Governments and corporations borrow money in the form of loans known as bonds. Like most borrowers, bond issuers have to pay interest on the debt. Creditors that lend money to high risk borrowers face a higher degree of principal risk than creditors that lend to low risk borrowers. These risk levels impact interest rates.
Risk Versus Reward
Every debt agreement involves a creditor and a debtor. The debtor views the loan as a liability while the creditor views the same debt as an asset. The interest rates on bonds are often set at auction. Potential investors have the opportunity to review financial information about the bond issuers. A corporation with healthy profits has a better chance of repaying a debt than a corporation that reports an annual loss. If both entities issued bonds with the same interest rates, everyone would buy bonds issued by the healthy firm and no one would buy bonds issued by the struggling firm. If the struggling firm issues higher yield bonds, then investors willingly take on risk in exchange for higher potential rewards.
In the United States, Moody's, Standard and Poor's and Fitch issue credit ratings on bonds and bond issuers. These agencies attempt to predict the chances of a bond issuer defaulting on a particular debt. Bonds tied to seemingly unprofitable ventures may expose investors to higher levels of risk than bonds backed by necessary projects like hospitals --- such bonds receive low credit ratings. Each rating agency has its own credit scoring system, but high-risk bonds are classified as non-investment grade bonds and receive low ratings. Investors commonly refer to these low-grade high-yield bonds as junk bonds.
You can sell most types of bonds on the secondary market to other investors. If you hold a bond to maturity, the bond issuer provides you with a return of premium, but when you sell a bond mid-term you must agree on a sale price with another investor. If interest rates have fallen, you can sometimes sell bonds for a premium. The opposite occurs when interest rates rise. The price you pay for a bond has no impact on the yield and many junk bond investors aggressively buy high-risk bonds when interest rates begin to fall. If you buy a $10,000 bond that pays 5 percent interest, and you buy it at a 50 percent discount to par value, then you effectively get a 10 percent yield on your investment.
Interest Rate Risk
High-yield bonds expose you to high-levels of default risk but people who buy junk bonds are less likely to face inflation risk than people who buy low-risk bonds. When inflation causes prices to rise, people on fixed incomes have reduced spending power even though their income level remains the same. Conservative investors who buy low-yield bonds may succumb to the effects of inflation whereas the high-yields paid on junk bonds often outpace inflation.
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