Junk bonds are a type of corporate bond. While you may think of “junk” as that pile of old stuff in the basem*nt that you’ve been meaning to throw out, the term means something very different for bonds. Junk bonds are below-investment-grade corporate bonds with a higher risk and generally a higher yield than other corporate bonds.
For some investors, the added risk is completely worthwhile for the potential added returns. However, others may want to shy away from these riskier assets. Keep reading to learn more about investing in junk bonds and their pros and cons.
What Are Junk Bonds?
Junk bonds, or “high-yield” bonds, carry a higher risk of default than investment-grade corporate bonds. Junk bonds are easy to spot when you review lists of potential bond investments, as they earn credit ratings of BB or below from ratings agencies such as Standard & Poor’s (S&P) or Fitch or a rating of Ba or below from Moody’s.
If you’re investing in junk bonds, it’s a good idea to look at the historic credit ratings of the underlying business issuing the bond. If the bond’s credit rating is trending upward, it could be a “Rising Star” on the way to investment grade. If it has a downward-trending credit score, it could be a “Fallen Angel” that once earned an investment-grade rating but was downgraded.
Junk Bond Credit Ratings
The following are the range of junk bonds’ credit ratings as expressed by the dominant rating agencies:
- High Risk: Rated Ba or B by Moody's, and BB or B by S&P. This means the company currently can meet payments, but probably won't if economic or business conditions worsen. That's because it's unusually vulnerable to adverse conditions.
- Highest Risk: Rated Caa, Ca, or C by Moody's; and CCC, CC, or C by S&P. Business and economic conditions must be favorable for the company to avoid default.
- In Default: Rated C by Moody's and D by S&P.
Why Would Investors Buy Junk Bonds?
As with any other investment or borrowing, higher risk leads to higher interest rates. As an investor, that means you can earn more when investing in junk bonds than you would in less risky bonds.
Note
If you have an appetite for more risk than is delivered by investment-grade bonds within the fixed-income asset class, junk bonds are the logical choice to investigate.
Junk bonds can boost overall returns in your portfolio while allowing you to avoid the higher volatility of stocks. These bonds offer higher yields than investment-grade bonds and can do even better if they are upgraded when the business does improve.
Junk bonds’ performance is often highly correlated to stocks’ performance and less closely correlated to other bonds’. Unlike stocks, however, bonds provide fixed interest payments. And they are lower-risk than stocks in some aspects. For example, bondholders generally get paid before stockholders in the case of a bankruptcy.
Junk bonds are issued with a maturity range of four years to over 10 years, with 10 being the most common. Junk bonds are often non-callable for three to five years, meaning the borrower can’t pay off the bond before that time period.
Note
Junk bonds perform best in the expansion phase of the business cycle. That's because the underlying companies are less likely to default when times are good. A healthy economy—and favorable economic conditions for the business’s industry—both reduce the risk.
Pros and Cons of Junk Bond Investing
Pros
- Higher investment yields
- Lower risk than stocks
- Recurring payments
- Diversifies a portfolio
Cons
- Higher risk of default
- Asset-price risk
Pros Explained
- Higher investment yields: High-yield bonds typically pay a higher interest rate than investment-grade bonds.
- Lower risk than stocks: In the event of a company bankruptcy, bondholders are paid back before stockholders.
- Recurring payments: Like most corporate bonds, the typical junk bond includes an ongoing “coupon” payment until the bond matures.
- Diversifies a portfolio: Investing in just one asset class may be risky. Adding a diverse group of junk bonds to your holdings improves portfolio diversification if this asset class aligns with your investment goals.
Cons Explained
- Higher risk of default: Lower credit ratings indicate a greater risk of default or bankruptcy at the issuing company, particularly if the economy sours.
- Asset-price risk: If the bond’s rating is lowered, future buyers will demand a higher yield, forcing down the bond’s market price.
How Do Investors Buy Junk Bonds?
If you’re interested in adding junk bonds to your investment account, you have a few ways to get started. The best option for most individual investors is to buy a junk bond mutual fund or electronically traded fund (ETF). These give you exposure to a diverse basket of junk bonds from a single purchase in your brokerage account:
- Individual bonds: If you have the cash available, you may be able to invest directly in individual bonds with your brokerage account. However, an individual bond doesn’t offer very effective diversification and isn’t right for most investors.
- ETFs: These funds are bought and sold like stocks and give you exposure to many bonds at once. Take note of the fund’s fees, historical performance, and ratings before buying.
- Mutual funds: Bond mutual funds are another accessible route into the bond markets for individual, or retail, investors. They are bought and sold in overnight batches but otherwise work similarly to ETFs.
The Bottom Line
Junk bonds are a significant part of the bond market, but that doesn’t mean they should be a big part of your portfolio. For many individual investors, it’s OK to skip junk bonds completely. For others, this type of holding should represent a relatively small portion of your portfolio and is best purchased through diverse ETFs.
Unlike that pile in your basem*nt, you may find junk desirable for your investment portfolio. Just invest carefully and make sure you understand the risks before hitting the buy button.
