What are Junk Bonds?
Junk bonds have a long and storied history as they first made their appearance in the 1980s. A couple of popular names, Michael Milken and Drexel Burnham Lambert became synonymous with the high risk, high-reward investment vehicles. Milken’s junk bonds were often used to finance hostile takeovers and leveraged buyouts, but they also helped fund the growth of many companies. While the market and attractiveness for junk bonds has evolved since that time, they remain a popular investment for those seeking high yields.
It’s important to understand junk bonds, and how they function within the market. Junk bonds are simply bonds that are rated below investment grade, meaning that they have a higher risk of default.
They offer higher yields than investment-grade bonds to compensate for this risk. Junk bonds are often issued by companies that are struggling financially or are considered risky investments. They are also sometimes used to finance mergers and acquisitions or other corporate activities. Despite their higher risk, junk bonds can be a suitable option for some investors.
Why are Junk Bonds Risky?
Junk bonds are rated below investment grade, meaning they have a higher risk of default. This is primarily due to companies often struggling at the time of a junk bond investment. As a result of this, there is a higher likelihood that the company will default on the bond, meaning that investors may lose some of all of their investment.
They offer higher yields than investment-grade bonds to compensate for risks. Investors could potentially earn a higher return on their investment, but it also means that they are taking on more risk. Investors should be weighing the potential rewards against the potential risks before investing.
Junk bonds can be highly sensitive to changes in the economy or in the issuing company’s financial situation. Further, junk bonds may not trade as frequently as investment-grade bonds, which means you might have a harder time selling your bonds immediately or without taking a more substantial discount on the market price. This affects the liquidity of the bond, which can be problematic for some investors.
If the issuing company defaults on the bond, investors may lose some or all of their investment. Default is the failure to repay a debt including interest or principal on a loan or security. Junk bonds have a higher risk of default because of an uncertain revenue stream or a lack of sufficient collateral. The risk of bond defaults increases during economic downturns making these bottom level debts even riskier.
Investing in individual junk bonds is not for the average investor, but a junk bond fund can work for many investors, offering diversified exposure to them. Even still, before investing in junk bonds, it’s important to understand the risks and weigh them against the potential benefits. As always, conduct thorough research prior to investing to eliminate financial losses.
What the Pros of Junk Bonds?
Higher yields: Junk bonds are more volatile than other bonds, but you can expect to receive higher interest rates from them than their investment-grade counterparts. Higher yields refer to the amount of income that an investor can expect to earn back on their investment.
Cash flow: Junk bonds, like bonds generally, are a good way to provide consistent cash flow for your portfolio. Bonds generally are not as volatile as stocks, so you’re less likely to experience permanent losses.
Diversification: Bonds offer a way to diversify your portfolio away from just stocks, and they may perform differently in different market environments, potentially rising when stocks fall.
Who Invests in Junk Bonds?
As we’ve explored above, investors who are interested in high reward, high-risk investments are primarily interested in junk bonds. Further, Business Development Companies tend to invest in these Bonds due to their possible capacity to pay interest and repay principal. BDCs invest a large percentage in junk bonds. A Business Development Company (“BDC”) is a form of investment company that invests in small and mid-sized businesses. Investors can buy shares in a BDC, and the money from their investment is used to fund the businesses. In turn, investors can profit from dividends paid on their investments, or, in some cases, the sale of their shares.
In some cases, BDC’s such as the Corporate Capital Trust II fluctuate heavily with the use of junk bonds. It is important to understand the idea that Bonds may appreciate if an issuer improves. If a company is actively paying down its debt and improving its performance, the bond can appreciate in value as its issuing company’s rating improves. From the prospectus it appears that Corporate Capital Trust has a great deal of junk bond exposure:
The Decline of Junk Bonds
The junk bond market is shrinking in the new era of rising rates. The size of the US junk bond market is down 11% from the October 2021 peak, and firms are turning to loans, private credit, or skipping the market altogether. As recorded in the graph below, the junk bond market has been declining in recent years due to a number of factors. One of them being increased regulation, which has made it more difficult for companies to issue junk bonds.
Additionally, the overall economic environment has been relatively stable in recent years, which has reduced the demand for higher-yielding, riskier investments, like junk bonds. Lastly, the lower interest rate environment has made it more difficult for companies to offer attractive yields on their junk bonds, which has further reduced demand for these types of investments. As reported by Financial Times, the shrinking market is surely affecting the lives of junk bond investments. 
Junk Bonds Gone Bad
Continental Resources (NYSE: CLR) is a top 10 independent oil producer in the U.S. Lower 48 and a leader in America’s energy renaissance. Continental is exposed more than many of its peers to the price fluctuations as it famously canceled its oil hedges at the end of 2014, betting that prices would rise. However, these investments, otherwise known as junk bonds, only dropped further. Continental, which was founded by billionaire wildcatter Harold Hamm, posted a net loss of $139.7 million, or 38 cents per share, compared with a net profit of $114 million, or 41 cents per share, in the year-ago period.
According to a Bloomberg report, less than seven months after raising $175 million in a junk-bond offering, American Eagle Energy Corp. recently announced that it wouldn’t make its first interest payment on the debt. The oil and gas producer, which operates in North Dakota’s Bakken shale, has 30 days to make the $9.8 million interest payment before triggering a default on the 11 percent bonds due September 2019. American Eagle Energy’s shares have lost 96 percent since the bonds were issued in mid-August, closing at 20 cents in New York.
FINRA Arbitration – How Does it Work?
FINRA is a non governmental organization that regulates the securities industry in the United States. It is responsible for overseeing the activities of brokerage firms, and for enforcing rules and regulations related to the trading of securities.
Seeking restitution through FINRA arbitration can be a helpful process if you feel as though you’ve been defrauded. Once you’ve retained a securities fraud attorney, the process of filing a claim through FINRA could take place. This claim should include a description of the fraud, the amount of money lost, and any supporting documentation. Once the claim is filed, FINRA will appoint an arbitrator to hear the case.
The arbitrator is responsible for reviewing the evidence and making a decision about whether the investor is entitled to restitution. If the arbitrator rules in favor of the investor, they will issue an award for damages, and this can be used to seek restitution from the person or company that defrauded the investor.
FINRA is overseen by the Securities and Exchange Commission (SEC) and is authorized by Congress to protect U.S. investors from investment fraud by making sure the broker-dealer industry operates fairly and honestly.
The White Law Group – Free Consulation
The White Law Group, LLC is a national securities fraud, securities arbitration, investor protection, and securities regulation/compliance law firm with offices in Chicago, Illinois and Seattle Washington. The White Law Group has the expertise to help investors defrauded in securities, investment and financial business transactions.
