A bond is really an IOU that confirms you have lent a sum of money to someone else due for repayment with interest.
Whether the bond is issued by a government, financial institution or a company does not really matter, they still work the same way.
To an investor, the bond rating is the key indicator about the credit status of the bond issuer.
Rating firm’s like Moody’s, Fitch and Standard & Poor’s look to assess that credit status by analysing the finances of the issuer. The more As and stars the issuer has, generally the better the rating and the higher chance you have of receiving your money back in full.
The rating system goes down to D – for defaulted bonds.
Bonds and yields
Investment-grade bonds have this top rating, but issuers judged to have a poor chance of meeting their obligation are non-investment grade or speculative.
The third grade are low-grade bonds that carry a high risk of default. On the markets, these are called ‘junk bonds’. – which will have a rating of BB or lower.
One of the best ways of telling a bond with a low grade besides the rating is the yield or interest rate. The higher the rate, the more risky the investment – which is why government bonds returning more than 6% interest are called high-yield bonds.
Just because the yield exceeds 6% does not make the bond junk, it’s the rating that determines this.
Investors specialise in high yield bonds and junk bonds because although the risk of default is high, so are the returns if the issuer does not default.
Pros and cons of junk bonds
A junk bond may still retain some value in default – called the default loss rate, which is not necessarily the same as the bond’s face value.
Junk bonds give investors the chance of obtaining higher yields than more highly rated bonds, but the downside is the risk of default and difficulty in selling.
As the bonds have shorter terms and higher yields, junk bonds trading on secondary markets are less affected by interest rates than the prices of most bonds.
Before buying, carefully analyse the credit and the industry of companies that are making high-yield bond issues. The truth is the company would not issue the bond at such a rate if cheaper finance was available elsewhere.