What are junk bonds and why are they considered risky investments?

Junk bonds, also known as high-yield bonds, are fixed-income securities issued by companies or governments with a higher risk of default compared to investment-grade bonds. These bonds are considered risky investments due to several reasons:

1. Credit risk: Junk bonds are issued by entities with a lower credit rating, indicating a higher probability of default. These issuers may have a weak financial position, high debt levels, or a history of missed payments. As a result, investors face a higher risk of not receiving interest payments or principal repayment.

2. Higher interest rates: To compensate for the increased risk, junk bonds offer higher interest rates compared to investment-grade bonds. However, this also means that the issuer needs to pay a higher cost of borrowing. If interest rates rise, the issuer's debt servicing costs increase, potentially straining their financial position and increasing the risk of default.

3. Market volatility: Junk bonds are more sensitive to changes in market conditions and investor sentiment. During periods of economic uncertainty or financial market downturns, investors tend to become more risk-averse and demand higher returns for holding risky assets. This can lead to a decrease in the price of junk bonds, resulting in capital losses for investors who need to sell their holdings.

4. Limited liquidity: Junk bonds often have lower trading volumes and a smaller pool of potential buyers compared to investment-grade bonds. This limited liquidity can make it challenging for investors to sell their holdings at desired prices, especially during times of market stress. Illiquidity increases the risk of being unable to exit a position when needed, potentially leading to losses.

5. Subordination: In some cases, junk bonds may be subordinated to other debt obligations of the issuer. This means that in the event of bankruptcy or default, holders of higher-ranking debt, such as secured creditors or bondholders of higher priority, will be paid first. Junk bondholders are more likely to face losses or receive a smaller recovery in such situations.

6. Lack of information: Companies issuing junk bonds may have limited financial disclosure requirements compared to larger, more established entities. This lack of information can make it difficult for investors to assess the issuer's financial health and make informed investment decisions.

Overall, junk bonds are considered risky investments due to their higher default risk, sensitivity to market conditions, limited liquidity, subordination, higher interest rates, and potential lack of information. Investors seeking higher returns must carefully evaluate the creditworthiness of the issuer and consider the associated risks before investing in junk bonds.