What is a Junk Bond
A junk bond is a fixed-income instrument that refers to a high-yield or noninvestment-grade bond. Junk bonds carry a credit rating of BB or lower by Standard & Poor's (S&P), or Ba or below by Moody's Investors Service. Junk bonds are so called because of their higher default risk in relation to investment-grade bonds.
BREAKING DOWN Junk Bond
Bonds are fixed income products that corporations and governments issue to investors in order to raise capital. When an investor purchases a bond, s/he is in effect loaning money to the issuer who promises to repay the money on a specific date, also known as the maturity date. To compensate investors for purchasing bonds, issuers affix interest rates to the bond. These interest rates, known as coupon rates, is the rate of return that bondholders earn for loaning their money to the issuer. For example, a bond that has a 5% annual coupon rate means that an investor who purchases a bond with a $10,000 face value will receive 5% x $10,000 = $500 every year until the bond matures.
Companies that have a high risk of defaulting on their interest payments usually have high interest rates on their corporate bonds. These types of bonds are referred to as high yield bonds, or junk bonds. Junk bonds are risky investments, but they have speculative appeal because they offer much higher yields than bonds with higher credit ratings. Investors demand that junk bonds pay higher yields as compensation for the risk of investing in them. If a junk bond manages to turn its financial performance around and has its credit rating upgraded, the investor may see a substantial appreciation in the bond’s price.
How a Bond Is Rated
Bonds are rated based on the revenue they generate to make principal and interest payments, and based on any assets pledged to secure the bond. Corporations, for example, are judged on their ability to generate earnings, while a municipality may issue a bond backed by fees from a toll road or a sports venue. A state or local municipality may also issue a general obligation bond, which is backed by the taxing power of the municipality. The more revenue a bond can generate, the higher its credit rating.
A secured bond uses specific assets that serve as collateral, which can be sold to make principal or interest payments if any payments are missed. Unsecured bonds, on the other hand, are simply backed by the issuer’s ability to pay. Both the ability to generate revenue and the existence of collateral impact the credit rating of a bond.
Factoring in Defaults
If a bond misses a principal and interest payment, the bond is considered to be in default. Junk bonds have a higher risk of default because of an uncertain revenue stream or a lack of sufficient collateral. In a declining economy, the risk of bond default increases, and the risks are highest for junk bonds.
Investors purchase junk bonds to earn a higher interest rate than bonds of higher quality and to speculate on price increases. If the company’s financial performance improves, the credit rating may increase, which increases the price of the junk bond. Some investors buy junk bonds to profit from a potential price increase and not for the interest income. These bonds, however, have much larger price swings than bonds of higher quality.
Junk Bonds as an Indicator
Investment in junk bonds usually serves as an indicator for predicting the turn of an economy. When investors pull out of junk bonds, it usually means that investors are more risk averse and are opting for more secure and stable investments. This could lead to a market correction in which the market declines in value and the economy contracts.
On the other hand, when there is a surge in junk bond investing, this translates to increased optimism in the market and investors' willingness to take on more risk. The economy will be expected to expand following a bull market.
Investors looking to purchase junk bonds can either buy the bonds individually or invest in a junk bond fund managed by a professional portfolio manager.