We are always told that investments can swing two ways - the good way, where you reap the benefits of your investment, and the bad way - where you make lesser than you invested, leaving you with lesser than you started out with. The key is determining how you choose what to invest in, and more importantly - what you invest in.

Bonds are touted as a safe investment option - ideal for risk-averse investors and for those who desire an alternative source of income - tapping into the bonds’ regular coupon payouts. But this narrative belongs almost exclusively to the investment-grade bonds that dominate the market - proving to be everybody’s first choice. Junk bonds or high yield bonds have poor credit ratings with steeply high returns. The catch is in their high rate of return which compensates for their volatility - making it a risky investment. Traditionally, novice investors are cautioned against such bonds, if their goal is to nurture their investments and stay put for the long haul.

The discourse around high yield bonds has been evolving - as is the demand for it. While a healthy chunk of the investing population still holds its reservations, junk bonds have cultivated their own niche brand of investors, who use their risky profiles to their advantage. The recent years have witnessed an increased demand for junk bonds, in the South Asian markets, especially in India. A report published by the Economic Times in 2019, finds that the junk bonds issued by Indian companies soared to a five year high - recording its peak, since 2014. Companies like Vedanta Resources and JSW Steel Ltd held big stakes in the total sales registered. The hike followed the move to relax offshore borrowing rules, ushering almost $3.7 billion in junk bond sales. Hot on its trail, despite the financial crisis brought on by the COVID 19 pandemic, Bloomberg Quint also reports that junk bonds will be imperative in accelerating growth in the South Asian markets, in 2021 - predicting a heavy cash infusion from the western markets.

While junk bonds get the reputation of being risky investments, they have also proven their worth in many dynamic investment situations. We don’t claim that junk bonds have been medically cleansed of quality instability but we’re pushing the envelope in saying that they are not evil. As an investor, it is prudent to weigh the merits of the options available to you - and sometimes, high yield bonds might just be what you need to fit into your investment plans.

In this article, we give you the lowdown on high yield bonds, detailing their pros and cons; allowing you to gauge if it makes the right fit for you.

HOW JUNK ARE JUNK BONDS: HIGH YIELD BONDS EXPLAINED

Before we dive deep for determining whether or not junk bonds are worth your time, it is essential to understand what it means, and how they function in the market. In understanding how high yield bonds function, one also inherits a more nuanced understanding of the bond market and its movements.

What is a High Yield Bond?

High Yield Bonds, also colloquially known as junk bonds are investment bonds that are issued by companies that have been credited with a BB rating, or lower - not ranking as high on the credit rating scale, as their investment-grade counterparts do. The reason behind why they are called high yield bonds is their often unrivalled rates of return - that is extremely rewarding if the bonds perform well. These bonds are able to offer such high returns only in a way of compensating for their volatility. Junk Bonds are evaluated and appraised by credit rating agencies, and their creditworthiness decides their ratings. Such bonds are often red-flagged with the high possibility of defaulting. Investors are compensated with high returns for taking the risk of investing in these bonds and the ratings are indicative of the issuer’s ability to pay investors back.

Types of High Yield Bonds

High Yield Bonds can be broadly classified into categories, depending on the bond’s nature, potential and merit. Titled somewhat dramatically, they are separated based on their market performances as well. They are, as follows -

• Fallen Angels: Fallen Angels are typically those high yielding bonds, that was once rated investment grade but had to be rated down, because of concerns around payability and the issuer’s ability to service their debt.
• Rising Stars: Quite opposite to the fallen angels, rising stars are those bonds who are new on the market - hence, don’t have much credibility to go off on, but show financial promise and potential. Their credit rating ranks low, because of their financial age and these could very well go on to be investment-grade bonds.

LAYING ALL THE CARDS ON THE TABLE: THE PROS AND CONS

As an investor, when you evaluate the risks of investing in securities you have to list down the advantages and the disadvantages that come along with the investment. High Yield Bonds have garnered more attention in recent years, becoming more and more availed by investors looking for quick gains. What we have here is a compiled list of all the pros and cons of investing in Junk Bonds, leaving you richer with the information you need to make your decision, keeping in mind your investment needs.

