Loading the player...

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.

RELATED TERMS
  1. Bond Fund

    A bond fund is a fund invested primarily in bonds and other debt ...
  2. High-Yield Bond

    A high-yield bond pays a higher yield due to having higher risk ...
  3. Bond

    A bond is a fixed income investment in which an investor loans ...
  4. Credit Market

    Credit markets are where investors go to buy bonds, mortgages, ...
  5. High-Yield Bond Spread

    A high yield bond spread is the percentage difference in current ...
  6. Obligation Bond

    A municipal bond whose face value of the bond is greater than ...
Related Articles
  1. Investing

    Everything You Need to Know About Junk Bonds

    Despite their name, junk bonds can be valuable investments for informed investors, but their potential high returns come with the potential for high risk.
  2. Investing

    Will The High Times In High Yield Continue?

    With junk bond yields at around 5% now, investors are wondering whether the risk is worth the reward.
  3. Investing

    Should Junk Bond ETFs Be a Part of Your Portfolio?

    Should junk bonds be a part of your portfolio? Here's what you need to know.
  4. Investing

    Investing in Bonds: A Look at Returns and Risks

    A look at the risks, returns and ratings of different types of bonds.
  5. Investing

    The History of High-Yield Bond Meltdowns

    The high-yield bond market experienced its major growth streak in the 1970s and 1980s and has had several noteworthy meltdowns between then and now.
  6. Investing

    How Rising Interest Rates Affect Junk Bonds

    We examine the impact of rising interest rates on higher-yielding bonds.
  7. Investing

    Investing in Bonds: 5 Mistakes to Avoid in Today's Market

    Investors need to understand the five mistakes involving interest rate risk, credit risk, complex bonds, markups and inflation to avoid in the bond market.
  8. Investing

    Junk Bonds: A Correction May Be Looming

    Corporate debt issued by companies with riskier balance sheets and lower credit ratings typically carries higher interest rates.
  9. Investing

    Corporate Bonds for Retirement Accounts

    Corporate bonds are usually the preferred choice in retirement accounts. Here are some of the benefits of corporate bonds, and strategies for a portfolio.
RELATED FAQS
  1. What are the risks of investing in a bond?

    Are you thinking of investing in bond market? Learn more about bond market investment risk, including interest rate risk, ... Read Answer >>
Trading Center