Definition of Junk Bonds
Junk bonds are bonds that have a rating below investment grade. Many times, junk bonds are dismissed by investors as being bad investments. Dependent on the goals and circumstances of the investor, this is not always the case. In fact, some investors have enjoyed significant returns with investments in junk bonds.
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Definition of a Junk Bond
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Junk bonds are simply corporate debt rated as non-investment grade. As such, junk bonds are generally considered riskier than investment grade bonds. Specifically, junk bonds are considered more likely to go into default than investment grade bonds, and therefore there is a higher chance that the investor will not get his investment repaid.
Risk and Return With Junk Bonds
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Junk bonds offer higher yields than investment grades. In fact, junk bonds are often called high-yield bonds or high-yield debt. This higher yield is required in order to entice investors to buy the riskier debt instead of lower-risk, investment-grade debt. The gap between the returns for investment-grade debt and junk bonds varies with the state of the economy. For example, in late 2008 and early 2009, the gap was wider than normal because many feared the bad economy would cause defaults in junk bonds.
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Considerations Before Investing in Junk Bonds
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Junk bonds are riskier than investment grade bonds; so, they are not a good choice for every investor. Most investors should consult a financial adviser before making any investments in junk bonds. Smaller investors do, however, have an increasing number of ways to invest in junk bonds with the increase in exchange traded funds (ETFs). There are several ETFs that make investment in junk bonds possible, even with small amounts of money.
Types of Junk Bonds
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Junk bonds generally can be broken into two broad categories: fallen angels, and rising stars. Fallen angels are companies that once had investment-grade ratings, but for some reason have been downgraded to junk status. General Motors bonds would be an example of a fallen angel. Conversely, a rising star is a company that may be new to the bond market and is progressively improving its bond rating. Even though it is improving, it is possible for a rising star to still have a noninvestment-grade rating.
Who Should Consider Investing in Junk Bonds
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Junk bonds generally should not be depended upon as fixed income instruments. They are more volatile than investment grade bonds, and consequently behave more like stocks than high-grade bonds do. Also, because the risk associated with junk bonds can be so high, they are not generally desirable as core investments (i.e., assets that will depended upon) for individual investors. Instead, they should be considered part of a more speculative investment that may increase overall returns.
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