Many investors incorporate bonds into their portfolios to benefit from the interest payments they typically provide. But a bond's investment value is only as good as its issuer's ability to make those payments. When a bond's credit rating falls below what's considered investment-grade level, it's referred to as a junk bond. Though junk bonds carry more risk than investment-grade bonds with higher ratings, they tend to offer much higher yields, and as such, they're an attractive option for some buyers.
What makes a bond junk?
Junk bonds trade just like regular bonds, only they're considered a much riskier investment. When you buy a bond, what you're essentially doing is agreeing to lend the issuer an amount of money in exchange for regular interest payments. Once the bond matures, or comes due, the issuer is required to give you back your principal investment in full.
The problem with junk bonds is that because their issuers are in such poor financial shape, they're less likely to make those interest payments as scheduled. To compensate investors for that added risk, they typically offer considerably higher yields than investment-grade bonds. Because most investors stay away from them, they're considered unwanted, or junk.
Credit ratings and junk bonds
Just as individuals are assigned a credit score, bond issuers are also evaluated from a financial perspective. A bond's likelihood of meeting or defaulting on its obligations are expressed in its credit rating. The higher the rating, the less likely a bond is to default.
Bonds that have a high enough credit rating are considered investment-grade, which means that they're suitable for most investors. On the other hand, bonds with a low enough rating are considered non-investment-grade, or junk.
There are three major ratings agencies used to evaluate bonds' creditworthiness:
- Standard & Poor's (S&P)
These agencies analyze a number of factors, such as assets, liabilities, and cash flow management, when assigning ratings to issuers. S&P and Fitch use a similar ratings system where issuers can receive as high a rating as AA, and as low a rating as D. Moody's uses a slightly different system where issues can go as high as Aaa and as low as C. A bond that carries a credit rating of BB or lower by S&P and Fitch, or Ba or lower by Moody's, is considered non-investment-grade, or junk.
Should you invest in junk bonds?
Many financial professionals make loads of money investing in junk bonds, but they're not for the faint of heart. When you buy junk bonds, you're taking the risk that you won't receive your interest payments, or, worse yet, your principal, as scheduled. As such, only those in a position to do a deep analysis of an issuer's assets, liabilities, and management should move forward with a junk bond purchase. Though junk bonds do offer high yields, and, in some cases, can be sold at a profit as market conditions evolve, if you're going to buy junk bonds, you'll need to prepare for the possibility of taking a loss. But if you know what you're doing and choose the right junk investment, the upside can be substantial.
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