Author : Konstantina Karatzoudi
Junk bonds are corporate bonds that are high-risk and high-return. They have been rated as not investment grade by Standard & Poor’s or Moody’s because the companies that issue these bonds are not economically sound. Therefore, they give higher return to compensate the higher risk, such as default risk, interest rate risk, economic risk and liquidity risk. So, why would investors invest in junk bonds? When cash deposits pay almost zero, investors are willing to take risks for hunting higher returns. But these bonds are much likelier to default. They have more similarities with stocks in their acting as their prices are closely tied to the corporations that issue them and their ability to service their debt. They are an attractive income stream to investors but if they are part of a diversified portfolio.
But what was their impact on the economic landscape? The economic conditions at the birth of this new market of high-yield debt offered the fertile ground to increased acceptance of junk bond at this time. The changing industrial structure stimulated the growth of a huge number of medium-sized companies whose lack of credit history prevented them from qualifying for investment grade bond ratings. Junk bonds were their opportunity to gain direct access to investors and had been provided a lower cost alternative to borrowing through financial intermediaries. At this time, junk bonds were a means that boosted the economy as it gave the opportunity to non-financially sound companies to have access to more cost-effective borrowing resources. This greatly expanded the use of high-yield debt in corporate finance and mergers and acquisitions which in turn boosted the leveraged buyout boom. Thus, high-yield bonds were extremely attractive as they had lower interest rates and greater liquidity.
So, the financial technology, including the use of non-investment-grade debt helped right than wrong. Many public and private markets started to replace banks and insurance companies as their main capital source. The results were extraordinary, as from 1970 to 2000 junk companies created 62 million net new jobs in America even as the large investment grade businesses contracted by 4 million employees. The growing flexibility of capital markets allowed many companies to recapitalize during the recent economic downturn proving that the capital structure plays a significant role.
But a pitfall to high-yield investing is that a poor economy and rising interest rates can worsen bonds’ yields, as there is inverse relationship between bond prices and interest rates. Therefore, the impacts that junk bonds can have depends highly on economic conditions.
References
Amadeo, K. (2016, April 2). What Are Junk Bonds? Pros, Cons, Ratings.
Carpenter, D. (2010, January 8). Junk bonds: Savvy investment or fool’s gold?
Merkel, S. (2016, June 29). Are High-Yield Bonds Too Risky?
Taggart, R., Jr. (1987) . The Growth of the ”Junk” Bond Market and Its Role in Financing Takeovers. The National Bureau of Economic Research. University of Chicago Press.
The Economist (2013, October 19). High-yield bonds. An appetite for junk.
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