A junk bond is debt, known as a corporate bond, issued by a company that does not have an investment-grade credit rating. Junk bonds are also known as high-yield bonds because the interest payments are higher than for the average corporate bond.
When you buy bonds, you’re lending money to the bond issuer—a company or a government entity—that promises to pay you back with interest when the bonds mature. The thing is, not all companies can deliver on that promise.
That’s where bond ratings come in. They are letter grades issued by an independent bond ratings agency—Standard & Poor, Moody’s or Fitch—that suggest the likelihood a company will repay what it borrows. Like in school, A’s and B’s are generally better and indicate a high chance of repayment, while lower letter grades signal a company’s bonds may be a risky bet.
Securities with a rating of BBB (or Baa on Moody’s scale) or higher are considered “investment-grade” bonds, meaning the bond rating agency thinks it’s pretty likely investors will get their money back. But bonds with a rating below BBB/Baa have a higher likelihood of failure to repay their debts, and they’re called speculative-grade or non-investment grade bonds—a.k.a. junk bonds. They’re normally issued by companies that are relatively new or that have faced recent financial difficulties. And these companies pay these high interest rates to entice investors to take on the higher risk of lending them money.
Junk Bond Credit Ratings
The following are the range of junk bonds’ credit ratings as expressed by the dominant rating agencies:
High Risk: Rated Ba or B by Moody’s, and BB or B by S&P. This means the company currently can meet payments, but probably won’t if economic or business conditions worsen. That’s because it’s unusually vulnerable to adverse conditions.
Highest Risk: Rated Caa, Ca, or C by Moody’s; and CCC, CC, or C by S&P. Business and economic conditions must be favorable for the company to avoid default.
In Default: Rated C by Moody’s and D by S&P
Why Would Investors Buy Junk Bonds?
Junk bonds can boost overall returns in your portfolio while allowing you to avoid the higher volatility of stocks. These bonds offer higher yields than investment-grade bonds and can do even better if they are upgraded when the business does improve.
Junk bonds’ performance is often highly correlated to stocks’ performance and less closely correlated to other bonds’. Unlike stocks, however, bonds provide fixed interest payments. And they are lower-risk than stocks in some aspects. For example, bondholders generally get paid before stockholders in the case of a bankruptcy.
Junk bonds are issued with a maturity range of four years to over 10 years, with 10 being the most common. Junk bonds are often non-callable for three to five years, meaning the borrower can’t pay off the bond before that time period.
While an investment-grade credit rating denotes little risk that a company will default on its debt, junk bonds carry the highest risk of a company missing an interest payment (called default risk). Yet even when considering default risk, junk bonds still are less likely than many stocks to generate permanent portfolio losses since a company is obligated to repay bondholders before shareholders if it goes bankrupt.