Glossary · Bonds and rates
Junk bond (high yield)
A junk bond is a bond from a borrower with a low credit rating (below BBB). It pays a higher interest rate because it is more likely to default.
Also called: high-yield bond, high yield, speculative-grade bond, non-investment-grade bond
In plain words
Two friends ask to borrow $100. One has a steady job and always pays back; the other is starting a risky business. You would lend to the second only for a bigger reward. A junk bond is that second loan: a bond from a borrower that the rating agencies grade below BBB.
The polite name is high-yield bond, because to attract lenders it must pay much more interest than safe bonds. The extra yield over a Treasury of the same maturity is its credit spread, and for junk bonds it is far larger than for investment-grade ones.
Junk bonds are sold by young, fast-growing or heavily indebted companies, and they include “fallen angels”: bonds of once-solid firms whose rating was cut. They default far more often, so their extra yield is pay for real risk.
Example
Is the extra yield worth it?
Compare $10,000 in two 5-year bonds.
- A Treasury yielding 4%: $400 a year, almost certain.
- A junk bond yielding 8%: $800 a year, if all goes well.
- Suppose 1 in 5 such borrowers defaults within the 5 years and lenders recover 40%. The expected loss is about 20% × 60% = 12% of your money, roughly 2.4 points a year.
- So the junk bond’s 4 points of extra yield shrink to roughly 1.6 points of expected extra return, with a real chance of a big loss.
The numbers are an example: real default and recovery rates swing a lot with the economy.
One level deeper
Rating agencies call these bonds speculative grade: BB+ and below at S&P and Fitch, Ba1 and below at Moody’s. The market grew in the 1980s, when the bank Drexel Burnham Lambert and its financier Michael Milken made it a way for smaller and riskier companies, and buyout firms, to borrow.
Junk bonds behave partly like stocks. In good times their prices rise and spreads narrow; in recessions defaults jump, spreads blow out and prices fall, as in 2008 and early 2020. They tend to fall together with stocks, so they protect a portfolio less in a crash than government bonds do.
Most investors hold them through funds, which spread the risk over hundreds of borrowers, since a single default can wipe out years of extra interest.
Why it matters
They let riskier companies borrow from investors instead of only from banks, which finances new firms, buyouts and rescues.
Their spreads are a quick gauge of fear: when investors dump junk bonds, it often signals trouble for the economy and for stocks.
Their high yields tempt savers; knowing why they are high helps judge whether the extra pay covers the extra risk.
A common mistake
Myth: A higher yield means a better investment.
In fact: A high yield is the market’s price for risk. Part of it is likely to be lost to defaults, and the rest is pay for living with the chance of a big loss. A yield is a promise, not a forecast of what you will get.
Questions people ask
Why are they called junk bonds?
The name, which spread in the 1970s and 1980s, reflects their rating below investment grade. The industry prefers “high yield”. Many issuers are ordinary companies, not junk in any everyday sense.
What is a fallen angel?
A bond that was investment grade when it was sold and was later downgraded to junk. Some funds must then sell it, which can push its price below what the risk alone would justify.
Are junk bonds riskier than stocks?
Usually less risky than the same company’s shares, since bondholders are paid before shareholders. But a junk bond’s upside is capped at its interest and face value, while its downside can be large.
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About the numbers
- This page explains a term. It is not investment advice.