Loading the player...

What is a 'Junk Bond'

A junk bond refers to high-yield or noninvestment-grade bonds. Junk bonds are fixed-income instruments that carry a credit rating of BB or lower by Standard & Poor's, 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'

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 the credit rating.

A secured bond uses specific assets that serve as collateral, and that collateral 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 poor 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.

RELATED TERMS
  1. Bond

    A bond is a fixed income investment in which an investor loans ...
  2. Bond Market

    The bond market is the environment in which the issuance and ...
  3. Credit Market

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

    A high yield bond spread is the percentage difference in current ...
  5. Fixed-Rate Bond

    A fixed-rate bond is a bond that pays the same amount of interest ...
  6. Fixed Income

    Fixed income is a type of investment in which real return rates ...
Related Articles
  1. Financial Advisor

    Junk Bonds: Why You Should Pass Right Now

    Why you should probably wait on allocating to junk bonds right now.
  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

    9 Junk Bond ETFs You Should Eye Right Now (HYG, JNK)

    Volatility aside, there’s still some value left in high yield bonds. Pending rate increases shouldn’t effect junk as gravely as investors fear.
  4. 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.
  5. Investing

    High Times Ahead For High Yield Bonds

    For those investors looking for a good balance of risk and reward, high yield bonds could be a great play this year. There’s plenty of bullish catalysts that should propel junk bonds ahead.
  6. Investing

    Junk Bonds’ Performance After the Financial Crisis

    How did higher-yielding bonds perform during and after the financial crisis of 2007-2009?
  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

    The Appeal of Crossover Bonds

    Bonds that tend to cross from junk to investment-grade status, or the other way around, can provide interesting investment opportunities. Here's a look,
  9. Investing

    Corporate Bond Basics: Learn to Invest

    Understand the basics of corporate bonds to increase your chances of positive returns.
  10. 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.
Hot Definitions
  1. Initial Public Offering - IPO

    The first sale of stock by a private company to the public. IPOs are often issued by companies seeking the capital to expand ...
  2. Cost of Goods Sold - COGS

    Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold in a company.
  3. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and expenses incurred during a specified period of time, usually ...
  4. Monte Carlo Simulation

    Monte Carlo simulations are used to model the probability of different outcomes in a process that cannot easily be predicted ...
  5. Price Elasticity of Demand

    Price elasticity of demand is a measure of the change in the quantity demanded or purchased of a product in relation to its ...
  6. Sharpe Ratio

    The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk.
Trading Center