Junk bond is a colloquial investing term for non-investment grade bonds.
These bonds carry a rating or BB or less from Standard & Poor’s or Ba and below from Moody’s. Junk bonds typically offer a higher yield as compensation for their higher default risk. Otherwise there is no fundamental difference between a junk bond and any other standard bond.
Bond Credit Ratings
The factor that differentiates a junk bond from any other bond is its credit rating. Credit ratings are given by independent credit rating agencies that evaluate the ability of the issuing company to make interest and principal payments, as well as the value of any assets that are pledged as collateral.
It would be extremely difficult for most investors, even large institutional ones, to evaluate the creditworthiness of individual bond issuers, so these ratings are taken very seriously.
That said, much of the speculation in the bond market is based on the prospect that one or more aspects of a bond’s credit rating are wrong or will change, thereby leading to a higher credit rating and a higher trading value of the bond.
Junk Bonds in the Market
Most of the time junk bonds behave much the same as any other bond in the market. Although junk bonds have a higher risk of default, defaults are still generally rare events, and most of the time junk bonds are simply bonds with higher yields and more volatile prices.
The junk bond market is, however, one of the first areas to be affected by economic downturns, and junk bonds suffer more than most other assets during hard economic times.
The market for junk bonds and emerging market (EM) bonds are often considered to be bellwethers for the health of the overall domestic and global economy respectively.
Trading and Junk Bonds
Junk bonds are an often overlooked area of the markets where day traders have a significant chance of finding profitable trades.
Junk bond prices can be highly volatile, particularly around relevant news releases or periodic credit rating revisions.
The price action surrounding these events follows many of the same technical patterns that are observed in the equity markets, so day traders with equity experience are well-positioned to find profitable trades in the market for junk bonds.
Junk bonds, like most bonds, generally feature a fixed interest rate payment, which will influence the price action of the bond more than with lower-yielding bonds or in the case of the shares of dividend-paying companies, and day traders should be aware of this dynamic when they trade in junk bonds.
Junk Bond and Vulture Funds
Vulture funds, professionally knows as distressed-debt funds, specialize in trading junk bonds.
These funds look for junk bonds that are low in value due to either an existing default or the threat of default in the hopes of achieving significant returns if the bond issuer can manage to exit default successfully or negotiate a generous settlement with bondholders.
Vulture funds are often able to buy junk bonds for pennies on the dollar, which means that even small absolute increases in the price of the bond can mean significant returns on their investment.
Vulture funds often engage in lengthy and costly legal battles with bond issuers and other bondholders in an attempt to force settlements that are to their advantage.
Day traders can find very profitable trades by tracking the activities of vulture funds and creating positions that stand to profit from certain outcomes of vulture fund activity.
Despite their ominous name junk bonds are commonly traded securities that are held by many conservative investment vehicles, such as pension funds and bond funds. Investors who purchase junk bonds are merely taking on a higher degree of default risk in exchange for significantly higher yields.
The volatility and responsiveness to news and other events of the junk bond market make it an ideal trading area for day traders who can handle the small amount of math involved in bond pricing, particularly around the issues of interest and principal repayment dates.
Otherwise the price action in the junk bond market is very similar to that seen in the market for popular equities, and an ideal place for applying classic technical analysis techniques.