What are junk bonds and should you invest in them?

Junk bonds (high-yield bond, non-investment-grade bond, speculative-grade bond, junk bond) are speculative securities with an extremely low credit rating. They are characterized by a negative financial reputation and high risks. However, this is a highly profitable instrument, trading in which allows you to get big profits. Bonds are issued at high interest rates, attracting entrepreneurs who want to buy out their companies that are about to fail.
Investors choose this instrument because of its high yield compared to traditional securities. Profitability on safe bonds is guaranteed to be 10% per year. While the yield on junk securities can reach 200%, however, the likelihood that the issuer will repay its debts is extremely small.

Despite this, there is a category of investors who invest in this highly risky instrument. Junk bonds are issued by companies with a low reputation in order to quickly raise working capital for doing business or paying off debts. In addition, they are issued during takeovers of enterprises to replace money for investors.

How the history of the junk bond market began

The history of the junk bond market began in the 1970s. Michael Milken was engaged in analytical studies of securities that do not have a rating. He was able to prove that the formation of a diversified portfolio of low-grade bonds in the long run, brings more profit in comparison with instruments with a high rating. However, in this case, the probability of default increases significantly. Michael Milken identified the cyclicality of the market, which consists in periodic declines in reliable securities, it is at this time that the rise of junk bonds begins.
There are several types of such papers:

• fallen angels – firms that previously had a high rating, but now faced with certain difficulties;
• rising stars – start-up companies with small assets and insufficient financial stability, which have a low rating;
• High-debt companies are practically bankrupt or actually acquired firms with huge debts;
• Capital-intensive companies are firms that have insufficient capital or enterprises that are unable to obtain loans, as well as those wishing to attract investors from among individuals and legal entities.

How to invest in junk bonds

Before investing in this instrument, it is necessary to calculate how expedient it is and analyze the existing risks. Initially, the market is analyzed to study the history of the issuing companies. Market research is carried out to get an idea of ​​the current economic activity and other factors affecting the solvency of firms. You will need to take care of the diversification of investments and buy securities of several issuers. Based on the analysis carried out, a long-term forecast of interest rates and the dynamics of their change is carried out. The profitability of the instrument and its behavior in the market is characterized by a number of features:

• active use of debt obligations in the market with their real yield exceeding the profit on rating assets;
• an increase or decrease in the interest rate does not affect the price of the instrument, which cannot be said about ordinary debt obligations. This is due to the insignificant terms to the maturity period and the high profitability of the asset;
• profitability on junk bonds directly depends on the situation in the economy.

The behavior of these assets is comparable to the dynamics of shares, since their profitability depends on the stability of the issuer’s condition and its strengths. If the economy enters a recession, the price of junk paper drops significantly, as the issuer’s earnings decrease. If the yield of the company increases, then the value of the bonds increases significantly. The stability of the economy in the state reduces the risks of working with debt obligations. High-yield bonds (HDO), history of formation, current state, is it worth investing in junk bonds and how not to lose money, junk bond market in Russia: https://youtu.be/j8FsQKE2l84

How to choose an issuer

Investors recommend investing no more than a quarter of your savings in junk bonds. To reduce risks, the share of one issuer in the portfolio should not exceed 5%. Experienced investors rarely invest more than 10% of their available funds in this type of assets. When choosing bonds for purchase, it is necessary to study the activities of the issuer, in particular, to find out if he has other securities and debt obligations. They pay attention to the public debts of the company and the total debt burden, which determines the possibility of on-lending in a situation with an increase in the risk of default. They also take into account the prospects of the business with which the enterprise is connected. The prospects of a business idea will most likely help the company pay off creditors.
To reduce risks, you need to invest in bonds issued by companies operating in the real sector of the economy. They own production assets and generate financial flows. It is recommended to refrain from assets pledged for loans. This is important because the worst-case scenario simplifies the procedure for negotiating loan restructuring. Experts recommend refraining from investing in junk bonds of IT companies, as their debt obligations exceed the amount of assets they have on their balance sheets. When investing in junk bonds, foreign issuers should prioritize high-yield bond indices. This will make it possible to better diversify the portfolio and minimize the risks caused by the issuer’s probable default. Is it worth investing in junk bonds and what is the yield of junk bonds: https://youtu.be/4Rfas4RGSEM Investors around the world prefer junk bonds, as high-rated instruments do not allow you to count on high returns. For example, ten-year US Treasury bonds give an annual return of only 2.1%. And the average profitability of US junk bonds reaches 5.8% per year.