What Are Junk Bonds?
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What Are Junk Bonds?
When you buy a bond, you are lending your money to someone (the government or a private company) who promises to pay you back the money when the bond matures, plus interest. The ability of the bond issuer to meet its obligation is expressed in the bond’s credit rating. Whether a company defaults on its bonds or not depends on its ability to pay back its debt.
Things To Know
- Junk bonds are considered "low grade."
- Their high default risk makes junk bonds speculative.
Junk bonds explained
Bonds that have a high credit rating are known as investment-grade bonds. Bonds that are likely to default are called speculative or non-investment grade. Low-grade bonds may be issued by companies without long track records, or with questionable ability to meet their debt obligations. Because most brokers do not invest in these low-grade bonds, they are known as junk bonds. However, because of the very high interest rates these bond issues typically offer, they are also referred to as high-yield bonds.
Junk bonds and default risk: the connection
Because junk bonds have a high default risk, they are speculative. Default risk is the chance that a company or government will be unable to pay its obligations when the bonds mature. Defaults on bonds most often occur within the first several years of a bond’s issue.
Even when a junk bond defaults, it might still keep some of its value. The impact of a default on a bond’s price is known as its default loss rate. Sometimes a bond’s actual price loss is not the same as its rate of default loss. A default due to bankruptcy will probably reduce a bond’s price more than a default due to a company changing its strategic direction.
How the risk of default is determined and graded
Default risk is determined by a credit rating system. A bond’s credit rating is based on the risk of a bond issuer not making its payments on time, or at all. A bond’s credit rating is measured by a grading system that starts with a rating of AAA for bonds least likely to default, all the way down to "D" for bonds that default. Junk bonds have a rating of BB or lower.