Loading the player...

For many investors, the term "junk bond" evokes thoughts of investment scams and high-flying financiers of the 1980s, such as Ivan Boesky and Michael Milken, who were known as "junk-bond kings." But don't let the term fool you - if you own a bond fund, these worthless-sounding investments may have already found their way into your portfolio. Here's what you need to know about junk bonds.

What Is a Junk Bond?
From a technical viewpoint, a junk bond is exactly the same as a regular bond. Junk bonds are an IOU from a corporation or organization that states the amount it will pay you back (principal), the date it will pay you back (maturity date) and the interest (coupon) it will pay you on the borrowed money.

Junk bonds differ because of their issuers' credit quality. All bonds are characterized according to this credit quality and therefore fall into one of two bond categories:

  • Investment Grade - These bonds are issued by low- to medium-risk lenders. A bond rating on investment-grade debt usually ranges from AAA to BBB. Investment-grade bonds might not offer huge returns, but the risk of the borrower defaulting on interest payments is much smaller.
  • Junk Bonds - These are the bonds that pay high yield to bondholders because the borrowers don't have any other option. Their credit ratings are less than pristine, making it difficult for them to acquire capital at an inexpensive cost. Junk bonds are typically rated 'BB' or lower by Standard & Poor's and 'Ba' or lower by Moody's.

Think of a bond rating as the report card for a company's credit rating. Blue-chip firms that provide a safer investment have a high rating, while risky companies have a low rating. The chart below illustrates the different bond-rating scales from the two major rating agencies, Moody's and Standard & Poor's:

Bond Rating Grade Risk
Moody's Standard & Poor's
Aaa AAA Investment Lowest Risk
Aa AA Investment Low Risk
A A Investment Low Risk
Baa BBB Investment Medium Risk
Ba, B BB, B Junk High Risk
Caa/Ca/C CCC/CC/C Junk Highest Risk
C D Junk In Default

Although junk bonds pay high yields, they also carry higher-than-average risk that the company will default on the bond. Historically, average yields on junk bonds have been 4-6% above those for comparable U.S. Treasuries.

Junk bonds can be broken down into two other categories:

  • Fallen Angels - This is a bond that was once investment grade but has since been reduced to junk-bond status because of the issuing company's poor credit quality.
  • Rising Stars - The opposite of a fallen angel, this is a bond with a rating that has been increased because of the issuing company's improving credit quality. A rising star may still be a junk bond, but it's on its way to being investment quality.

Who Should Buy Junk Bonds?
You need to know a few things before you run out and tell your broker to buy all the junk bonds he can find. The obvious caveat is that junk bonds are high risk. With this bond type, you risk the chance that you will never get your money back. Secondly, investing in junk bonds requires a high degree of analytical skills, particularly knowledge of specialized credit. Short and sweet, investing directly in junk is mainly for rich and motivated individuals. This market is overwhelmingly dominated by institutional investors.

This isn't to say that junk-bond investing is strictly for the wealthy. For many individual investors, using a high-yield bond fund makes a lot of sense. Not only do these funds allow you to take advantage of professionals who spend their entire day researching junk bonds, but these funds also lower your risk by diversifying your investments across different asset types. One important note: know how long you can commit your cash before you decide to buy a junk fund. Many junk bond funds do not allow investors to cash out for one to two years.

Also, there comes a point in time when the rewards of junk bonds don't justify the risks. Any individual investor can determine this by looking at the yield spread between junk bonds and U.S. Treasuries. As we already mentioned, the yield on junk is historically 4-6% above Treasuries. If you notice the yield spread shrinking below 4%, then it probably isn't the best time to invest in junk bonds. Another thing to look for is the default rate on junk bonds. An easy way to track this is by checking the Moody's website.

The final warning is that junk bonds are not much different than equities in that they follow boom and bust cycles. In the early 1990s, many bond funds earned upwards of 30% annual returns, but a flood of defaults can cause these funds to produce stunning negative returns.

The Bottom Line
Despite their name, junk bonds can be valuable investments for informed investors. But their potential high returns come with the potential for high risk.

Related Articles
  1. Mutual Funds & ETFs

    Can You Become Rich Investing in Mutual Funds?

    Find out how you can use mutual fund investments to get rich, including which types of funds are best suited for rapid wealth creation.
  2. Investing Basics

    What Is A Corporate Credit Rating?

    Is the bond you're buying investment grade, or just junk? Find out how to check the score.
  3. Investing

    The Advantages Of Bonds

    Bonds contribute an element of stability to almost any portfolio and offer a safe and conservative investment.
  4. Bonds & Fixed Income

    Corporate Bonds: An Introduction To Credit Risk

    Corporate bonds offer higher yields, but it's important to evaluate the extra risk involved before you buy.
  5. Bonds & Fixed Income

    Find The Right Bond At The Right Time

    Find out which bonds you should be investing in and when you should be buying them.
  6. Personal Finance

    When To Trust Bond Rating Agencies

    Despite investor distrust, rating agencies can be helpful. Just be sure you use these ratings as a starting point.
  7. Investing Basics

    Contingent Convertible Bonds: Bumpy Ride Ahead

    European banks' CoCos are in crisis. What investors who hold these high-reward but high-risk bonds should know.
  8. Mutual Funds & ETFs

    The 3 Best T. Rowe Price Funds for Value Investors in 2016

    Read analyses of the top three T. Rowe Price value funds open to new investors, and learn about their investment objectives and historical performances.
  9. Active Trading Fundamentals

    4 Stocks With Bullish Head and Shoulders Patterns for 2016 (PG, ETR)

    Discover analyses of the top four stocks with bullish head and shoulders patterns forming in 2016, and learn the prices at which they should be considered.
  10. Investing

    How to Ballast a Portfolio with Bonds

    If January and early February performance is any guide, there’s a new normal in financial markets today: Heightened volatility.
RELATED FAQS
  1. Which mutual funds pay the highest dividends?

    For many people, the reliability of dividend or interest income is one of the primary benefits of investing. Like individuals ... Read Full Answer >>
  2. How is risk priced in the market?

    In most cases, market actors have to be compensated for assuming risk, and the higher the degree of risk, the greater the ... Read Full Answer >>
  3. How do I compare one junk bond to another?

    Junk bonds have the same technical functionality as other bonds; bond buyers lend money to an organization in exchange for ... Read Full Answer >>
  4. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  5. What is a basis point (BPS)?

    A basis point is a unit of measure used in finance to describe the percentage change in the value or rate of a financial ... Read Full Answer >>
  6. How many free credit reports can you get per year?

    Individuals with valid Social Security numbers are permitted to receive up to three credit reports every 12 months rather ... Read Full Answer >>
Hot Definitions
  1. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  2. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  3. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  4. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  5. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
Trading Center