What Is A Junk Bond?

By Alice Chen on June 1 2020 in Economics

Junk bonds are far riskier than other types of bonds. Image credit: picpedia.org
  • You can invest in gold
  • Bonds are commonly referred to as fixed income securities
  • Junk bonds are are bonds that carry a higher risk than normal bonds

The world of investing is made up of many different financial instruments. Those with money that they wish to see returns on have a variety of options when it comes to what they can put their money into. The various avenues of investment include gold, a commodity that goes up in times of scarcity; real estate, which can involve lots of property management but tends to be a stable resource especially in space-starved cities; and stocks, which are basically individual companies that you put money on in hopes of them performing well. Other potential areas to put your money into include mutual funds, which are managed funds that take the stress of decision making out of your hands, and, of course, bonds.

Fixed Income Securities

Bonds are fixed income securities. Photo by Precondo CA on Unsplash

Bonds, the focus of this article, are complex and hard to describe. Basically, they're fixed income securities provided by corporations, governments, and occasionally privately between borrowers and lenders. They're typically used when companies need to raise money to finance new projects. Investors can purchase bonds from these entities. Bonds come with terms of the loan, defined interest payments, and the time at which the loaned/invested funds will be paid back. The interest payments are received as part of the return for loaning money to the company. Basically, once the bond matures the face value, which typically is the amount invested, will be paid out to the bondholders. Meanwhile, before this maturity date, there are coupon dates wherein a certain percentage of the face value will be paid out on those set days and times as interest.   

Even for experts in the field, it can be hard to predict the performance of any of these types of investments, including bonds, and the return you can get back on them can vary greatly, so it's best not to put in more than you're willing to risk losing. This is especially true when it comes to junk bonds.

Junk Bonds

Junk bonds are riskier but offer a higher yield. Image credit: thecanadianencyclopedia.ca

Junk bonds operate essentially in the exact same way as normal bonds only they come with an increased risk. That risk comes in terms of the company issuing the bond. Basically, junk bonds are bonds for corporations that carry with them a much higher risk of defaulting than the average company or government. Defaulting is when an entity is unable to pay a debt, whether in interest or the actual amount. Because junk bonds are typically associated with companies that are struggling financially, there is an increased risk that interest payments and the eventual face-value payment will never be received. These bonds are typically defined as such by credit rating agencies who assign the related company a poor credit rating. Still, there is one advantage to these risky bonds and that's in the fact that they tend to pay a much higher yield, meaning that their interest payments are larger, if you ever receive them. Basically, a junk bond is a bond where the higher risk begets higher rewards for investors who are willing to take their chances. Whether you want to take the leap is a decision that is entirely up to you.  

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