Junk Bond

A junk bond is a debt security whose credit rating falls below the investment-grade threshold set by the major rating agencies, which places it in what those agencies call speculative grade. Because a lower rating signals a higher assessed probability that the issuer will miss payments or default, the issuer must offer a higher interest rate to attract buyers. The bond and the higher yield are two sides of one bargain: investors accept greater default and price risk in exchange for the prospect of a greater return. "Junk bond" is the informal name; the industry's own term is "high-yield bond," and both describe the identical category.

Rating agencies grade a bond issuer's creditworthiness on a letter scale. On the S&P and Fitch scales, everything from AAA down to BBB− is investment grade; BB+ and below is speculative grade, the formal term for junk. On the Moody's scale the investment-grade floor is Baa3, and Ba1 and below is junk. The line matters because many institutions, such as pension funds and certain regulated portfolios, are permitted to hold only investment-grade debt, so a bond that crosses below the line can face forced selling. Junk bonds arrive in two ways. A "fallen angel" was issued as investment grade and later downgraded when the issuer's finances deteriorated. An original-issue high-yield bond was sold below investment grade from the start, often by a young, heavily indebted, or turnaround company. The extra yield a junk bond pays over a comparable Treasury is its credit spread, and that spread widens when the market grows more worried about defaults and narrows when confidence returns. The category behaves less like safe fixed income and more like a hybrid of a bond and a stock, since its price is sensitive to the issuer's business fortunes and to the broader economy, not only to interest rates. Diversifying across many issuers, usually through a fund, is the standard way to hold this risk, because a single default in a concentrated position can wipe out years of extra yield.

A junk bond pays a higher coupon than a safer bond, and the size of that premium reflects the market's view of the issuer's default risk.

A hypothetical example. Two five-year bonds are available with $1,000 face values.

• An investment-grade corporate bond pays a 5 percent coupon: $50 a year.
• A junk bond from a riskier company pays a 9 percent coupon: $90 a year.
• The extra $40 a year is the compensation for higher default risk, a spread of 4 percentage points (400 basis points) over the safer bond.

Whether that extra $40 is worth it depends on how often bonds like the junk one actually default and how much investors recover when they do. If bonds in that rating band default at, say, 4 percent a year and recover 40 cents on the dollar, the expected annual loss from default is roughly 2.4 percent of value, which eats into but does not erase the 4-point yield advantage, provided the investor holds enough different issuers that no single default dominates.

Pros

• Pays a higher yield than investment-grade bonds, which can lift a portfolio's income.
• Returns are less tied to interest-rate moves and more to issuer and economic conditions, offering a different source of risk and return than safe bonds.
• A downgraded "fallen angel" can be mispriced by forced institutional selling, occasionally rewarding buyers willing to take the credit risk.

Cons

• Carries a materially higher risk of default, and a default can mean losing much of the principal.
• Prices fall hard in recessions and market stress, exactly when an investor may most want stability, so the diversification benefit against stocks is weakest when it is needed most.
• Less liquid than investment-grade and Treasury debt, so selling in a downturn can mean accepting a steep discount.