here are a few advantages of junk bonds.

1. Higher Yield Potential

Because of the associated risk, junk bonds typically offer much higher interest rates than investment-grade bonds. These companies are struggling financially, so they offer high returns to find investors. Investors seeking income are often attracted to the potential payments, and some investors find that the risk is worth the reward

2. Diversification

Junk bonds can be a great way to diversify your portfolio. The performance of junk bonds doesn’t typically correlate to the trends of investment-grade bonds and other stocks. So they can help mitigate some risks within a portfolio. Having a mix of safe and high-risk investments can help create a portfolio that is seeking returns while also balancing out risk.

3. Potential for Capital Gains

Struggling companies hope to use capital from bonds to improve their business. And if they’re successful, the investor may see capital gains. If the company’s credit rating improves during the bond’s term, the value of that bond may increase. This factor could allow the investor to achieve capital gains in addition to their interest payments. 

4. Opportunity for Higher Total Returns 

Similarly, if the economy improves and the company’s default rates decrease, the investor could be getting attractive income as well as capital gains. These returns will be much higher than investment-grade bonds and can help investors get closer to their financial goals.

Cons of Investing in Junk Bonds

With the potential for high reward comes the chance of high risk. Here are a few drawbacks of junk bonds that investors should consider.

1. Higher Default Risk 

Companies that are issuing junk bonds often have lower credit ratings and are struggling. Otherwise, they wouldn’t need to issue bonds with attractive potential yields. These companies are much more likely to file for bankruptcy and default on their payments. If they do, investors will likely lose most, if not all, of their investment.

2. Increased Volatility

When a company is struggling,it is much more susceptible to movements in the macroeconomic environment. It may be impacted by inflation, rising interest rates and other factors. Because of susceptibility to these factors, junk bonds are volatile investments. Their prices could rise and fall unexpectedly without warning, increasing the risk to investors.

3. Limited Liquidity 

Bonds aren’t very liquid, and junk bonds are even less liquid. Once your capital is invested, you won’t regain the principal until the maturity period is up. Investors could try to sell them on the secondary market but may find it hard to find a buyer and could lose money this way. In times of market stress, finding a buyer will be especially difficult and may require high transaction costs.

4. Limited Access

Buying individual junk bonds can be difficult for investors. The junk bond market is typically dominated by institutional investors and financial institutions. However, investors could look for junk bond ETFs and funds that provide them exposure to the bonds purchased by investment firms.

High Risk, High Reward

Despite their high levels of risk, junk bonds can be a good investment for some investors. Investors should ensure their portfolio will be able to handle the associated risk. Investors also shouldn’t invest money that they’ll need back. The chance for high yields is tempting but should not be taken if investors can’t afford to lose that capital.If you’re wondering if junk bonds are an appropriate investment for you, then you should talk to an investment professional. With professional advice and thorough research, you can determine whether junk bonds will help you on your financial journey.

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