Bonds are an important part of every investor’s portfolio, offering a lower volatility security to help offset the quick rises and falls of stocks. If you’ve invested in bonds before, you may be familiar with the term “junk bonds.”
Despite their name, junk bonds aren’t entirely worthless. The term is used for bonds from issuers with less-than-stellar credit ratings. They involve a bit more risk than the highest-rated bonds but make up for it with higher interest rates.
What Are High-Yield (Junk) Bonds?
Junk bonds, often called high-yield bonds, are bonds from issuers that don’t have great credit.
Bonds are a way for organizations such as state and local governments, national governments, and businesses to borrow money. Investors buy bonds and in exchange receive regular interest payments. They serve as a source of fixed income until they mature, at which point the issuer pays back the principal of the bond.
Just as individuals have credit scores, companies and other bond issuers have credit ratings. These ratings come from credit rating agencies like Moody’s or Standard & Poor’s, which specialize in rating corporate bonds and other types of bonds.
Bonds from issuers with very strong credit ratings, such as the U.S. government, are called investment-grade bonds. By contrast, junk bonds come from issuers with low credit ratings.
To compensate for the higher risk of default, junk bonds must offer higher yields, giving bondholders an opportunity to earn higher returns on their bond investments.
If you look at the bond market, you’ll see that yields increase as the credit quality of the issuing company decreases.
What Rating Is Considered a Junk Bond?
Credit ratings for bond issuers use a letter grading scale. The highest rating is AAA. Below that is AA+, then AA, AA-, A+, A, A-, BBB+, and so on.
According to most investors, any bond with a rating of BBB- or better is an investment-grade bond. That means the default risk is relatively low. Bonds rated BB+ or worse are characterized as junk bonds or high-yield bonds. These carry a greater risk and therefore must offer higher interest rates.
Some go further and label anything rated C or below as speculative grade, meaning they are incredibly high-risk. Often, the issuers of these bonds are already in default, although there is a chance they might recover and begin making payments again.
An example of an AAA-rated bond is a U.S. Treasury bond. The U.S. government is large and trusted to repay its debts, which means the U.S. can borrow money at a very low cost. By contrast, the government of Argentina has a CCC+ rating from Standard & Poor’s, meaning it must pay investors more to borrow money from them.
How Do High-Yield Bonds Work?
High-yield bonds work like other bonds. They simply carry more risk and higher interest rates.
You can purchase a bond directly from the bond issuer or from another investor on the open market. Bonds have a face value, a coupon rate, and a maturity date.
The face value is the amount paid to the bond issuer to purchase the bond. Once the bond matures, the issuer will return the face value of the bond to the investor.
The coupon rate is the amount the investor receives with each interest payment. For example, if an investor buys a $1,000 bond with a 5% coupon rate, the issuer pays the investor $50 each year. Once the bond reaches its maturity date, the issuer makes a final payment of $1,050, which includes the final interest payment plus a return of the principal.
Bonds can trade on the open market, meaning investors can buy and sell bonds to each other. The liquidity of individual bonds can vary based on many factors, including the issuer’s credit rating. In general, bond prices rise when interest rates fall and fall when rates rise. Investors who hold bonds to maturity don’t need to worry about these price changes, but they will matter if you want to sell a bond before it matures.
Types of High-Yield Junk Bonds
There are a few different types of junk bonds out there. Some exchange-traded funds (ETFs) or bond mutual funds might focus on a specific type of junk bond, making it important to understand the difference.
A fallen angel bond is one issued by a company that previously had a strong credit rating. The credit rating of a company can change over time, especially if it falls on hard financial times. Financial struggles like declining revenue or significant cost increases can cause a corporation’s bond rating to be cut.
Although the coupon rate on already-issued bonds won’t change, bond prices can change over time. The price of a fallen angel bond might fall significantly below its face value because of the credit risk of the issuer, driving up its potential return to a buyer on the secondary market.
A rising star is a junk bond issued by a company or other entity that doesn’t have an established credit history. Like individuals, new bond issuers typically start with low credit ratings until they build a history of making their debt payments.
