High-yield corporate bonds (also known as junk bonds) have existed for nearly as long as most other types of corporate bonds. Some investors, however, consider junk bonds to be a product of the 1970s and 1980s when the bonds had their first major growth streak.
Just like an investment-grade bond, a junk bond is an IOU from a business or corporation that details how much it will pay back (the principal), when it will pay back (the maturity date), and the interest it will pay (the coupon).
The main difference between investment-grade and high-yield corporate bonds comes in the form of the issuer's credit status. Because issuers with poor credit ratings have few other options, they offer bonds with far higher yields than issuers with better credit ratings do. These higher yields come with greater risk for investors—there's even potential that investors may wind up with, as the bonds' name suggests, junk.
Growth of Junk Bonds
The boom in high-yield corporate bonds in the 1970s and the 1980s was largely due to what was called fallen-angel companies. These companies had been issuing investment-grade bonds before undergoing a significant drop in their credit profile, which made them dip to a BBB- overall rating, typically the lowest rating for investment-grade bonds.
Particularly in the 1980s, these “junked bonds” began to develop a new appeal for leveraged buyouts (LBOs) and as a business financing mechanism through mergers, which fueled their significant initial growth.
The practice caught on quickly, and soon it was considered acceptable for issuers and investors of all sorts to turn to the speculative-grade bond market as a financing mechanism. This led the market to evolve into a refinancing mechanism for bank loans and debt-finance tools like the amortization of older bonds.
Notable Historical Crises
The junk bond market has had several periods of crisis, with three notable examples of when the market took a serious downturn:
One major hitch in the development of junk bonds as a viable financing mechanism was the huge scandal that involved many "Savings & Loan" institutions in the 1980s. Investing in junk bonds was one of the S&Ls' many risky practices, and the fallout from the scandal affected high-yield bond issuance and performance until the 1990s.
Although junk bonds were utilized as financing mechanisms by many companies that died during the dot-com crash—and the junk bond market took a strong hit as a result—this crash was ultimately more attributable to investors falling for “big ideas” spurred by the birth of the internet rather than investing in companies with solid business plans. As such, the junk bond market soon recovered.
Many of the so-called toxic assets in the subprime housing market scandal and subsequent crash were linked to corporate high-yield bonds. One important note is that the junk bonds involved with this scandal weren't sold as such but were originally rated AAA, generally the highest rating for investment-grade bonds.
The Big Picture
Despite these setbacks, and specifically given its overall growth since the early 2000s, the so-called junk bond market continues to provide companies and investors with attractive financing mechanisms. High-yield bonds are an essential piece of the overall U.S. corporate bond market, accounting for upwards of 10% of the total U.S. corporate bond market.