What are junk bonds? A risky yet high-yield investment that can bring rewards if you're willing to take the chance

Yield sign — Junk bonds offer income-oriented investors some of the highest yields around—but they come with considerable risks.

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Junk bonds are bonds that are low-ranked by credit rating agencies, due to the sketchy track record of their issuers.
Because they are riskier, junk bonds pay greater interest than higher-rated bonds, especially during economic downturns.
Investors can mitigate the risks, while enjoying the income, by investing in junk bond mutual funds or ETFs.

If investments were students, junk bonds would be the problem kids of the class. They show a lot of promise, but can’t get their grades up.

Junk bonds’ popularity tends to ebb and flow, depending on the stage of the economic cycle. During recessions or declines, many investors choose to buy junk bonds in the belief that market conditions will soon improve, and that the price of purchased bonds will rise in parallel with the fortunes of the corresponding companies.

What is a junk bond?

A junk bond, like all bonds, is a type of debt security. The party buying the bond is essentially loaning money to the party issuing the bond. In return, the issuer promises to repay the money after a certain period, along with interest payments along the way.

A junk bond is a particular kind of bond that receives a low rating, or grade, from the credit rating agencies that evaluate bonds for investors.

Officially known as high-yield bonds, junk bonds have historically served the purpose of raising funds for financially weaker companies, while also providing investors with higher returns than other debt securities — such as US Treasury bonds, or corporate bonds issued by stronger, richer firms.

To understand how junk bonds work, a little background on bond ratings is in order.

Understanding the bond rating system

Since a bond is like an IOU, knowing the creditworthiness of the issuer — its ability to pay its bills and honor its debts — is important to bond-buyers. That’s why all bonds get graded for quality by independent credit rating agencies. And, the same way academic grades symbolize how strong or weak a student is, a bond’s grade acts as shorthand for how safe or risky this investment is.

The higher the grade, the better the company (and its bonds) — meaning, the more likely it is to make the interest payments on time and to repay investors in full when the bond falls due. The lower the rating, the less likely the company is to meet these obligations — resulting in it collapsing, defaulting on its debt, and leaving its investors with worthless paper.

Among the credit agencies, the Big Three are Moody’s, Standard & Poor’s, and Fitch. They assign letter ratings to companies and the bonds they issue, based on an analysis of their assets, underlying financial circumstances, and credit history.

While the exact systems differ a bit, depending on the agency, the ratings take the form of letter grades: A, B, C, D. The lowest possible credit rating is D, meaning that a company is in default (and often bankrupt as well).

Anything rated BBB (or Baa, for Moody’s) or above is considered “investment-grade,” which — as the name implies — indicates the most suitable choice for investors.

The highest rating — the coveted AAA — is generally reserved for bonds issued by the US Treasury (which has never defaulted in its history) and the strongest, blue-chip companies on the stock market.

How junk bonds work

“A junk bond is a bond that falls below the investment grade credit rating provided by credit rating agencies,” says John Cronin, a financial analyst with the Ireland-based stockbrokers Goodbody. More specifically, “that is a credit rating below Baa3 from Moody’s, a credit rating below BBB- from S&P, and a credit rating below BBB- from Fitch.”

While any rating below investment-grade is enough to qualify a bond as “junk,” the grade could be issued for different reasons. It could mean that the company is simply new, without much of a track record or credit history. Or it signifies a once-sound firm that has run into business troubles of late, a “fallen angel,” as the investment pros like to say.

Whatever the reason, because junk bonds are issued by “riskier” companies — or even governments — they usually pay a higher rate of interest than U.S. Treasury bonds or bonds issued by companies deemed investment-grade — anywhere from 2% to 7% higher, on average.

For example, in March 2020, the S&P 500 Bond Index, which tracks the bonds issued by S&P 500 companies, showed an average yield of 4.29%, while the S&P U.S. High Yield Corporate Bond Index stood at 11.36%.

Currently, the Brazil Federative Republic is offering a 30-year bond (rated BB) with a 12.25% interest rate, while Walmart (rated AA) is offering a 30-year bond with a 7.55% interest rate.

The rationale is simple: Troubled companies have to try harder. The higher interest they pay is intended to compensate for their greater riskiness, attracting investors who might otherwise prefer to play it safe with investment-grade or U.S. Treasury bonds.

What risks are associated with junk bonds?

