Junk bond definition
a debt instrument offering higher return but with high risk and high default probability
What is a junk bond?
A junk bond is a debt instrument offering higher return but with high risk and high default probability. They can be issued by companies with worsening financial health, which may not be able to meet its obligations when they are due. In addition, junk bonds can be issued by a start-up company looking to raise money to finance its operations and expansion. Junk bonds are also called high-yield bonds because of the return that investors can make from these bonds.
The process for issuing a junk bond is the same as for other bonds- the difference is in the credit rating, i.e., the issuer’s credit quality. Bond credit rating defines bond risk levels and the expected yield. Corporate bonds with the highest credit quality are rated with AAA (S&P and Fitch) or Aaa (Moody’s) credit rating. Junk bonds are usually rated “BB” or lower by S&P and Fitch, and “Ba” or lower by Moody’s. On the basis of the assigned credit rating, bonds are categorized as investment grade bonds or junk bonds.
Investing in junk bonds: pros and cons
The most important reason in favor of investing in junk bonds is the opportunity for earning higher yield compared to other instruments. On the other hand, you should take into account the risk levels of this instrument. There is a high probability that a company issuing junk bonds will default on its obligations or will not be able to pay on time. Moreover, junk bond prices can be highly volatile because of the uncertainty related to the issuer.
Types of junk bonds
Junk bonds can be classified as fallen angels or rising stars. A fallen angel is a bond which had been primarily assigned an investment grade rating but has been downgraded to junk bond rating. The downgrade could be the result of the worsening financial standing of the issuer.
The rising stars bonds are in some way the opposite of the fallen angels. Namely, the rising stars have been initially issued as junk bonds, but there have been improvements in the issuer’s financial health and a reduction in the default risk. Rising stars can also be bonds issued by newly created or young companies with limited historical data. The rising stars are considered to be junk bonds with the potential of being upgraded to investment grade bonds in the future.