Pros/Cons of Junk Bonds as Interest Rates Rise

The attractive yields and diversification benefits come with plenty of risks

Featured Bonds

High-yield fixed-income investments, also known as "junk bonds," are a type of debt security that offers a higher yield than investment-grade bonds due to their higher risk of default.

In a rising rate environment – where interest rates are increasing – these investments can offer investors attractive advantages but also bring plenty of worrisome disadvantages.

Types of Bonds

Bonds are debt instruments that allow investors to loan money to corporations and governments. They come in two main types: investment-grade bonds and non-investment-grade bonds.

Moody's and Standard & Poor's are two of the world's most widely recognized credit rating agencies. These agencies issue credit ratings to companies based on their financial stability, creditworthiness, and ability to repay debt. Moody's rating ranges from Aaa (highest) to C (lowest), while Standard & Poor's rating ranges from AAA (highest) to D (lowest). Both agencies use a combination of qualitative and quantitative factors to determine a company's credit rating, including financial ratios, industry trends, and management quality. Companies with higher credit ratings are considered less risky and are, therefore, more likely to receive favorable interest rates and terms on loans and other forms of credit. Conversely, companies with lower credit ratings may have difficulty securing financing or may need to pay higher interest rates to compensate for the increased risk.

Moody's Investors Service considers anything rated from Ba1 or below and Standard & Poor includes BB and below to be considered speculative, non-investment grade, or, more commonly, junk bonds.

What Is a Junk Bond?

A junk bond has a credit rating below investment grade. This means that the issuer has a higher risk of defaulting, making it riskier for investors. The credit ratings agencies, such as Moody's and Standard & Poor's, determine the credit ratings of bonds based on the issuer's ability to repay the bond's principal and interest on time.

Junk bonds carry a higher risk than investment-grade bonds, resulting in a higher yield or interest rate to compensate for the added risk. This can appeal to investors seeking potentially higher returns and are open to taking on more risk.

Advantages of Junk Bonds As Rates Rise

As interest rates rise, investors may consider turning to junk bonds as a way to diversify their portfolio and potentially earn a higher yield. However, there are some advantages to investing in junk bonds as rates rise.

Higher Yield: Higher yield is a major advantage of junk bonds. As interest rates increase, the yields on junk bonds also tend to rise, making them an attractive option for investors seeking higher returns. This can be especially beneficial for those who are looking to generate income from their investments.

Diversification: By adding junk bonds to a portfolio, investors can diversify their holdings. Junk bonds are an asset class by themselves and tend to have lower correlations with other asset classes, such as stocks and traditional bonds, meaning that they may perform differently in different market conditions.

Inflation: Junk bonds can provide a hedge against inflation. As rates rise, inflation can also increase, eroding traditional bonds' value. However, junk bonds' higher yield can help offset the effects of inflation, making them a potentially valuable addition to a portfolio.

Capital Appreciation: On the other hand, high-yield bonds can also offer potential capital appreciation if interest rates begin to fall again. This is because when interest rates fall, bond prices rise, which can provide investors with a capital gain on their investment.

Disadvantages as Rates Rise

However, with the recent rise in interest rates, investors should be aware of the potential risks associated with high-yield bonds. It is important to carefully consider these risks before investing in high-yield bonds.

Higher Default Risk: High-yield fixed-income investments are considered riskier than investment-grade bonds, as they have a higher risk of default. This risk can be amplified in a rising rate environment, as companies may struggle to make their debt payments when interest rates are higher. Historically, the lowest-rated junk bonds have a default rate of almost 50%!

Interest Rate Risk: High-yield bonds are also susceptible to interest rate risk, which is the risk that bond prices will fall as interest rates rise. This can be a significant risk in a rising rate environment, as investors may experience a decline in the value of their investment.

Liquidity Risk: High-yield fixed-income investments can also be less liquid than other fixed-income securities. This is because they are typically issued by smaller, less-established companies that may not have as much demand for their bonds. In a rising rate environment, this can make it difficult for investors to sell their bonds (at their desired price) if they need to raise cash quickly.

Recession Risk: Recession risk is a major consideration when considering investing in junk bonds. As interest rates rise, the odds of a company defaulting on its debt may increase as its ability to service debt payments becomes strained. This puts investors at greater risk during a recession as the default rate of companies increases.

Credit Risk: As interest rates rise and the odds of defaults increase, companies also face the risk of downgraded credit ratings. When a company receives a lower credit rating, previously issued bonds lose value. The longer the maturity, the larger the losses on the outstanding bonds.

Your Financial Advisor

High-yield fixed-income investments can provide attractive yields and diversification benefits to your portfolio but also bring plenty of risks.

As such, investors should carefully consider their risk tolerance and investment goals before investing in these securities, especially in a rising rate environment.

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