Junk Bond
Definition
A junk bond is a bond rated below investment grade, meaning it pays a higher yield to compensate investors for a meaningfully higher risk that the issuer defaults.
Detailed Explanation
The entire category is defined by a single notch on a ratings scale. Investment grade stops at BBB- from S&P and Fitch, or Baa3 from Moody's. One step down (BB+ or Ba1) and the bond is speculative grade. The industry prefers "high-yield"; "junk" is the blunt version of the same label. Nothing about the bond itself changes at that line. What changes is who is allowed to own it.
That's why the notch carries so much weight. Pension funds, insurance companies, and many bond funds operate under mandates restricting them to investment grade. When an issuer gets downgraded below the line, a large pool of buyers has to sell regardless of what they think of the company, which is its own source of price pressure. A bond that was issued investment grade and later downgraded is called a fallen angel.
Before the 1980s, fallen angels made up most of the speculative-grade market. Michael Milken's work at Drexel Burnham Lambert built the market for companies issuing below-investment-grade debt from the start, which is where the modern high-yield market comes from.
The extra yield over Treasuries is called the spread, and it is payment for taking real risk, not free money. Speculative-grade default rates run several times investment-grade rates and swing hard with the credit cycle (low in easy-money years, sharply higher in recessions). Default also doesn't mean total loss; bondholders typically recover a fraction of face value.
The more important problem for a portfolio is correlation: junk bonds tend to fall when stocks fall, because both are bets on corporate health. That undercuts the main reason most people hold bonds in the first place.
Buying individual junk bonds well is difficult for an individual investor. It requires real credit analysis, and the bid-ask spreads on small lots are punishing. Most retail exposure comes through high-yield mutual funds and ETFs, which at least deliver diversification across hundreds of issuers.
Even then, it's worth being honest about what the asset does: it offers equity-like drawdowns with a capped upside, since the best case on a bond is that you get paid back. Investors who want higher expected returns and can stomach volatility usually get a better deal from stocks.
Example
Suppose a 10-year Treasury yields 4% and a BB-rated company issues a 10-year bond yielding 7%. That three-percentage-point spread is what the market demands to take the default risk. On a $10,000 position, it's $300 a year in extra income. But if the company defaults and bondholders recover 40 cents on the dollar, the loss is $6,000.
Key Articles Related To Junk Bond
Related Terms
Investment-Grade Bond: A bond rated BBB-/Baa3 or higher, indicating relatively low default risk and eligibility for most institutional portfolios.
Fixed-Income Investment: Any investment that pays a set schedule of interest and returns principal at maturity, the broader category junk bonds belong to.
Credit Rating: An agency's assessment of an issuer's ability to repay its debt, which determines whether a bond is investment grade or speculative.
Fallen Angel: A bond originally issued as investment grade that has since been downgraded to speculative grade.
Yield Spread: The difference in yield between a bond and a comparable Treasury, representing the extra compensation investors demand for taking credit risk.
FAQs
Why are they called junk bonds?
It's blunt market slang for debt rated below investment grade. Issuers, fund companies, and analysts almost always say "high-yield" or "speculative grade" instead, because they're describing the same securities to people they'd like to sell them to.
What rating makes a bond a junk bond?
BB+ or lower from S&P and Fitch, or Ba1 or lower from Moody's. That's one notch below the lowest investment-grade rating of BBB-/Baa3.
Are junk bonds a good investment?
It depends entirely on what job you're hiring them for. They pay more than Treasuries or investment-grade corporates, but they fall alongside stocks in a downturn, so they don't provide the ballast most people want from a bond allocation. They also don't offer the unlimited upside stocks do.
What is a fallen angel?
A bond that was investment grade when issued and has since been downgraded to speculative grade. These often see forced selling from funds that aren't permitted to hold below-investment-grade debt.
How do I invest in junk bonds?
Most individual investors use high-yield bond mutual funds or ETFs rather than buying individual issues. Single junk bonds require credit analysis and carry wide bid-ask spreads on small trades, which quietly eats a lot of the yield advantage.
Do junk bonds lose value when interest rates rise?
They can, but credit risk usually matters more than rate risk for this category. In a recession, junk bonds often fall while Treasuries rally (which is the opposite of what people expect bonds to do) and the reason asset allocation decisions should treat them as closer to stocks than to bonds.