The Disadvantages of Junk Bonds

by Tedra DeSue ; Updated July 27, 2017
Approach junk bonds with caution.

Junk bonds, which can be sold or traded by corporations and government entities, can be enticing to investors because of the higher yields they pay. However, investors considering them must be mindful of the disadvantages, which include losing the investment if the issuer of the bonds defaults. To avoid such pitfalls, thoroughly investigate the issuer of the bonds as well as the mechanics of how such bond deals work.

Issuers with Questionable Track Records

Junk bonds have below investment bond ratings from rating agencies because they are riskier credits. Their yields are higher because of this. For the investor, this means junk bonds receive higher interest rates.

Junk bonds are often issued by companies who have been stymied by a weak financial performance. That includes having a poor track record of sales and earnings, according to Standard & Poor's.

Municipalities do not issue junk bonds, but their bonds can be downgraded to that status if they have financial problems that could lead to a default.

Low Credit Ratings

Three major credit rating agencies that assign ratings to bond deals based on the issuer’s financial health are Fitch Ratings, Moody’s Investors Service and Standard & Poor’s.

Bonds are generally classified as being either investment grade or junk. Investment grade issuers have ratings that range from AAA, which is the best rating, to BBB from Fitch and Standard & Poor’s. Moody’s character system differs somewhat; it has investment grade ratings that range from Aaa to Baa.

Junk bonds have ratings from Fitch and Standard & Poor’s that go as low as D and Moody’s has ratings that sink as low as C.

Differences Between Investment Grade and Junk Bonds

Clifford G. Dow, a chartered financial analyst and certified financial planner for Dow Investment Group, notes that one of the main differences between investment grade and junk bonds is that investment grade bonds can usually be legally purchased by banks.

That is not the case for junk bonds.

Bank-held bonds are usually eligible for credit enhancements, such as letters of credit or insurance. Junk bonds are not eligible, which poses a disadvantage.

Unpredictability

The fact that junk bonds are highly volatile is another disadvantage. Also, in spite of promising higher returns, the party issuing the junk bonds can crash any time, which could set the stage for default on their outstanding bonds. That could lead to the bond buyer losing his entire investment.

Spread your risks by investing only a small percentage in junk bonds.

Stresses of High-Risk Investing

Investors don’t enjoy the same level of comfort from junk bond investments as they do from investment-grade ventures. This is frustrating and a point of stress.

About the Author

Tedra DeSue has more than 20 years of experience covering business news. She has worked for "The Bond Buyer," "Newsweek," "Business Week," "The Atlanta Journal Constitution" and "Creative Loafing." DeSue has worked as a volunteer for organizations throughout the metro Atlanta area, including Trees of Atlanta. She has a Bachelor of Arts degree from DePauw University.

Photo Credits

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