What Is a Junk Bond?

The use of the term "junk bond" came into popular use in the 1980s, when aggressive use of high-yield bond financing eventually led to the conviction of high-flying corporate financier Michael Milken. Using the terminology of high-yield or non-investment grade for these corporate bonds instead of junk bonds is a more accurate description of an investment class that has provided attractive returns to investors.

Non-Investment Grade Ratings

Junk bonds get their name because these bonds are from issuers that have credit ratings below the cutoff for investment grade. The rating agencies of Standard & Poor's and Moody's rate debt issuers and give a grade based on the issuer's ability to pay its financial obligations. The possible credit ratings for S&P;/Moody's are AAA/Aaa, AA/Aa, A/A, BBB/Baa, BB/Ba, B/B, CCC/Caa, CC/Ca and C/C. By convention, the BBB/Baa credit rating is the lowest investment grade rating. Dropping to BB/Ba or lower is not investment grade and is junk bond territory.

High-Yield Results

A non-investment grade credit rating means a company has -- in the eyes of the rating agency -- a much higher probability of defaulting on interest or principal payments of its debt. To compensate for the higher risk, non-investment grade issuers must pay a higher rate of interest on the bonds they sell. There is a big step-up in yield going from investment grade to non-investment grade. In early February 2013, Bloomberg reported an average yield of 3.40 percent on investment grade corporate bonds. At the same time, the yield on non-investment grade or junk bonds was 6.11 percent.

Size of Market

High-yield bond issuers are primarily corporations. Government entities tend to have investment-grade credit ratings. Of the $8 trillion corporate bond market, about 15 percent is non-investment grade and in 2012 companies issued almost $350 billion of high-yield bonds. Although the term junk bonds sounds like something to avoid, in fact, high-yield bonds are a significant portion of the total bond market. High-yield bonds are often sold by start-up companies, companies turning around their business or corporations coming out of bankruptcy.

Investing High Yield

Individual investors have several avenues to find high-yield bond investments. With a good broker, you could buy individual corporate bonds with less than investment grade credit ratings. There are also mutual funds, closed-end funds and exchange-traded funds offering junk bond focused investments. If you see the words "high yield" in a fund's name you have a pretty big clue that the fund is involved in the junk bond market.

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