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Junk bonds are a high-risk investment, but they offer the potential for higher returns than investment-grade bonds. Junk bonds, also known as high-yield bonds, are best suited for investors who are willing to take on more risk in order to achieve higher returns.
Here are the key things to know about junk bonds and their pros and cons.
What are junk bonds?
Junk bonds are a kind of bond or debt investment that is rated below investment grade. The junk bond rating means that there is a greater risk that the issuer will default on the debt, relative to investment-grade bonds. As a result of this increased risk, junk bonds offer a higher interest rate than investment-grade bonds, all else equal.
The quality of junk bonds can vary markedly. Despite the name, junk bonds may be issued by companies that are in reasonably good financial shape, though they’re often issued by those in mediocre or poor shape. The worst junk bonds are issued by companies that are struggling financially and have a high risk of defaulting or missing their interest payments.
In contrast, investment-grade credit ratings are given to companies that are considered to be the least likely to default on their debt. These companies are able to issue bonds that are rated BBB up to AAA . Junk bonds, on the other hand, are rated below BBB and carry what is considered the highest risk of a company missing an interest payment (called default risk). Yet, companies with junk bonds are not simply defaulting left and right, and higher-rated junk bonds can perform well for investors, especially if diversified as part of a bond portfolio.
So it’s important to understand that not all junk bonds are the same, even if some of them are truly quite risky.
How to invest in junk bonds
Junk bonds can be purchased from a brokerage firm that buys and sells individual bonds. Investors can also buy a diversified portfolio of bonds through a mutual fund or ETF. In fact, several mutual funds and exchange-traded funds are dedicated to holdings of only junk bonds.
For investors looking to get into the junk bond game but who don’t have confidence in their own selection process, these funds offer an easy way to get access to junk bonds. You’ll enjoy the benefits of owning a diversified portfolio of junk bonds – less risk than owning just a few junk bonds – and you’ll likely enjoy a higher yield than you would with investment-grade bonds.
If you’re buying a fund, look at its long-term performance to see what returns you might expect. To get a sense of the fund’s volatility, check performance in each year. You can also check under the hood to see how much of the fund is invested in each credit grade, giving you an idea how risky the fund’s individual bonds may be. This perspective can help you determine whether a junk bond ETF may fit your needs.
Pros and cons of junk bonds
Junk bonds can be a good way to diversify your portfolio, but they’re not for everyone. Consider these pros and cons when deciding whether or not to invest.
Pros
- Higher yields. Junk bonds are more volatile than other bonds, but you can expect to receive higher interest rates from them than their investment-grade counterparts.
- Cash flow. Junk bonds, like bonds generally, are a good way to provide consistent cash flow for your portfolio. Bonds generally are not as volatile as stocks, so you’re less likely to experience permanent losses.
- Diversification. Bonds offer a way to diversify your portfolio away from just stocks, and they may perform differently in different market environments, potentially rising when stocks fall.
Cons
- Default risk. Junk bonds are riskier than investment-grade bonds because they’re issued by companies that are on less stable financial footing. They have higher default rates than investment-grade bonds.
- Liquidity. Junk bonds may not trade as frequently as investment-grade bonds, meaning you might have a harder time selling your bonds immediately or without taking a more substantial discount on the market price.
- Risk of individual bonds. Investing in individual junk bonds requires you to analyze the company, making investing in them riskier than simply buying a fund with a diversified collection of junk bonds.
Bottom line
Investing in individual junk bonds is not for the average investor, but a junk bond fund can work for many investors, offering diversified exposure to them. Even still, before investing in junk bonds, it’s important to understand the risks and weigh them against the potential benefits.
FAQs
Junk bonds are a kind of bond or debt investment that is rated below investment grade. The junk bond rating means that there is a greater risk that the issuer will default on the debt, relative to investment-grade bonds.
What are junk bonds in simple terms? ›
A junk bond is debt that has been given a low credit rating by a ratings agency, below investment grade. As a result, these bonds are riskier since chances that the issuer will default or experience a credit event are higher.
