A junk bond, more politely called a high-yield bond or speculative-grade bond, is a bond whose credit rating is below investment grade: BB+ or lower from S&P Global Ratings and Fitch, or Ba1 or lower from Moody's. Because the issuer is judged more likely to default, it must pay a higher coupon rate to attract lenders. Issuers include young growth companies, firms with heavy debt loads, companies bought in leveraged buyouts and some emerging-market governments.
High-yield bonds sit between investment-grade bonds and equities on the risk–return trade-off. Their prices depend more on the issuer's business prospects than on the level of interest rates, so they tend to rise and fall with the stock market. The terms "junk" and "high yield" describe the same bonds; the industry generally prefers the second.
Junk bond in plain terms
Think of two people asking to borrow money. One has a steady job and a long record of paying back; the other is starting a risky business or already owes a lot. You will lend to the second person only if they promise to pay you noticeably more. A junk bond is that second kind of loan, packaged so that many investors can share it.
Most of these borrowers do pay back, and the higher interest more than makes up for the few that do not. The danger is that failures tend to bunch together in bad times, so a lender can go years earning a good return and then lose a lot in a single downturn.
History of the high-yield market
For much of the 20th century, below-investment-grade bonds were mostly fallen angels: debt of companies that had once been rated investment grade and then slipped. In the late 1970s and 1980s the investment bank Drexel Burnham Lambert, led by Michael Milken, built a market for new bonds issued directly at speculative grades. The bonds financed growing companies and many of the decade's leveraged buyouts and hostile takeovers.
The market suffered a sharp setback around 1989–1990. Milken was indicted on securities fraud charges and pleaded guilty in 1990, and Drexel filed for bankruptcy in February 1990. Defaults rose in the 1990–1991 recession, but the market recovered and became a permanent part of corporate finance in the US and, from the late 1990s, in Europe. Today high-yield bonds compete with leveraged loans and private credit as ways for riskier companies to borrow.
Who issues junk bonds and why
Companies issue high-yield bonds when bank loans are too short, too restrictive or not available in the size needed. Common issuers are:
- Leveraged buyout targets. Private equity firms fund acquisitions partly with high-yield debt, which places heavy leverage on the bought company.
- Capital-hungry growth firms. Telecoms, energy producers and technology companies have used the market to fund large investment before they earn steady profits.
- Fallen angels. Established companies that were downgraded below BBB-/Baa3 keep their existing bonds, which then join the high-yield market.
- Emerging-market borrowers. Some governments and companies in lower-rated countries borrow in dollars or euros at high-yield ratings.
To protect investors, high-yield bonds usually carry stricter covenants than investment-grade debt, such as limits on extra borrowing or on paying dividends, and they are often callable after a few years.
Spreads, returns and defaults
The extra yield over a government bond of the same maturity is the high-yield credit spread. It is one of the most watched signs of market stress: it narrows when investors are confident and widens fast in a crisis, as it did in late 2008 and in March 2020. A bond's quoted yield to maturity assumes every payment is made, so for junk bonds it overstates the return investors should expect once likely defaults and partial recoveries are taken into account.
Defaults are uneven. They stay low in good years and jump in recessions, especially in sectors hit by a shock, such as US shale-oil producers when oil prices collapsed in 2015–2016 and again in 2020. When a high-yield issuer fails, recovery for bondholders depends on whether their bonds are secured and where they rank against other creditors.
Investing in high-yield bonds
Most individual investors reach the market through a high-yield bond fund or ETF, because spreading money across many issuers gives the diversification that this market needs. Fund buyers should note that high-yield bonds can be hard to sell in a panic, so liquidity risk is real, and that high returns in calm years can hide losses that arrive together in downturns. The SEC's investor education site warns that these bonds carry more credit risk than investment-grade debt and are not suitable for every investor.