Bond investors may purchase corporate debt from companies that seem poised for success but lack a long credit history. This gives investors the chance to capture higher yields from bonds that are a lower risk than their interest rates may imply.
What Are Junk Bonds Used For?
There are many reasons investors purchase non-investment grade bonds.
- Higher Yield. Bonds from issuers with lower credit ratings offer higher interest rates, which means investors can receive more income and a greater total return than they would from investing in safer bonds. This is especially true in low-rate environments where it is hard to find a good yield from safer investments.
- Diversification. Bonds are a popular way for investors to diversify their portfolios and reduce the volatility of investing in the stock market. Investing in multiple types of bonds can also aid in diversification.
- Speculation. Some investors want to buy high-risk investments that have the chance to produce significant returns. Junk bonds are one way investors can try to capture large returns.
Pros & Cons of High-Yield Junk Bonds
Junk bonds can be a strong source of income from individual investors, but there are also risks to consider.
Junk bonds are popular with investors for a few reasons.
- Higher Potential Return. Junk bonds offer higher potential returns because of their higher interest rates.
- Bonds May Gain Value. Investors can trade bonds on the open market. If market rates fall or the company issuing the bond improves its credit rating, the value of the junk bond could rise, letting the investor earn a profit from selling the bond before it matures.
- Consistent Source of Income. Investors who want to use their portfolio as a source of income often turn to bonds due to their regular interest payments. A company can cut its stock dividends at will, but bond interest payments must stay the same unless the issuer goes into default.
- Diversification. Investors often try to keep their portfolios diversified by holding different types of investments. Junk bonds let investors follow this investment strategy by adding a different asset class to their portfolios.
- Some Bonds Get Preferential Tax Treatment. Some bonds, like municipal bonds, receive preferential tax treatment. You don’t have to pay certain taxes on the returns you earn from these bonds.
While investing in high-yield junk bonds can be tempting, there are drawbacks to consider before jumping in.
- Risk of Default. The reason junk bonds offer such high yields is that they’re risky. There’s a chance the issuer won’t make its payments, meaning you’ll lose all the money you invested in the bond.
- Bonds May Lose Value. Just as bonds can gain value, bonds you hold might lose value if market rates rise. That means you could lose money if you have to sell the bonds before they mature. The bonds could also lose value if the issuer’s credit rating drops.
- Liquidity. Some investors may not want to buy bonds from issuers with poor credit, making it hard to sell junk bonds you own.
Should You Buy High-Yield Junk Bonds?
Whether you should buy high-yield bonds is a personal decision with no single answer.
Junk bonds can be a good choice for investors who want to add fixed-income securities to their portfolios and are willing to accept slightly higher risk. Investing in government bonds is very safe, but produces low returns. Junk bonds offer some diversification while keeping potential returns higher.
However, if you want a safe, secure source of income and can’t accept the risk of a default, junk bonds may not be a good fit for your portfolio. In that case, lower-risk securities are a better choice.
How to Buy High-Yield Junk Bonds
There are multiple easy ways to buy junk bonds.
- Through a Broker. You can work with your brokerage company to purchase bonds on the open market. Find a bond you’re interested in based on the issuer, yield, and maturity, and place an order to buy that bond. Just keep the commissions your brokerage charges in mind.
- Mutual Funds. There are many mutual funds and ETFs that invest in bonds. You can choose a bond index fund, which holds a huge variety of bonds and keeps costs low, or find a more actively-managed fund that aims to maximize returns, but often with higher fees.
- Direct Purchase. Investors can buy bonds directly from the companies issuing them. This involves contacting the businesses selling the bond directly when they’re issuing new debt, but it can help you avoid commissions and some other fees.
Junk bonds are just one option for investors looking to earn a higher yield on their money. Although their greater returns can be tempting, it’s important to remember that high-yield bonds have those yields for a reason: higher risk.
If you choose to invest in junk bonds, it’s a good idea to make it just one part of your investment strategy. Keep a diversified portfolio spread among many securities and you can avoid catastrophic losses from a single default.