Junk bonds are a type of corporate bond that carry a higher degree of risk and generally have lower credit ratings. The bond issuers are more likely to default, making junk bonds speculative investments.
So why would investors buy a junk bond? For one simple reason: They have the potential to produce bigger returns compared to other bond options.
Junk bonds aren’t necessarily right for every investor, because they are so risky. Understanding how junk bonds work can help you decide if they belong in your investment portfolio.
How Do Junk Bonds Work?
Bonds are a form of debt. When a corporation or government entity issues a bond, they’re doing so for the purposes of raising capital. Investors buy the bonds, providing the capital, and in return, they expect to get paid that money back along with interest.
There’s an implied agreement between the investor and the bond issuer that the latter will make interest payments on time, but in addition, bonds can be secured or unsecured. Treasury bonds, for example, are unsecured bonds that are backed by the full faith and credit of the U.S. government.
Junk bonds, also referred to as high-yield bonds, represent a category of bonds that fall below investment-grade. In simple terms, this means there’s a greater risk that the bond issuer could default or fail to follow through on their promise to repay investors. Whether a bond is considered to be investment-grade or not depends on its credit ratings.
Credit Ratings and Junk Bonds
Bond credit ratings are issued by a number of organizations. These agencies determine which bonds are considered to be investment-grade and which are non-investment grade or speculative-grade.
In the United States, the majority of bond credit ratings are issued by three agencies, on an ABCD scale:
• Moody’s Investors Services
• Standard & Poor’s Global Ratings
• Fitch Ratings
Bonds with a rating of BBB or higher (Baa on the Moody’s scale) are categorized as investment-grade. This means that in the eyes of the rating agency, default risk is low or in other words, investors are reasonably likely to get their money back from the bond issuer.
When bonds fall below the BBB rating range (Ba for Moody’s), they’re considered to be junk bonds. The further the rating drops, the riskier and more speculative the bond becomes. Here’s how junk bond credit ratings compare.
| Moody’s | S&P Ratings | Fitch Ratings | |
|---|---|---|---|
| High Risk | Ba or B | BB or B | BB or B |
| Highest Risk | Caa, Ca or C | CCC, CC or C | CCC |
| In Default | C | D | DDD, DD or D |
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Why Do Investors Like Junk Bonds?
The riskier an investment is, the more potential it has to deliver higher returns. That lies at the heart of why some investors might prefer junk bonds over investment-grade bonds. Junk bonds can have varying maturities like other types of bonds. Typically, these are longer term bonds, with maturities lasting in the five- to 10-year range.
Investing in junk bonds could yield returns on the same level as stocks but with less volatility. That’s because you’re getting the promise of a fixed interest payment, rather than depending on which way the market swings on any given day to determine returns. If the bond issuer undergoes a financial turnaround and its credit rating improves, that can reduce the level of risk associated with its bonds.
Junk bonds can be attractive to investors in low interest rate environments as well. That’s because unlike other bonds, they’re less sensitive to interest-rate movements. Bond issuers may be highly motivated to raise capital so they can offer higher rates to attract investors. Investor risk may also be reduced when the economy is growing, since that can be conducive to improvements in the financial health of bond issuers.
Recommended: How Do Corporate Bonds Work?
Examples of Junk Bonds
Companies that issue junk bonds tend to be newer companies or established ones that may be struggling financially following bankruptcy. For instance, one company that has junk bond ratings in 2023 is Coinbase (NASDAQ:COIN), a cryptocurrency exchange. Because of the speculative and high-risk nature of crypto trading, the company has a junk bond rating. In early 2023, Coinbase’s junk bonds were downgraded even further by Moody’s and Standard & Poor’s Global Ratings.
Advantages and Disadvantages of Junk Bonds
Investing in junk bonds has both pros and cons, just like other investments.
On the advantages side, investors have potential to earn higher yields from junk bonds than other types of bonds. There’s less volatility to contend with compared to stocks, and fixed interest payments could provide a steady source of income. Depending on the credit rating of the bond issuer, it’s possible that a junk bond could actually be less risky compared to a stock.
On the other hand, junk bond investing is speculative, so an investor has to be willing to accept the possibility of losses — specifically, default risk and the likelihood of the bond issuer missing an interest payment. In the worst-case scenario, the company could go bankrupt, meaning an investor may not get their initial investment back, much less the interest. One also has to consider the time component, since junk bonds are not designed to be held for the shorter term.
| Junk Bond Advantages | Junk Bond Disadvantages |
|---|---|
| Investors could earn interest rates above what investment-grade bonds are paying. | Default risk is typically higher with junk bonds vs. investment-grade bonds. |
| Compared to stocks, junk bonds are less susceptible to volatility and may be less risky overall. | If the bond issuer goes bankrupt, the investment could end up being a total loss. |
| Fixed interest payments may provide a consistent stream of income for investors. | They’re not suited to short-term investing given the duration of junk bonds and pricing fluctuations. |
How to Invest in Junk Bonds
If you’re considering investing in junk bonds, opening a brokerage account is a good place to start. If you already have an investment account, you can move on to purchasing junk bonds. There are a few different ways you can do this:
• Purchase individual junk bonds, if your brokerage offers them.
• Buy a junk bond mutual fund.
• Invest in a junk bond exchange-traded fund (ETF).
Buying individual junk bonds can be risky, as it concentrates investment dollars in a single security. Higher minimum investments may limit the number of junk bonds an investor is able to purchase.
Investing in junk bond funds or ETFs instead may make it easier to spread out your investment dollars while spreading out risk. Junk bond funds and ETFs can offer exposure to a basket of junk securities which can help with diversification and risk management.
When comparing junk bond funds or ETFs, consider the underlying credit ratings for each security that’s represented. This can tell you whether the fund mostly holds high risk, higher risk or in default bond offerings. Also consider the expense ratios involved and the maturity terms so you’re choosing a fund that fits both your budget and timeline for investing.
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Are Junk Bonds a Good Investment?
Should you buy junk bonds? The answer depends largely on your personal risk tolerance. Junk bonds may be a good investment for investors who are comfortable taking more risk for a shot at higher returns. On the other hand, you may choose to steer clear of them if you’re looking for fixed-income investments that are on the safer side.
What’s important to consider before investing is the entire makeup of your portfolio as a whole and your financial goals. If you’re interested in junk bonds, think about how much of your portfolio you’re comfortable dedicating to them and how that could affect your overall risk profile.
The Takeaway
Investing in bonds can add a fixed-income element to an investor’s portfolio, which may be helpful for diversification. Alongside stocks, bonds may help you devise a more well-rounded investment strategy as you work toward your financial goals.
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