discussion

If you have poor credit due to being delinquent on credit card debt or other issues, chances are the bank is going to charge you a higher interest rate on a personal loan, or it might not give you a loan at all. Corporations face the same problems. If a company takes on too much debt or is otherwise considered to be a credit risk, then it also gets low credit ratings. In this case, if it wants to take on more debt it needs to issue what is known as “junk bonds,” or as corporations prefer to call them, “high-yield bonds.”

Whatever you call these types of bonds, their key feature is that they pay higher interest than bonds from a corporation that has a high credit rating. If you have a 401(k) or other retirement investment fund, chances are you have the option to make a portion of your investment in these higher risk/higher return bonds.

Do some research on junk bonds. What kind of controversies do you see with them? Do you think they are a solid investment for your retirement, perhaps no riskier than most investments? Or do they deserve the derogatory term “junk”? Share the links to the articles you find with your classmates, and discuss your opinions as to whether you think the higher interest rate justifies the increased risk.

Response 1

Hello

Class,

A junk bond is the same as a regular bond, but the only difference is the credit quality of the issuer. Bonds are categorized as investment-grade bonds and junk bonds. Junk bonds are typically rated as BB, Ba, B, Caa Ca, CCC, CC, or D by Standard & Poor’s or Moody’s. According to Chen (2020), Junk bonds are issued by companies that are struggling financially and at high risk of defaulting or not paying interest payments and/or the principal to their investors. As we know, junk bonds are also referred to as high-yield bonds. This is so because the higher yields help to compensate for any risk of default. Some companies are willing to pay high returns because they need to attract investors to fund their operations. Moreover, active junk bond markets can indicate an overbought market meaning that investors are too complacent with risk and may lead to market downturns (Chen, 2020).

Junk bonds can be valuable investments, but certainly not for my retirement fund. It is a very risky investment, and I’m not sure if I’m going to receive my principal and interest payments. Indeed, junk bonds are at higher default risk than most bonds with better credit ratings (Chen, 2020). I would therefore lose all my hard-earned money if the company defaulted, which would definitely upset me. Overall, I do not believe that the higher interest rate justifies an increase in risk due to the uncertainty that investors will get repaid.

Chen, James. Oct 26 2020.

 

Junk Bond. Investopedia. 

https://www.investopedia.com/terms/j/junkbond.asp#:~:text=A%20junk%20bond%20is%20debt,a%20credit%20event%20are%20higher

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Response 2

Class,

            Hall  (2020) states that a junk bond, or high-yield bond, is nothing more than a corporate bond that is issued by a company who does not have an “investment-grade credit rating” and seeks to entice investors by way of paying high interest rates despite an increased risk.  The risk associated with the company and subsequent bond is derived by the potential for said company to default due to their financial instability (Kelly, 2020).  Chen (2020) breaks down junk bonds by in a very elementary manner by way of their advantages and disadvantages:

Pros: greater returns, potential for significant increase based on improved company health

Cons: greater risk, continuous volatility

 

Furthermore, these same bonds can be used as an analytical tool in that investors are said to dump their junk bonds in a risk aversion tactic indicating skepticism about the state of the economy (Amadeo, 2020).

 

So why are they these bonds shunned?  Does their name really do them justice? An interesting note is that these high risk companies who are said to likely default on these bonds are no more risky to one’s portfolio than investing in some high risk stock in that a company is obligated to payout bondholders prior to shareholders getting any compensation (Hall, 2020).  The aura and reputation that surrounds junk bonds I feel to be perception based as every investor is operating within their own world with regard to their personal stance on risk, their engagement and interaction with the market, and of course their financial goals and desired end state.  Naturally most would want an investment that sees growth but that growth is defined further by way of time and of course scale. 

In the context of retirement, an individual portfolio should be postured for the long run with an air of security (Roth, 2020).  Ell (2019) explains that to add stability to your investments, on is better served to focus on quality first siting those with ratings of A or above.  Again this all comes down to the persona of said investor and various factors that go into what to do with their hard earned dollar.

References

Amadeo, K. (2020, December 21). Junk bonds, pros, cons, and ratings. The Balance. Retrieved December 28, 2020, from https://www.thebalance.com/what-are-junk-bonds-pros-cons-ratings-3305606

Chen, J. (2020, October 26). Junk bond. Investopedia. Retrieved December 28, 2020, from https://www.investopedia.com/terms/j/junkbond.asp

Ell, L. (2019, March 5). Junk bond funds don’t belong in long-term portfolios. Kiplinger. Retrieved December 28, 2020, from https://www.kiplinger.com/article/investing/t047-c032-s014-junk-bonds-don-t-belong-in-long-term-portfolios.html

Hall, J. (2020, August 12). What are junk bonds? The Motley Fool. Retrieved December 28, 2020, from https://www.fool.com/investing/how-to-invest/bonds/junk-bonds/

Kelly, R. C. (2020, December 23). Everything you need to know about junk bonds. Investopedia. Retrieved December 28, 2020, from https://www.investopedia.com/articles/02/052202.asp

Roth, A. (2020, August 20). Investing to create retirement income can be dangerous. AARP. Retrieved December 28, 2020, from https://www.aarp.org/money/investing/info-2020/retirement-income-risks.html

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LEVERAGE, CAPITAL STRUCTURE, AND DIVIDEND POLICY

Required Reading

Please read through the following book chapters. Pay special attention to the concepts of operating leverage, financial leverage, business vs. financial risks, and the major theories of capital structure choices.

Vishwanath, S. (2007). Chapter 19: Optimal capital structure. Corporate finance: Theory and practice. SAGE Publications India. Available in the Trident Online Library.

Finally, take a look at the following book chapter on dividend policy. Take a close look at the concepts of regular dividend policy and low-regular-and-extra dividend policy, as well as stock splits and stock repurchases:

Clive, M. (2012). Chapter 15: Dividend policy. Financial management for non-financial managers. Kogan Page. Available in the Trident Online Library.