Junk Bonds

What Are They?

Junk bonds are issued by companies that have a relatively high risk of defaulting on their debt. Because of this, investors demand more interest from them. That’s why junk bonds are also known as high-yield bonds.

Rating agencies assess the financial stability of companies and grade them, usually on an alphabetical scale of AAA (the best) to D (in default). That’s how all debt is split into:

• Investment grade: BBB− or higher at S&P and Fitch
• High yield: BB+ or lower

That single step down from BBB− to BB+ puts a bond into junk territory. Note that the third big agency, Moody’s, has a slightly different rating system.

Why Should I Care?

Riskier than investment-grade bonds but usually less volatile than stocks, junk bonds can play a useful role in a diversified portfolio. For companies, they are an important source of capital, especially during high growth, big acquisitions, or financial trouble. Private equity firms frequently use high-yield debt to fund leveraged buyouts.

The junk-bond market is also a barometer of confidence:

• When investors feel optimistic, they're willing to lend to riskier companies and junk-bond yields tend to fall.
• A widening credit spread — the gap between junk-bond yields and investment-grade paper (typically US Treasuries) — usually signals growing worries about bankruptcies and a weakening economy.

What's The Catch?

If the economy slows, heavily indebted companies are usually the first to struggle. A recession that dents the profits of a strong company could push a weaker borrower into bankruptcy.

In a market panic, junk bonds can fall sharply alongside stocks. And in bankruptcy, bond investors are usually in the queue behind banks and other senior lenders. If there's not enough money to go around, bondholders can take significant losses.

American financier Michael Milken, nicknamed the "Junk Bond King," helped kickstart high-yield bonds in the 1980s into a five-trillion-dollar market today. But the same debt-fueled deals also became a symbol of Wall Street excess. High returns are attractive, but they come with high risks.