The Advantages of Investing in High Yield Bonds

• Higher Rate of Income: The most obvious benefit of investing in High Yield Bonds, is their payout. Their high rate of return promises a higher income, should the bond perform well. Typically, fixed income instruments are not able to offer such competitive coupon payouts.
• The Value of the Bond Could Appreciate: If the issuer company’s financial health and performance perseveres and gains momentum, that would mean that the value of your bond would also appreciate in the current market. This could mean a better price of your bond when you resell in the secondary market. This is often the case, with Rising Stars Bonds.
• Prioritized higher than Stock Payments: While junk bonds are a risky investment, they still outrank stockholders. In the advent of the company defaulting, when the money does come in - bondholders are given precedence over stockholders, meaning that if you held junk bonds of an issuer, in the event of that issuer’s default you will receive your due payment before the stockholders do.
• Unsuspecting Growth During Recession: While Junk Bond issuing companies could go under when a recession hits, quite often, some underdog companies also thrive. They may resist the impact of the recession and may witness a boom in their performances, during the economic downtime.

The Disadvantages of Investing in High Yield Bonds

• High Risk of Default: Risk-averse investors are better off without investing in such bonds, given the uncertainty that surrounds these bonds. The higher rate of return is promised only to cushion the blow, should the company default. Unlike investment-grade bonds, which have high ratings, and no risk of going under.
• Liquidity Issues: Because of the negative investor sentiments and their infamy that precedes them, Junk Bonds find fewer buyers in the secondary market, making it harder for them to pay back investors - owing to the lack of cash funds. This would tend to restrict investors from reselling their bonds, whenever they’d like, because of their payment limitations.
• Bond Prices are Sensitive to Credit Ratings: Especially valid in the cases of Fallen Angels Bonds, the prices of these bonds plummet when their creditworthiness goes down - resulting in a rating downgrade. If this is the case, the value of the bond will only further decrease in the secondary market.
• Not All Junk Bonds are Recession-Proof: While some bonds are better poised in the time of recession, it depends entirely on the quality of the company. Most Junk Bond issuing companies would buckle under the financial strain, going straight to defaulting at the hint of slightest trouble.

JUNK BONDS AND THEIR CLIENTELE

Before you reach a decision about whether or not to invest in a high yield bond, it would also be helpful to know who the target clientele usually is, for such kind of bonds. Big stakeholders also hold the power to influence the bond prices - helping them with hefty cash infusions. Knowing who your fellow investors are, can not only bolster your faith but also help you gauge if it is a worthwhile investment. Junk bonds are often favoured by the following investors:

• High Networth Individuals: High Networth Individuals often choose to invest in high yield bonds, cushioned by their already diverse portfolio. They can stand to sustain the loss and are in the market for risky investments with promising yields.
• Corporate Mutual Funds: While still largely cautious in their investment choices, Mutual Funds occasionally dip into the Junk Bonds pool, investing in bonds that they think show promise.
• Insurance Companies: In order to fund their large stream of annuities and payouts, Insurance Companies are regular junk bond investors - tapping into the high rate of returns.
• Pension Funds: Pension Funds have been known to place a small chunk of their earnings into Junk Bonds, to accelerate their income flow. Because of the nature of their business, their stakes are limited.

There is no end to the list of cautions investors have to pay heed to while making the decision to place their money in security, but having access to every kind of information is desirable. Junk Bonds could be a lucrative investment opportunity for those who can take the heat and withstand the market volatility it comes with, to reap the benefits of its returns. What it ultimately comes down to is weighing the merits of the bond, against one’s individual investment and portfolio requirements - assessing whether or not, they can bear the brunt of investing in high yield bonds. While credit ratings dictate investor sentiments, that is not all that ought to be taken into consideration. Aided with your own research and homework, go with a bond that your intuition guides you towards.