What is one disadvantage of junk bonds?
A. Junk bonds are difficult to purchase.
B. Junk bonds are government bonds.
C. Junk bonds are long-term bonds.
D. Junk bonds are high-risk bonds.
The correct answer and explanation is:
Correct Answer: D. Junk bonds are high-risk bonds.
Explanation:
Junk bonds, also known as high-yield bonds, are corporate bonds that carry a lower credit rating than investment-grade bonds. This lower rating, given by agencies like Moody’s or Standard & Poor’s, signals a higher risk of default, meaning there’s a greater chance the company that issued the bond might not be able to repay the principal or interest.
The main disadvantage of junk bonds lies in their high risk. Because they are issued by companies that are financially weaker, in distress, or have uncertain future prospects, investors must carefully evaluate whether the higher potential return is worth the extra risk. The companies may be startups, in highly competitive industries, or facing legal or financial challenges.
Investors are attracted to junk bonds because they offer higher interest rates than safer bonds to compensate for the risk. However, if the issuing company goes bankrupt or faces financial difficulties, the bondholder may lose part or all of their investment. This is especially problematic during economic downturns when risky companies are more likely to default.
Let’s evaluate the other choices:
- A. Junk bonds are difficult to purchase: This is incorrect. Junk bonds are traded in financial markets and are generally accessible to investors through brokers, mutual funds, or exchange-traded funds (ETFs).
- B. Junk bonds are government bonds: False. Junk bonds are corporate bonds, not government-issued. Government bonds are usually considered low-risk.
- C. Junk bonds are long-term bonds: Not necessarily. Junk bonds can have both short-term and long-term maturities. The risk comes from the creditworthiness of the issuer, not the duration.
In conclusion, the primary disadvantage of junk bonds is that they are high-risk investments, making D the correct answer.