A junk bond, also known as a high-yield bond or speculative-grade bond, is a type of fixed-income security issued by companies or governments with credit ratings that are considered below investment grade. Junk bonds are characterised by a higher risk of default compared to investment-grade bonds, which are issued by entities with higher credit ratings and, therefore, are considered less risky.
Credit ratings are assigned by rating agencies such as Standard & Poor's, Moody's, or Fitch, and they reflect the creditworthiness of the issuer. Bonds with credit ratings below the investment-grade threshold (usually below BBB- by Standard & Poor's and Fitch, or below Baa3 by Moody's) are classified as junk bonds.
Key characteristics of junk bonds include:
- Higher Yield: Junk bonds offer higher yields compared to investment-grade bonds as compensation for the increased risk of default. Investors demand higher interest rates to compensate for the possibility of not receiving their full principal and interest payments.
- Increased Default Risk: Junk-rated issuers are more likely to face financial difficulties or business challenges, making them more prone to default on their debt obligations. As a result, investing in junk bonds carries a higher risk of loss compared to investment-grade bonds.
- Volatility: Due to their higher risk profile, junk bonds tend to be more volatile than higher-rated bonds. Their prices can fluctuate significantly in response to changes in the issuer's financial condition or general market sentiment.
- Attractive to Some Investors: Despite the higher risk, junk bonds can be appealing to certain investors seeking higher returns in a low-interest-rate environment. Additionally, some funds and institutional investors have mandates that allow them to invest in high-yield securities.
Investing in junk bonds can be suitable for investors who are willing to take on higher risk for the potential of greater returns. However, it's crucial for investors to carefully assess the credit quality of the issuer and conduct thorough due diligence before investing in junk bonds. Diversification and understanding the specific risks associated with individual junk bond investments are also important for managing risk in a high-yield bond portfolio.