Junk bond

3 key takeaways

• Junk bonds offer higher interest rates compared to investment-grade bonds to compensate investors for the higher risk of default.
• They are rated below investment grade by credit rating agencies, indicating a higher risk of issuer insolvency.
• Junk bonds can be attractive to investors seeking higher yields but require careful risk assessment due to their potential for significant losses.

What is a junk bond?

A junk bond is a debt security issued by a corporation or government with a lower credit rating, typically below BBB- by Standard & Poor’s or Baa3 by Moody’s. These bonds are considered speculative investments and are associated with higher risk compared to investment-grade bonds. The higher interest rates offered by junk bonds compensate investors for the increased likelihood that the issuer may default on interest payments or fail to repay the principal.

Characteristics of junk bonds

High yields

Junk bonds offer higher yields than investment-grade bonds to attract investors willing to take on more risk. The higher interest payments provide compensation for the increased default risk.

Lower credit ratings

Credit rating agencies assign lower ratings to junk bonds, reflecting the issuer’s higher probability of financial instability. These ratings are below BBB- (Standard & Poor’s) or Baa3 (Moody’s).

Greater risk

The issuers of junk bonds are often companies with weak financial positions, high levels of debt, or uncertain business prospects. As a result, these bonds carry a higher risk of default.

Benefits of investing in junk bonds

Higher returns

Investors can potentially earn higher returns compared to investment-grade bonds due to the higher interest rates paid by junk bonds.

Diversification

Including junk bonds in an investment portfolio can provide diversification benefits, potentially improving the overall risk-return profile of the portfolio.

Capital appreciation

If the issuing company’s financial situation improves, the value of its junk bonds may increase, leading to capital gains for investors.

Risks of investing in junk bonds

Default risk

The primary risk associated with junk bonds is the higher likelihood of default by the issuer, which can result in significant losses for investors.

Interest rate risk

Like all bonds, junk bonds are subject to interest rate risk. Rising interest rates can lead to a decline in bond prices, affecting the market value of junk bonds.

Economic sensitivity

Junk bonds are more sensitive to economic downturns and business cycles. During economic recessions, default rates tend to increase, adversely affecting the performance of junk bonds.

Examples of junk bonds

Corporate junk bonds

• Example: A company with a BB credit rating issues bonds to raise capital for expansion. These bonds offer a higher interest rate than investment-grade bonds to attract investors despite the company’s higher risk of default.

Fallen angels

• Definition: Bonds that were originally issued as investment-grade but have been downgraded to junk status due to the issuer’s deteriorating financial condition.
• Example: A formerly stable company experiences financial troubles and its bonds are downgraded from BBB to BB, reclassifying them as junk bonds.

How to invest in junk bonds

Direct investment

Investors can purchase individual junk bonds through a brokerage account. This approach requires thorough research and analysis to assess the creditworthiness of the issuers.

Junk bond funds

Investors can also gain exposure to junk bonds through mutual funds or exchange-traded funds (ETFs) that specialize in high-yield debt. These funds provide diversification across a portfolio of junk bonds, reducing the impact of any single default.

Related topics

• High-yield bonds: Explore the broader category of high-yield bonds, which includes junk bonds and their role in investment portfolios.
• Credit ratings: Understand the role of credit rating agencies and the significance of credit ratings in assessing bond risk.
• Bond investing: Learn about different types of bonds, their risk and return characteristics, and strategies for bond investing.

Consider exploring these related topics to gain a deeper understanding of junk bonds, their benefits, and risks, and how they can fit into an investment strategy.