Junk bonds (a.k.a. high-yield bonds) refer to debts that have been given a credit rating below investment grade. This means junk bonds often come with a high risk of default but also have the potential to yield high returns.
In other words, you either hit gold with a high-yield bond…or collect junk (hence the name).
The junk bond market alone stands at $1.2 trillion, according to a MarketWatch report in April 2020. For a point of comparison, the municipal bond market comes in at $3.8 billion.
In this article, the Zero Theft Movement will provide a thorough explanation of junk bonds. We will also explore the part they played in some of the major financial crises in recent history.
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What is a Junk Bond?
For those of you who don’t know, bonds are fixed-income debt instruments. Individuals, corporations, and governments essentially receive capital, which they must repay over time.
In other words, they’re an IOU from a business or corporation, featuring three components:
- The principal: how much the business will payback
- The maturity date: when it will pay the debt back
- The coupon: the amount of interest on the original debt it will pay
EXAMPLE
A bond that has a 10% annual coupon rate means that an investor who buys the bond makes 10% annually. So, a bond with a $1,000 face value will receive 10% x $1,000 which comes to $100 each year until the bond reaches its maturity date.
High-Yield Bonds and Bond Ratings
Junk bonds, as we briefly explained above, is a high-risk, high-reward type of bond.
Investment-grade and high-yield bonds mainly differ in the credit status of the issuer (the borrower). Issuers with poor credit ratings often do not have investment-grade bonds as an option; they have to take high-risk options—junk bonds being one of them.
| Moody’s Bond Rating | Standard and Poor’s Bond Rating | Grade | Risk |
|---|---|---|---|
| Aaa | AAA | Investment | Lowest risk |
| Aa | AA | Investment | Low risk |
| A | A | Investment | Low risk |
| Baa | BBB | Investment | Medium risk |
| Ba, B | BB, B | Junk | High risk |
| Caa/Ca/C | CCC/CC/C | Junk | Highest risk |
| C | D | Junk | In default |
Advantages and Disadvantages
| + Advantages | - Disadvantages |
|---|---|
| Junk bonds have the potential to bring in higher returns than most fixed-income debt securities. | Junk bonds have a higher risk of default than most other bonds. |
| High-yield bonds have the potential of considerable price increases if the company's financial situation improves. | High-yield bond prices can fluctuate considerably due to the issuer's uncertain financial performance. |
| Junk bonds can be a gauge of when investors are taking or avoiding risks. | Active junk bond markets can indicate an overbought market and an eventual downturn (investors being complacent/risk averse. |
Fallen Angels and Rising Stars
In the 1970s and 80s, the junk bond market experienced a boom. That growth came about due to ‘fallen-angel companies.’ Fallen angels were issuing investment-grade bonds before their credit ratings plummeted to borderline junk grade (BBB).
These junk bonds, primarily in the 80s, appealed to many. They were used to fund leveraged buyouts (LBOs), and as a business financing mechanism through mergers. The latter gained popularity rapidly and soon became common practice. Issuers and investors of all sorts began to use the speculative bond market as a business financing mechanism.
Junk bonds usually come in two forms:
- Fallen Angels – A bond that was once investment grade but has since dropped to junk-bond status due to the issuer’s poor credit quality.
- Rising Stars – A bond with a rating that has increased because the issuer has improved its credit quality. A rising star can still have a junk grade as long as it is trending towards investment quality.
According to the Tax Policy Center, “The corporate income tax raised $230.2 billion in fiscal 2019, accounting for 6.6 percent of total federal revenue, down from 9 percent in 2017.” Do you think corporations are getting away with paying a small percentage of the government’s total tax revenue?
Junk Bond Market Collapses
The bond market has experienced three major collapses in the past four decades: the Savings & Loan Crisis in the 80s, the ‘Dot Com’ crash in the early 2000s, and the Financial Crisis in 2007-2009.
The Savings & Loan Crisis
With the astronomic rise of high-yield bonds in the 80s came serious problems—namely, the Savings & Loan Crisis (S&L Crisis). For those of you who don’t know, savings and loan associations are financial institutions that specialize in helping individuals get residential mortgages.
According to the Federal Reserve, the direct cost of the S&L bailout came out to be around $124 billion. The cost of bailing out the Federal Savings and Loan Insurance Corporation (FSLIC), which insured the deposits in failed S&Ls, may eventually exceed $160 billion.
S&Ls essentially over-invested in higher-yielding corporate bonds, resulting in a precipitous drop in the performance of junk bonds. In a matter of 24 hours, new junk bonds disappeared from the market and did not rebound for close to a year. Investors lost a net 4.4% on the high-yield market in 1990 The junk market had not returned negative results in over a decade.
That being said, the Library of Economics and Liberty argue that junk bonds actually played a relatively inconsequential role in the S&L Crisis.
“
A GAO report issued just five months before the passage of FIRREA [Financial Institutions Reform, Recovery, and Enforcement Act of 1989] cited a study by a reputable research group that showed junk bonds to be the second most profitable asset (after credit cards) that S&Ls held in the 1980s. The report also pointed out that only 5 percent of S&Ls owned any junk bonds at all. Total junk-bond holdings of all S&Ls amounted to only 1.2 percent of their total financial assets. Even so, Congress mandated in FIRREA that all S&Ls sell their junk-bond investments—which they did, often at a significant loss.
The “Dot Com” Crash of 2000-2002
Many companies that had financed themselves with high-yield bonds during the “dot-com” boom of the late 1990s failed as the new millennium arrived. With the failures of those companies, the junk bond market experienced a collapse, completely tanking net returns.
The crash itself has often been attributed to idealism. The dream of massive profits seemingly guaranteed by the global reach of the Internet enchanted many. Simply put, investors pumped their money into speculations and ideas, not concrete plans.
After the bubble burst, investors plummeted back down and quickly shifted their investments back to more solid choices in the high-yield bond market. The recovery proved swift. The following is the financial data from Investopedia that shows the bounce-back of the junk bond market:
“
During 2000-2002, the default average for the market was 9.2%, nearly four times higher than the period of 1992-1999. During this period, the average total return rate dipped as low as 0% with 2002 setting the record number of defaults and bankruptcies before these numbers fell again in 2003.
The Financial Crisis of 2007-2009
During the subprime mortgage crisis, junk bonds lost as much as 18% in the fourth quarter of 2008. Many viewed high-yield bonds as ‘toxic assets,’ one of the major contributing factors in the near-total collapse of the economy.
Subprime or high-yield assets were being sold as AAA-rated bonds (investment grade with the lowest risk). When the crisis occurred, junk bond yield prices dropped, causing their yields to shoot up. The yield-to-maturity (YTM) for junk bonds increased by over 20% during this period.
A record-setting high had been reached for junk bond defaults, with the average market rate reaching 13.4% by Q3 of 2009.
Eradicate the Rigged Layer with the Zero Theft Movement
Since the rise of the junk bond market, the U.S. economy has experienced massive dips in performance. Junk bonds, at least in some cases, seem to have majorly contributed to the economic crises we have experienced.
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