Securities

Junk Bond (High-Yield Bond)

A junk bond is a corporate bond rated below investment grade (BB+/Ba1 or lower) that offers higher interest rates to compensate investors for the increased risk of default.

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Exam Tip

Junk = BB+/Ba1 and BELOW (below investment grade). Higher yield compensates for higher default risk. Also called "high-yield bonds."

What is a Junk Bond?

A junk bond, also called a high-yield bond, is a bond rated below investment grade by credit rating agencies. These bonds pay higher interest rates because they carry a greater risk that the issuer may default on payments.

Credit Rating Classification

RatingS&P/FitchMoody'sClassification
Investment GradeBBB- and aboveBaa3 and aboveLower risk
Junk/High-YieldBB+ and belowBa1 and belowHigher risk

Why Called "Junk"?

The term reflects the higher risk of default, but "high-yield" is the preferred industry term because:

  • These bonds pay significantly higher interest rates
  • Many have never defaulted
  • They serve legitimate financing needs

Junk Bond Characteristics

CharacteristicDescription
Higher Yield4-8%+ more than Treasuries
Higher Default RiskHistorically 3-6% annual default rate
Price VolatilityMore sensitive to economic conditions
Credit SpreadsWiden during economic stress

Types of Junk Bond Issuers

TypeDescription
Fallen AngelsFormer investment-grade companies downgraded
Rising StarsImproving companies that may be upgraded
Start-upsNew companies without track records
Leveraged BuyoutsCompanies with high debt from acquisitions
TurnaroundsDistressed companies attempting recovery

Junk Bond Yields vs. Investment Grade

Bond TypeTypical YieldSpread Over Treasuries
Treasury Bond4%Baseline
Investment Grade Corp5-6%100-200 bps
BB-rated (Junk)6-8%200-400 bps
CCC-rated10-15%+600-1000+ bps

Who Invests in Junk Bonds?

Investor TypeReason
High-Yield Mutual FundsDiversified junk exposure
Hedge FundsHigher returns, distressed opportunities
Individual InvestorsIncome seeking, risk tolerant
Pension FundsLimited allocation for yield enhancement

Risks of Junk Bonds

RiskDescription
Default RiskIssuer may not pay
Interest Rate RiskPrice falls when rates rise
Liquidity RiskHarder to sell quickly
Economic RiskPerform poorly in recessions

Historical Default Rates

RatingAverage Annual Default Rate
AAA0.0%
BBB0.3%
BB1.5%
B5.0%
CCC25%+

Exam Alert

Junk bonds = rated BB+/Ba1 or BELOW. They pay higher yields to compensate for higher default risk. Know that "high-yield" and "junk" mean the same thing. Spreads widen during recessions.

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