Junk bonds are risky investments, but if the buyer is lucky and there is no default, then there could be enough money to be made through high coupons.
By Sunil K. Parameswaran
One of the biggest risks for a bondholder is credit risk or the risk of default. This is the risk that the issuer will not pay the coupons on the due dates and / or that the nominal will not be repaid on the due date. Unlike other inherent risks, such as interest rate risk or inflation risk, default risk varies from issuer to issuer. Rating agencies rate securities.
To obtain a better rating, some issuers choose to have their obligations insured by an insurance company. The advantage is that these obligations are reviewed by two entities, in the sense that the due diligence process is followed by both the rating agency and the insurance company. A good grade makes borrowing easier and cheaper. In the case of an insured bond, the issuer will have to pay a premium to the insurance company. However, this can be passed on to investors in the form of lower coupons, if the insured status allows a better rating. Insurance is generally irrevocable. That is, if the rating agency were to downgrade the issue at a later date, the insurance company could not withdraw from its commitment.
Like rating agencies, insurance companies also look at factors such as the issuer’s asset base, the track record of sponsors, and available lines of credit. If an emergency line of credit is available to potential issuers, the chances of obtaining a better credit rating are higher. In the case of bonds issued to finance projects with a projected income stream, the uncertainty associated with obtaining the cash flow is a key factor. Standard industry practice in such cases is to reduce projected income and increase projected expenses and see if the project is still financially viable.
Quality bond issues are rated investment grade, meaning they are recommended for investment. Others, which present a greater risk of default, are called speculative or non-investment grade bonds or junk bonds. Junk bonds can be the original show of junk or fallen angels. Originally issued junk bonds are issued by entities with poor credit quality at the time of issuance. Deprecated angel investors are bonds that were once investment grade, but subsequently downgraded due to deterioration in credit quality. Thus, these bonds will be characterized by low coupons and high yields to maturity.
Junk bonds are risky investments, but if the buyer is lucky and there is no default, then there could be enough money to be made through high coupons. In the US market, investment banks have successfully marketed bonds such as high yield bonds.
In countries like the United States, investors can purchase insurance policies for their individual portfolios. That is, if a person owns 5,000 IBM bonds, they can acquire a policy for their portfolio, which insures them against the specter of default. The premium, in such cases, is directly payable by the bondholder.
Rating agencies have a pretty good track record. Analysis of 80 years of data in the United States shows that no AAA-rated bond defaulted in the first year after issuance, and less than 1% of those bonds defaulted in the 10 first years after issuance.
The author is CEO of Tarheel Consultancy Services
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