Junk bonds are high-interest loans with unfavorable terms to offset high risk of default. They are rated BB or lower and are traded like commodities. Some companies manipulate their debt to receive a higher rating. Junk bonds are used in all sectors requiring significant capital and play a role in leveraged buyouts and hostile takeovers.
A junk bond is typically a high-interest loan with relatively unfavorable terms to offset a high risk of default. Junk bonds are a type of high-yield debt, and by far the most common.
Bonds are rated based on the borrower’s credit rating. In the United States, the main rating agencies are Fitch, Standard and Poor’s, and Moody’s. The rating scheme in descending order of value is: AAA, AA, A, BBB, BB, B, CCC, CC, C, D. Anything rated BB or lower is generally considered a junk bond because credit risk is so big .
In the modern economy, bonds are traded like any commodity. Investment companies try to maximize their profits by balancing the security of an investment against the cost of the bond in the market. Junk bonds are very attractive to some investment groups due to their low cost.
In some cases, the statutes of the group to which they belong, such as a company pension fund, may prohibit an investor from buying bonds rated below A or BB. This limitation makes the market for junk bonds considerably more limited than the market for highly rated bonds, commonly known as investment grade bonds.
Junk bonds are widely used in all sectors that require significant amounts of capital to operate. The telecommunications and energy sectors are two industries that make extensive use of junk bonds. It has recently come to light that several companies have manipulated the appearance of their debt to help them receive a higher rating on their bonds so that they can be more easily traded on the market.
Enron is probably the best-known example of a company distorting apparent debt so that its portfolio does not consist primarily of junk bonds. By hiding much of its debt off the book, Enron received higher ratings than it otherwise would have earned. WorldCom, similarly, was not initially rated as a junk bond company due to unfair accounting practices.
Junk bonds also play an important role in leveraged buyouts and hostile takeovers, allowing investment banking groups to raise large amounts of capital to use for the acquisition of a target corporation, paying the interest on junk bonds out of the flow. of cash from the newly acquired corporation.
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