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 point of view, 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 the credit quality of their issuers. All bonds are characterized according to this credit quality and therefore fall into one of two categories of bonds:
- Investment Grade - These are 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 yields 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 at 'BB'/'Ba' or less.
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 and 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 between 4-6% above those on 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.
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