A junk bond refers to high-yield or noninvestment-grade bonds. Junk bonds are fixed-income instruments that carry a credit rating of BB or lower by Standard & Poor's, or Ba or below by Moody's Investors Service. Junk bonds are so called because of their higher default risk in relation to investment-grade bonds.
Junk bonds are risky investments, but they have speculative appeal because they offer much higher yields than bonds with higher credit ratings. Investors demand that junk bonds pay higher yields as compensation for the risk of investing in them. If a junk bond manages to turn its financial performance around and has its credit rating upgraded, the investor may see a substantial appreciation in the bond’s price.
How a Bond Is Rated
Bonds are rated based on the revenue they generate to make principal and interest payments, and based on any assets pledged to secure the bond. Corporations, for example, are judged on their ability to generate earnings, while a municipality may issue a bond backed by fees from a toll road or a sports venue. A state or local municipality may also issue a general obligation bond, which is backed by the taxing power of
the municipality. The more revenue a bond can generate, the higher the credit rating.
A secured bond uses specific assets that serve as collateral, and that collateral can be sold to make principal or interest payments if any payments are missed. Unsecured bonds, on the other hand, are simply backed by the issuer’s ability to pay. Both the ability to generate revenue and the existence of collateral impact the credit rating of a bond.
Factoring in Defaults
If a bond misses a principal and interest payment, the bond is considered to be in default. Junk bonds have a higher risk of default because of an uncertain revenue stream or a lack of sufficient collateral. In a poor economy, the risk of bond default increases, and the risks are highest for junk bonds.
Investors purchase junk bonds to earn a higher interest rate than bonds of higher quality and to speculate on price increases. If the company’s financial performance improves, the credit rating may increase, which increases the price of the junk bond. Some investors buy junk bonds to profit from a potential price increase and not for the interest income. These bonds, however, have much larger price swings than bonds of higher quality.