Junk Bond (High-Yield Bond)
A junk bond is a corporate bond rated below investment grade (BB+/Ba1 or lower) that offers higher interest rates to compensate investors for the increased risk of default.
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Exam Tip
Junk = BB+/Ba1 and BELOW (below investment grade). Higher yield compensates for higher default risk. Also called "high-yield bonds."
What is a Junk Bond?
A junk bond, also called a high-yield bond, is a bond rated below investment grade by credit rating agencies. These bonds pay higher interest rates because they carry a greater risk that the issuer may default on payments.
Credit Rating Classification
| Rating | S&P/Fitch | Moody's | Classification |
|---|---|---|---|
| Investment Grade | BBB- and above | Baa3 and above | Lower risk |
| Junk/High-Yield | BB+ and below | Ba1 and below | Higher risk |
Why Called "Junk"?
The term reflects the higher risk of default, but "high-yield" is the preferred industry term because:
- These bonds pay significantly higher interest rates
- Many have never defaulted
- They serve legitimate financing needs
Junk Bond Characteristics
| Characteristic | Description |
|---|---|
| Higher Yield | Yield premium varies with credit and market conditions |
| Higher Default Risk | Default experience varies by rating, period and methodology |
| Price Volatility | More sensitive to economic conditions |
| Credit Spreads | Widen during economic stress |
Types of Junk Bond Issuers
| Type | Description |
|---|---|
| Fallen Angels | Former investment-grade companies downgraded |
| Rising Stars | Improving companies that may be upgraded |
| Start-ups | New companies without track records |
| Leveraged Buyouts | Companies with high debt from acquisitions |
| Turnarounds | Distressed companies attempting recovery |
Credit Spreads
Credit spreads compare yields with a benchmark such as Treasuries. They vary over time; a quoted yield is not a guaranteed realized return.
Who Invests in Junk Bonds?
| Investor Type | Reason |
|---|---|
| High-Yield Mutual Funds | Diversified junk exposure |
| Hedge Funds | Higher returns, distressed opportunities |
| Individual Investors | Income seeking, risk tolerant |
| Pension Funds | Limited allocation for yield enhancement |
Risks of Junk Bonds
| Risk | Description |
|---|---|
| Default Risk | Issuer may not pay |
| Interest Rate Risk | Price falls when rates rise |
| Liquidity Risk | Harder to sell quickly |
| Economic Risk | Perform poorly in recessions |
Ratings and Defaults
Ratings are opinions about credit risk, not guarantees. Compare ratings, issuer finances, seniority, covenants, liquidity and maturity. Investment-grade bonds can also default.
Exam Alert
Junk bonds = rated BB+/Ba1 or BELOW. They pay higher yields to compensate for higher default risk. Know that "high-yield" and "junk" mean the same thing. Spreads widen during recessions.
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Investment Grade
Investment grade refers to bonds rated BBB-/Baa3 or higher by credit rating agencies, indicating lower default risk and greater creditworthiness compared to high-yield (junk) bonds.
Bond
A bond is a fixed-income debt security where the issuer owes the holder a debt and pays interest (coupon) plus principal at maturity.
Yield
Yield is the income return on an investment, expressed as a percentage, including interest or dividends received.
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