This is one of the riskiest investments out there. Your risk is much higher than equities, although the returns can be spectacular.
Junk bonds are the lower credit quality firms belonging to the real possibility of imminent bankruptcy. Do not confuse a junk bond with a high yield bond. The high-yield bonds are those issued by small and their risk is higher than that of government bonds or large companies but the possibility of bankruptcy is not imminent, at least publicly available information.
Suppose a company issues a bond to 1 year of 100 euros by offering a 10% interest. Under normal circumstances that bond can be sold in the market for a price of around 100 euros. On one side will affect the rise and fall of interest rates and on the other the time remaining to maturity. For example, the bond is issued on January 2 of year 1 and ending on January 2 of Year 2, when he returns the $ 100 capital and interest 10 for a total of 110 euros. On January 5 of Year 1 the bond will be priced close to $ 100 because almost no time has passed but as we get closer to January 2 of Year 2 the price will go closer and closer to 110 euros for date approaches to collect those 110 euros.
The problem arises when the company suspended payments and there is a real and imminent possibility to fail and when the January 2 of Year 2 the company promised to pay the 110 euros. In this situation, no one will pay a price around 100 euros for a bond at any time can be worth $ 0. So the price of the bond market is closer to 0 to 100 euros, depending on the situation in which the enterprise. Suppose that the bond quoted at 10 euros. The investor paid the 10 euros can be lost completely the next day but there is a possibility that is precisely what we should value the investor, the company will not go away and when the January 2 of Year 2 pay 110 euros promised. That would mean that the investor who bought the bond for 10 euros has increased its investment by 11 soon, and he paid 10 and get 110. It is even possible that the company goes bankrupt and liquidate its assets and pay the debt as possible with the money from investors receive 30 euros per bond, for example. For investors who bought the bonds for EUR 100 before the company fell from grace the loss is 70%, but you bought the bond money has multiplied 10 by 3.
Such investment is extremely risky and complicated. Not only should you know about economics but too of law because in these situations are as important or more. For example, not all bonds issued by companies are equal from a legal standpoint when it reaches the liquidation of the company and it may be that those with certain types receive 80 euros bonus while others charge only 20 euros and some nothing. The legal status of the company business is also crucial.
Many times these situations are more appropriate for investor’s lawyers or economists. And anyway the purely economic analysis is extremely complicated because you have such knowledge of the situation is usually only available to those who run the company or super-specialized investors in such situations.
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