11 October 2023
In recent days, the Japanese authorities have begun to clear the way for a rebirth of the Japanese junk bond market. Currently, companies rely on a small number of banks to fund their expansion with minimal, if any, activity in the junk bond market. However, times will change, but what are the attractions of the junk bond market?
Popular in the 1980s, a junk bond is a speculative grade bond with a high yield due to the increased risk of potential default. When looking at credit ratings, A's and B's are classified as investment-grade bonds, but anything below this level is deemed speculative, non-investment, or simply junk.
As the Japanese junk bond market has been relatively quiet over the last decade, if we look at the US junk bond market, these bonds have a yield of between 4% and 6% above investment-grade bonds. Those of an exceptionally high risk will offer an even higher yield, but this gives you an idea of the differential between investment-grade and junk bonds.
Despite using the term "junk" to describe high-yield bonds, a recent S&P Global Ratings report found that the default rate was just 5.5% in 2020. While this is not good compared to investment-grade bond defaults of 0%, it gives you a basis on which to consider junk bonds.
If the company's underlying performance were to improve, this could lead to a upgrade in the bond credit rating and an uplift in the bond price. This would lead to capital appreciation for bondholders as the risk is reduced, with the yield falling to reflect this.
In theory, bondholders are repaid before equity investors if the company were to go under. How much they would be repaid will vary significantly, but they will be ahead of equity investors if any funds are left.
Cons of junk bonds:-
As mentioned above, the default rate for junk bonds is significantly higher than investment-grade bonds. Consequently, those looking towards junk bonds must go in with their eyes wide open - their capital is at risk.
You will often find large spreads on junk bond quotes because many financial institutions will not/cannot invest in such high-risk instruments. Therefore, a relatively large buyer or seller could significantly impact the bond price.
If a company was struggling and the credit rating was downgraded even further, this would impact the price and the yield of the junk bonds. The price would fall, the yield would rise, and there would be an even greater level of risk associated with the investment.
As we wait for the Japanese junk bond market to reignite, it is worth noting that we have seen some high-profile junk bond issues in the US over the last couple of years. For example, Coinbase, the cryptocurrency exchange, raised $2 billion in 2021, and shoemaker Crocs raised $350 million in August 2021.
While the term "junk" should be a warning sign for any investor, some investors choose to enter the market via bond funds specialising in high-yielding junk bonds. Interesting, but certainly not for everybody!Back to News