If an entity is at a heightened risk of defaulting, who is lining up to buy those junk bonds? What’s the benefit? From vantage point, purchasing junk bonds holds much more downside risk than there are upside. So, what’s the point of purchasing these bonds?
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There is more downside, which is why the borrower has to pay higher yields/interest to attract lenders. If they *don’t* default, then the lender makes bigger profits.
In reality, people with a lot of money to invest choose a mixture of safer and riskier investments, and they often try and set some of the risks off against each other. For example, suppose you think that two industries are going to be negatively correlated with each other – when one makes a lot of money, the other one doesn’t. If that’s the case, then making risky investments across both industries works out a bit like making a safer investment, since it’s unlikely that both industries will do poorly.
There is more downside, which is why the borrower has to pay higher yields/interest to attract lenders. If they *don’t* default, then the lender makes bigger profits.
In reality, people with a lot of money to invest choose a mixture of safer and riskier investments, and they often try and set some of the risks off against each other. For example, suppose you think that two industries are going to be negatively correlated with each other – when one makes a lot of money, the other one doesn’t. If that’s the case, then making risky investments across both industries works out a bit like making a safer investment, since it’s unlikely that both industries will do poorly.
Two general reasons:
1) Junk bonds give better returns. For example, US bonds (which are VERY safe) give about 5% – so if I loan them $100, I get $105 a year later. In order for me to get the same expected value from a company that has a 50% chance of failing before they pay me back, I need to get back $210 – a 110% loan. While that’s probably not realistic; that does give an idea why you might want them: if you’re willing to take the risk, they can be worth it.
2) The person or company owes you. If they fail to pay you back, you (at least in theory) get something from them. For this reason, some times people will loan money to a failing organization with the goal of getting something that organization has – intellectual property (patents, copyrights, and occasionally even trademarks), equipment, land ownership, or so on.
Two general reasons:
1) Junk bonds give better returns. For example, US bonds (which are VERY safe) give about 5% – so if I loan them $100, I get $105 a year later. In order for me to get the same expected value from a company that has a 50% chance of failing before they pay me back, I need to get back $210 – a 110% loan. While that’s probably not realistic; that does give an idea why you might want them: if you’re willing to take the risk, they can be worth it.
2) The person or company owes you. If they fail to pay you back, you (at least in theory) get something from them. For this reason, some times people will loan money to a failing organization with the goal of getting something that organization has – intellectual property (patents, copyrights, and occasionally even trademarks), equipment, land ownership, or so on.
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