Tesla Motors Inc. is the electric car company owned by Elon Musk, the world’s richest man. The once youngest publicly traded U.S automaker has tapped the debt market with below Investment Grade Index from the Credit Rating Agencies.

A valid question one might ask is: Why would such a global brand be rated junk or non-investable? According to the Credit Raters, Tesla has maintained a junk credit rating because of ‘’considerable uncertainty” about its long-term prospect. It was further revealed that Tesla has a smaller scale relative to peers, a narrower product focus and limited demand for its products.

Despite the junk rating, Tesla was still able to raise about $2.3 billion by selling convertible debt to fund its battery factory in 2014.

So, what is it with junk bonds?  A junk bond is debt, known as corporate debt, issued by a company that does not have an Investment-Grade rating (below BBB).  Junk bonds are also known as high-yield bonds because the interest payments are higher than the average corporate bond. Companies that issue junk bonds pay these high-interest rates to entice investors to take on the higher risk of lending them money.

Typically, they are issued by a company seeking to raise capital quickly to finance a takeover, restructuring or project. They involve a bit more risk than the highest-rated bonds but make up for it with higher interest rates.

Credit Rating Agencies (CRAs) are often inclined to issue the junk rating grade when there are doubts or considerable uncertainties about the long-term prospects of the bond instrument or the Issuer. However, a company rated junk may not always remain at that position as circumstances may improve its credit rating, causing the value of the junk bond to rise so investors could sell and earn a profit before the bond matures.

Bonds issued with lower than investment grade ratings (junk) offer higher interest rates, causing investors to receive more income/return than they would in investing in safer bonds. For diversification purposes, a junk bond in an asset portfolio may help to reduce the volatility of investing in a specific nature of bond. Favorable results from speculation can capture large returns to investors from junk bonds.   

To put things into proper perspective, asides Tesla, Ford Motors and Netflix presently have below investment grade rating.

Ford has been rated as investment grade in the past, but the company lost its investment-grade rating in 2020 due to the coronavirus pandemic and global economic downturn. Its junk bonds are still trading at a premium reflecting the company’s legacy status.

Netflix is also in this category. The company generated negative free cash flow for years to pay for new content creation for its streaming service issuing junk bonds as part of its strategy to fund in-house production of movies and TV shows. Netflix’s bonds, which also trade at a premium, have gained slightly more value as the company has gotten closer to producing positive cash flow. 

Junk bonds carry the highest risk of a company missing an interest payment (called default risk). Yet even when considering default risk, junk bonds still are less likely than many stocks to generate permanent portfolio losses since a company is obligated to pay bondholders before shareholders if it goes bankrupt.

Junk bonds are not generally suitable as short-term investments since their prices tend to fluctuate in the years before maturity.

Before investing in high yield junk bonds, however, there are critical factors to consider. Some investors may not want to buy bonds with a low credit rating thus, making it difficult to sell the junk bonds one owns. Although junk bonds have the probability of rising in value, bonds held might lose value if market rates rise.

Ultimately, investing in junk bonds will depend on the risk appetite and portfolio diversification of the investor.