What are junk bonds? The risks and rewards of high-yield fixed income

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Sometimes you get a diamond, but sometimes it’s a lump of coal.

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If you’ve ever tuned into the financial news on a regular basis, you’ve probably heard the term junk bonds now and then. On the surface, it doesn’t sound very attractive. If they’re junk, why would anyone be interested in them?

Junk bonds may get a bad rap based on their name, but in reality they’re a vital and important part of the fixed-income world. Still, they’re not for everybody.

A junk bond is a high-yield, fixed-income security. But that high yield is meant to compensate for increased risk. In other words, you earn a much higher return than you would for, say, a Treasury bond, but there’s a risk that the issuer might skip out on payments, and worst case, not return your principal. That’s known as a default.

In an investment world hungry for yield, junk bonds have their place.

Junk bonds are issued by corporations and governments that need to borrow money to fund different aspects of their operations. They are also prevalent in merger and acquisition financing, particularly strategies that rely on large amounts of debt (aka leverage), which is why acquisitions using junk bond financing are often called leveraged buyouts.

Junk bonds work much like any bond. As the holder (i.e., “owner”) of the bond, you’ve lent money to the issuer, who promises to give you periodic interest payments and return your principal when the bond matures.

Bond ratings fall into two general categories: investment grade and non-investment, or “speculative,” grade. Each category contains several letter and sub-letter grades to further pinpoint the issuer’s ability to meet the bond’s financial obligations. Junk bonds fall into the “speculative” category—those rated BB or lower.

The lower the rating, the higher the default risk, and thus the higher the yield—to compensate for the extra risk. Because junk bonds are risky, their yields will typically trade at a 4% to 6% premium over investment-grade bonds. If a bond makes it to the D level, default is imminent (or the issuer has already defaulted). Just like in school, a D on a report card spells trouble.

High-yield or high-risk bonds are nothing new. For example, in the 1780s, when the fledgling United States of America was trying to pay off its war debt and start a new nation, its debt certainly would have been considered “junk.” Nowadays, U.S. Treasury bonds are considered among the safest investments in the world.

The term “junk” dates back to the 1980s when such issues rose to popularity, led by investment bank Drexel Burnham Lambert Inc. and the head of its bond department, Michael Milken (who purportedly used the term to describe a particular set of bonds the firm was underwriting at the time).

As with all bonds, there’s an inverse relationship between the price of the bond and its yield.

The health of the junk bond market is greatly affected by, and can also act as a barometer for, the health of the overall economy. In good times, investors are willing to take more risk and accept lower yields on junk bonds. In economic downturns, junk bonds struggle. Their prices may fall and yields will rise because of the real and perceived notion that the probability of default is higher.

A junk bond is in default when principal or interest payments are missed. Does it mean you’ve lost all your money? No—not necessarily (although you could). Default rates have historically been different for each rating class. For example, according to Standard & Poor’s, between 1981 and 2018, the default rate for BB rated bonds (the top junk bond rating) was 18% and over 50% for CCC rated (low-rated) bonds.

Before investing in junk bonds, you should factor in whether the yield offered is enough to compensate you for the risk. The potential return might be greater compared to U.S. Treasurys, but you’d need to consider the potential for default and the “recovery rate,” which is how much of the money owed to you (in expected interest payments plus the return of your principal) you’d get if the issuer did default.

If allocating some of your portfolio to high-yield bonds falls within your objectives and risk tolerance, you might want to start with liquid, high-yield mutual funds and exchange-traded funds (ETFs). Buying junk bonds directly through the primary and secondary markets requires a great deal of expertise and is perhaps best left to professionals.

When you invest in a well-managed mutual fund or ETF, you’re enlisting the help of the fund’s management team, who specialize in the high-yield market. Plus, you get a natural layer of diversification by spreading your risk over a portfolio of high-yield assets.

Research is essential. Here are four key criteria to review:

If you shop for bonds or bond funds through an online broker, you should have access to their bond research tools. If not, you can look at Fund Analyzer, which is provided by financial watchdog FINRA, to get historical performance data, expense ratios, ratings data from Morningstar, and more.

Junk bonds are an important part of fixed-income financing, but because of their risky, speculative nature, they’re not for everyone. The risk may be just too high.

On the other hand, if you’re considering these bonds, it’s best to start small. Test the waters with only a small percentage of your portfolio, and consider sticking with professionally managed funds. If you work with a financial advisor, you’ll want to discuss whether junk bonds are an appropriate fit.

If you have a higher risk tolerance, junk bonds may be a complementary mix to a well-diversified portfolio. But do your research, particularly if you’re considering investing in individual junk bonds.