Are junk bonds a good investment? ›
The simple reason to buy a junk bond is for higher returns. Junk bonds are risky assets but due to their high risk, they come with returns that are higher than safer, investment-grade bonds. Investors willing to take on higher risk for higher returns would buy junk bonds.
How much can you make on junk bonds? ›
Because junk bonds are risky, their yields will typically trade at a 4% to 6% premium over investment-grade bonds. If a bond makes it to the D level, default is imminent (or the issuer has already defaulted). Just like in school, a D on a report card spells trouble.
What is the difference between a junk bond and a Treasury bond? ›
Compared to investment-grade bonds, junk bonds have a much higher default risk, meaning that the issuer may be unable to repay the bond interest or principal on time, and so the bond should command a commensurately higher return to compensate for that risk.
Can banks hold junk bonds? ›
Corporate debt securities used to finance corporate takeovers are generally considered to be predominantly speculative with limited marketability. Accordingly, national bank commitments to acquire such "Junk Bonds" will be viewed as violations of 12 USC 24 and 12 CFR 1.
What happens when a junk bond defaults? ›
What bond holders receive after the default—and when they receive it—can vary significantly. Recovery proceeds may come in different forms, including as a newly issued bond, cash, stock, or some combination of the three, and the process can take anywhere from a few months to several years.
What is one disadvantage of junk bonds? ›
An investment-grade credit rating denotes little risk that a company will default on its debt. Junk bonds, however, carry the highest risk of a company missing an interest payment (called default risk).
How to purchase a junk bond? ›
As an individual investor, there are a couple of different ways to buy junk bonds:
- Buy individual bonds. You may be able to buy junk bonds through your online brokerage account's trading platform, just like you can stocks or funds. ...
- Invest in bond funds.
Investment-grade refers to bonds rated Baa3/BBB- or better. High-yield (also referred to as "non-investment-grade" or "junk" bonds) pertains to bonds rated Ba1/BB+ and lower.
How to get the most value from your savings bonds
| Face Value | Purchase Amount | 30-Year Value (Purchased May 1990) |
|---|
| $50 Bond | $100 | $207.36 |
| $100 Bond | $200 | $414.72 |
| $500 Bond | $400 | $1,036.80 |
| $1,000 Bond | $800 | $2,073.60 |
May 7, 2024
Basic Info. 1 Year Treasury Rate is at 5.13%, compared to 5.10% the previous market day and 5.33% last year. This is higher than the long term average of 2.96%. The 1 Year Treasury Rate is the yield received for investing in a US government issued treasury security that has a maturity of 1 year.
How often do 2 year treasury notes pay interest? ›
Notes are relatively short or medium-term securities that mature in 2, 3, 5, 7, or 10 years. Both bonds and notes pay interest every six months. The interest rate for a particular security is set at the auction.
What is a real world example of a junk bond? ›
You may think of junk bonds as being issued by smaller corporations or very troubled companies. But just as often they are issued by well-known companies with long histories, or new companies without an established track record. Some recent examples include Coinbase and Crocs.
Which of the following is the best definition for a junk bond? ›
“Junk” or “high-yield” bonds are issued by companies with poor credit ratings, meaning that compared with better-rated “investment-grade” bonds, the risk is greater that these companies will default on their interest payments or even go bankrupt and be unable to redeem their bonds when they mature.
What is the lowest rated junk bond? ›
The riskier a bond is, other things being equal, the lower its rating. The highest-rated nondefaulted bonds are rated AAA or Aaa, and the lowest are rated C, with defaulted bonds rated D; thus, junk bonds can be rated anywhere between Baa (BB) and D.
What is the difference between secured junk bonds and unsecured junk bonds? ›
Those backed by entities with strong economic profiles will have relatively lower rates. And, although “secured” sounds more reliable than “unsecured,” the reality is that a secured bond of “junk” quality is actually riskier than an investment grade unsecured bond.
