A junk bond is a corporate bond issued by a company that does not have an investment-grade credit rating. These are also known as high-yield bonds. Companies that issue junk bonds pay higher interest rates to entice investors to take on the higher risk of lending them money. 

Of the various types of bonds, including investment-grade corporate bonds, municipal bonds, and treasury bonds, junk bonds carry the highest risk of default, meaning they have a higher likelihood of losing money. Yet even with that risk, they still have lower risk of losses than stocks, since a company is obligated to pay bondholders back before shareholders get anything. 

Why invest in junk bonds?

Junk bonds offer the potential to earn more money than investment-grade-rated corporate bonds and federal government bonds because they pay higher yields. For example, the chart below compares the PIMCO Investment Grade Credit Bond Fund and the PIMCO High Yield Fund: 

PHIYX Dividend Yield Chart

PHIYX Dividend Yield data by YCharts

The High Yield Bond Fund, which invests exclusively in higher-quality junk bonds, pays investors nearly 35% more interest than the investment-grade bond fund. That's a lot of extra income potential; moreover, plenty of individual junk bonds offer even higher yields. That's why high yield bonds can be appealing investments. 

Junk bonds in general are a lower risk than stocks. If a company goes bankrupt, bondholders stand near the front of the line -- sometimes at the front -- to get repaid, while shareholders are at the very end. In other words, they can fit in between stocks and investment-grade bonds on the risk/reward scale. 

Another reason to invest in junk bonds is to avoid stock market volatility with assets you'll need to cash out at a known date, such as retirement income or a child's education. By owning bonds that mature before those financial needs appear, you can avoid the short-term risk of a stock market crash wiping out the value of your nest egg at the worst possible time. 

Junk bond companies

Companies that issue high-yield bonds have credit ratings that fall below what is considered investment grade by one of three ratings agencies: 

  • Standard & Poor's (S&P)
  • Moody's (NYSE:MCO)
  • Fitch

Bonds issued by companies with a credit rating of BB or lower by S&P and Fitch, or Ba or lower by Moody's, are considered junk bonds. 

Notable companies with a credit rating that puts them in "junk" status include Occidental Petroleum (NYSE:OXY), Ford (NYSE:F), and Tesla (NASDAQ:TSLA)

Occidental and Ford have been rated as investment grade in the past, but lost their investment-grade ratings in 2020 under the weight of the coronavirus pandemic and global economic collapse. Tesla is a younger, newer company, and its junk-rated credit profile is a product of its financial track record. Despite enormous growth, Tesla has reported profits in only eight quarters over the past 12 years, while also having a long history of negative cash flow (until very recently): 

TSLA Net Income (Quarterly) Chart

TSLA Net Income (Quarterly) data by YCharts

You may be wondering, since Tesla's stock price has skyrocketed, are its bonds more valuable, too? The short answer is no. While stocks represent ownership in a company, bonds are just a loan. The face value of the bond at redemption, plus the interest it will pay, is what a bond is worth. Sure, sometimes bonds trade for slightly above par (face value), but rarely by very much, and this is more a product of changes in the interest rate environment than a company's financial results. 

How to buy junk bonds

Buying junk bonds is similar to buying stocks. Many online discount brokers have a secondary market for bonds -- where you can buy bonds from other investors who want to sell bonds they own -- as well as some access to newly issued bonds. The best way to start is to determine what you're looking for in a bond:

  • How long do you want to invest? (Length of investment is determined by a bond's maturity date.)
  • How much income (yield) are you looking to earn?
  • How much risk are you willing to take on?

Once you've determined these parameters, you can search for bonds that meet your needs and are trading on your broker's secondary market. Once you've identified several possible bond investments, you can research the issuing companies and decide if they fit within your risk profile.

Just make sure to focus on managing risk, not just the highest yield. A yield that looks too good to be true probably is, indicating a company that investors expect may default. High-yield bonds can be an excellent investment so long as you diversify and limit how exposed you are to any one investment. 

Real-life junk bond examples

Here are two examples of bonds selling on the secondary market on July 24, 2020: 

  • Ford Motor Co Bond 6.625% 2/15/2028
  • OCCIDENTAL PETE CORP SER B Bond 7.125% 10/15/2027

Here's what the above means: who issued it, the coupon rate (interest yield of the bond at face value), and the maturity date. 

The price investors are willing to pay for these bonds tells us how risky investors consider them.

The Ford bonds trade for a premium to par -- the face value of the bond -- meaning investors are willing to pay above par to buy them. This reduces the effective yield; at recent prices, the Ford bond's effective yield would be 5.8%. 

The Occidental bond sells for a discount to face value, since its financial troubles are much deeper. The effective yield on these bonds that paid 7.125% at issue is 7.486%, since investors are asking for a discount to par to buy. 

One more example, from offshore drilling company Transocean (NYSE:RIG):

  • TRANSOCEAN INC NOTE 7.45% 04/15/2027

At this writing, Transocean is at risk of insolvency due to the massive collapse in offshore drilling activity. As a result, bondholders are willing to sell those bonds at a 70% discount to face value to unload them, pushing the yield to 37.6%. The risk here is that Transocean won't be able to meet its obligations, so bondholders are selling now to get what they can and not have to ride out a possible bankruptcy settlement. Investors looking for dependable yield shouldn't consider this a safe bond. 

The takeaway: Bond prices can fluctuate greatly on the secondary market as a company's risk profile changes. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.