Junk bonds carry a number of risks for investors. These include risks associated with the company issuing junk bonds, as well as risks arising from wider economic conditions.

1. Default risk

The most obvious danger involves default risk, also known as credit risk. This is the risk that the company issuing a junk bond will fail to meet interest or principal payments, or may even default on its bond.

Default rates on junk bonds vary with the economic cycle. According to data from S&P, default rates hit a peak of around 12% after the 2007-8 financial crisis, before falling to under 3% in 2019.

The risk of default can be reduced depending on the actions of central banks. The Federal Reserve committed to purchasing junk bonds in May 2020, removing some of the dangers for private investors who purchase junk debt.

“Junk is no longer junk, just like being a millionaire nowadays does not mean you are wealthy,” says Edward Moya, a market analyst with New-York based forex broker OANDA, adding that “the Fed’s decision to buy junk bonds served many purposes, with the biggest benefit allowing many companies to cheaply raise money.”

2. Interest rate risk

Another risk for investors in junk bonds involves changes in interest rates. If general interest rates rise significantly after you purchase a junk bond, you can expect its price in the bond market to decrease.

Bonds that take longer to mature present the greatest risks in this respect.

3. Economic risk

Assuming that the wider economy struggles, investors will increasingly seek to sell high-yield bonds and move to safer assets, such as U.S. Treasury bonds. This could potentially glut the market with junk bonds, sending their prices downwards.

4. Liquidity risk

Related to economic risk, liquidity risk involves the inability to find a seller for a junk bond. Compared to investment-grade bonds, junk bonds are less likely to be traded frequently, so holders may find it difficult to sell at a price that reflects their justifiable value.

Why invest in a junk bond?

Higher income

“Junk bonds historically are an attractive bet for yield,” says Moya. While they can be more volatile, junk bonds generally outperform investment-grade corporate bonds, as indicated by a 2019 research paper from Vanguard. From 1987 to 2018, for example, it found that junk bonds offered, on average, yields that were 4.76% over investment-grade bonds’.

This could make them attractive to investors seeking a higher regular income from their assets. And if general interest rates are low, they may be the best option.

Speculative opportunity

Junk bonds can be bought during economic or market downswings and sold during upswings. By purchasing them cheap and then selling when they present less of a risk (due to improved economic conditions), investors can potentially make a profit.

Hedging strategy

High-yield bonds can be purchased as part of a hedging strategy that attempts to balance risk across investments. While junk bonds tend to rise and fall with the stock market, they can compensate investors for equities’ declines by providing above-average yields. In other words, even though the market may fall, junk bonds may continue to pay holders higher returns than stocks during downturns.

Conversely, the correlation of junk bonds with equities also means that high-yield funds can rise at times when investment-grade bonds remain relatively flat. This potentially makes it worthwhile to include them as part of a diversified portfolio that would otherwise focus more on investment-grade bonds.

For example, one strategy might involve buying junk bonds long and shorting U.S. Treasury bonds, so as to reduce the interest rate risk usually associated with junk bonds. When interest rates rise, the price of U.S. Treasury bonds will fall (due to less demand), thereby offsetting losses in junk bonds for investors selling Treasury bonds short.

How to buy junk bonds

Investors can gain exposure to junk bonds either by:

Purchasing individual junk bonds
Buying into a junk bond mutual fund or ETF (exchange-traded fund)

Individual junk bonds can be purchased directly through financial services companies and broker-dealers such as Fidelity, E*TRADE, Vanguard, and Charles Schwab.

However, because junk bonds are so speculative, a bond fund might be a better choice. Because it holds a diversified portfolio, it carries less risk. It’s highly liquid — can be sold at any time. And of course, you have a professional manager evaluating and choosing the bonds, so you don’t have to.

The financial takeaway

Junk bonds aren’t for everyone. From the specter of default to their illiquidity, they “carry a higher level of risk than investment-grade bonds. While the investor is usually compensated for this risk in the form of a higher return, losses can hurt,” says John Cronin.

That said, junk bonds historically offer higher yields than investment-grade bonds. This is particularly the case during stock market and economic downturns, which forces junk bond issuers to offer higher rates.

It all depends on your appetite for risk. The average individual investor probably shouldn’t go whole-hog into junk bonds. But as part of a balanced portfolio, they could offer a nice boost to income and overall returns.

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