Junk Bonds are nothing but those bonds which have higher yields. These bonds are also called as High Yield Bonds. The risk of credit associated with such bonds are generally higher than the other bond types. The agencies which give credit ratings to the different types of bonds mark it with the rating of either BB or lower than that. This means that the investors who are are putting their money in the same are buying a speculative proposition rather than any asset of any assured return. The traditional investors don't get into it or don't include them in their investment portfolios because the threat of depletion of their funds always looms large on the portfolio. Thus, the credit agencies don't regard the Junk Bonds under the investment grade and are generally regarded as below that level. It is thus evident that the risks associated with the Junk Bonds are quite high and are considered speculative in nature. Thus, for holding the same the investors want a more lucrative compensation. Hence, it is generally seen that he interest rate or the Bond Yield associated with the Junk Bonds are much higher than any of the available bonds in the entire bond market. Many studies have been done on the calculation of the compensation package that have been offered by the issuers to the investors. All of them point towards a single thing and that is the compensation package offered to the investors for holding the Junk Bonds is much higher than the default risk factor associated with the same.
The Junk Bonds were earlier been issued due to the fall in the credit rating of the issuing corporate which meant that the financial health of he company is not good enough and the chances of it going bankrupt has increased. This phenomenon was seen up to the year of 1980. But from the early 1980s it was seen that new theories relating to the portfolio management are cropping up and is bringing sea change in the mind set of the issuers. It has been observed from the research that the returns associated with the Junk Bonds after adjusting them with the expected default risk is considerably high. This showed that the bond yields of the Junk Bonds are much higher than the credit risk related with them which means that the compensation package given by the Junk Bond issuers are much better than the real credit loss.
The reasons associated with the credit risks are not single but many and are mostly related to the performance of the issuing corporation in the previous days. It has been observed that the issuers of the Junk Bonds have been some of the biggest corporates namely, IBM and General Motors. At a certain point of their business journey these corporations too had a poor credit rating. In United States of America, the companies having a revenue of more than thirty five million dollars come under the poor credit rating and hence have to pay a higher compensation package to the investors of its bonds. It has also been observed that most of the companies in USA (almost 95%) having revenue more than the thirty five million dollar mark also have a credit rating equal to BB or below. Hence the bonds issued by them too come under the category of Junk Bonds. Thus the bond yield in case of such Junk Bonds are also quite higher. Some of the recent household names of the corporate sector such as the Duracell or Time Warner also have a poor credit rating and are able to issue only the Junk Bonds.
The most advantageous aspect associated with the Junk Bonds is that they can be purchased and squared in the secondary market at any time just like the stocks. They investors in this case don't need to lock their fund for long because these Junk Bonds can be bought and sold instantly.
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Professor of Economics & Director of the Earth Institute at Columbia University. Special Adviser to the UN Secretary-General on the Millennium Development Goals. Founder & co-President of the Millennium Promise Alliance.
CEO and co-CIO of PIMCO. Served as President and CEO of the Harvard Management Company for 2 years, while also working at the IMF for 15 years. In 2008, his book "When Markets Collide", won the Financial Times award for Business Book of The Year in addition to being named as the one of the best business books of all time by The Independent.
Vice President and Director of the Global Economy and Development Program at the Brookings Institution. Former Turkish Minister of State for Economic Affairs. Head of the United Nations Development Program (UNDP) from 2005-2009.