A “junk bond”, also known as a “high-yield” bond or a “speculative bond”, is a bond with a credit rating of BB or lower by Standard & Poor’s or BA and below by Moody’s. These ratings are able to rise or fall over time. Junk Bonds earned their moniker because of their higher default risk compared to investment grade bonds. Junk Bonds have a maturity date, a principal amount and coupon. Companies can issue junk bonds to attract investment opportunities.
For example, Jean Corp has a poor credit rating and decides to issue junk bonds in order to attract investment. Average corporate bonds in Jean Corp’s industry have interest rates of 4% while Jean Corp is offering junk bonds with 7%. While investors are receiving a higher interest rate, they are also including much higher risk into their portfolio and exposing themselves to a potential default on principal.
If Jean Corp turns around its business and starts to build up its credit rating, the price of the junk bonds already issued within the maturity date will appreciate substantially (in order to justify a higher interest rate) as the default-risk associated with the junk bond has decreased.
In order to understand junk bonds, one needs to understand what classifies a bond as “investment grade.” An investment grade bond is a bond with a rating of BBB or BB or higher, depending on Standard & Poor or Moody’s scale respectively. Government and treasury bonds are not classified with credit quality ratings because these are considered to be the highest credit quality.
For example, a corporate bond with a quality rating of AAA or AA is considered to be a high credit quality bond, while a bond with an A or BBB credit rating is considered to be of medium quality credit. Both of these examples are considered to be of investment grade.
Fallen Angels vs. Rising Stars
Junk Bonds can be broken down into two different categories: Fallen Angels and Rising Stars. A Falling Angel is a bond that was once investment grade but then reduced to junk-bond status because of the company’s poor credit quality. A rising star, on the other hand, is a bond that experiences an increased rating due to the company’s improving credit quality. Rising stars can still be considered junk bonds, however they are on their way to becoming investment grade.
Overall, purchasing junk bonds tends to be an investment strategy used by particularly motivated individuals who are willing to take on significant risk in order to attain high returns. Many junk bonds do not allow investors to pull out for one to two years, so the importance of liquidity must be considered before investing. Finally, Junk bonds are similar to equities in that they follow the boom and bust cycles associated with the market.