What Is a Junk Bond?

Junk bonds were first issued in the late 1970s and gained notoriety in the 1980s as traders bought and sold these bonds frenetically, became overexposed in the market and lost dramatically with an uptick in bond defaults at the end of the decade. As with all investments, junk bonds may be a good option for any well-diversified portfolio, provided the investor is willing to take on a higher level of risk.

Bond Ratings

Junk bonds have a rating lower than Standard and Poor's BBB or Moody's Baa -- the fifth level or below in the rating system. These ratings indicate a greater risk of bond default due to the poor credit of the issuer. Like consumer debt, creditworthiness in the bond world is related to the ability of a company to pay its debt. Factors include the financial soundness of the company, how much debt it has outstanding and the amount of risk inherent in its business model.

Interest Rates

Junk bonds -- also known simply as high-yield bonds or non-investment grade bonds -- appeal to investors because they have better interest rates than investment grade bonds and treasury securities. Often, this difference is significant -- in March 2011, high yield bonds were averaging at least four percent higher interest rates than treasury bonds in a market where interest rates were very low for a long time.

What is "Junk?"

Since bond ratings are based on creditworthiness, the junk bond market is dominated by smaller, newer companies. "Small" is a relative term, however. All companies with revenue of less than $35 million per year and 95 percent of those with revenue above that line have bonds issued at grade B or lower, meaning that a number of well-known companies may fall into junk status when it comes to bonds.

Investing in High-Yield Bonds

Savvy investors note that if the majority of companies issue bonds at grade B or lower, not all high-yield bonds are junk. As with all riskier investments, a thorough review of a company's fiscal health and long-term growth potential will help to determine whether a particular bond is a good addition to your portfolio. Those looking for a more hands-off approach may consider a mutual fund focused on high-yield bonds as a way to branch into this market sector.

References

• MarketWatch; "Junk Bonds: What to Do Now"; Jane J. Kim, March 21, 2011
• Daily Finance; "The Junk-Bond Market's Best Days May Be Behind It"; Charles Wallace; February 15, 2011
• CNN Money; "Junk Bonds: Still a Good Bet"; Hibah Yousuf; February 18, 2011
• Creighton; "An Explanation of Junk Bond Ratings"; Clifford G. Dow, CFA, CFP; 1998
• The Motley Fool; "Daddy, What's a Junk Bond?"; Bill Mann, January 28, 2004
• The Concise Encyclopedia of Economics; "Junk Bonds"; Glenn Yago

Resources

• The Wall Street Journal: Corporate Bonds
• Investing In Bonds