Junk Bond

What Is a Junk Bond?

A junk bond is a type of bond that has been rated below investment grade by a credit rating agency. Rating agencies such as Moody's, S&P Global, and Fitch assess how likely a borrower is to repay its debt. Bonds rated at or above the investment-grade threshold are considered relatively safe, while those rated below it are considered speculative. Because of this speculative status, junk bonds are also called high-yield bonds or sub-investment-grade bonds.

Why Issuers Sell Junk Bonds

Companies with weaker finances, higher existing debt, or limited operating history often cannot borrow cheaply from banks or issue bonds with top ratings. To raise money, they may sell junk bonds and promise investors a higher coupon rate to compensate for the greater chance that they will fall behind on payments. Some junk bonds are also issued by companies that are taking on debt for a specific purpose, such as financing an acquisition or a leveraged buyout.

How Investors Evaluate Them

Investors in junk bonds usually focus on the difference between the bond's yield to maturity and the yield on safer government debt, known as the credit spread. A wider spread generally signals that the market sees more risk. Investors also look closely at the issuer's cash flow, debt levels, and ability to cover interest payments, since a default can result in partial or total loss of principal.

Advantages and Disadvantages

Junk bonds can offer higher income than investment-grade bonds and can perform well when the economy is strong and companies are meeting their obligations. They are also often more sensitive to the economy, and they tend to fall in value during periods of market stress or recession. Their prices can be volatile, and they are less liquid than many other bonds, which can make them harder to sell quickly at a fair price.

Why It Matters to Investors

Junk bonds are a distinct segment of the bond market that behaves differently from both government bonds and stocks. Many investors access them through mutual funds or exchange-traded funds to spread out the risk of any single issuer defaulting. Understanding a junk bond's credit rating, yield, and risk profile is important before adding one to a portfolio.