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Investors seeking higher returns often come across junk bonds—tempting but risky investments. These bonds offer attractive yields, but they come with a higher chance of default than safer alternatives, such as U.S. Treasury or investment-grade corporate bonds.
In this guide, we’ll break it down simply, with real-world examples to help you decide if they’re worth considering.
What Is a Junk Bond?
A junk bond is a type of corporate bond with a low credit rating, typically below BBB- (S&P) or Baa3 (Moody’s).
These ratings suggest that the issuer has a higher risk of defaulting on payments compared to investment-grade bonds. Junk bonds are also called high-yield bonds because they offer greater returns to compensate for the added risk.
Most junk bonds come from startups, companies in financial distress, or firms operating in volatile industries.
They’re not necessarily doomed to fail—but the risk is significantly higher. Investors accept this in exchange for the possibility of earning better returns than with safer bond types.
Rating Agency | Investment Grade | Junk (Speculative) Grade |
|---|---|---|
S&P | AAA, AA, A, BBB | BB+, BB, B, CCC, CC, C, D |
Moody’s | Aaa, Aa, A, Baa | Ba1, Ba2, Ba3, B1, B2, B3, C |
Fitch | AAA, AA, A, BBB | BB+, BB, B, CCC, CC, C, RD, D |
How Does a Junk Bond Work?
Junk bonds work similarly to other bonds: you lend money to a company, and they pay you back over time with interest.
What sets them apart is the risk level and yield. Because the issuer might not be in a strong financial position, they must offer higher interest rates to attract buyers.
Here’s how junk bonds function in practice:
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Example #1
Imagine a struggling retail chain trying to raise $100 million to avoid bankruptcy. Traditional lenders won’t bite, so it issues junk bonds with a 10% annual yield.
Investors willing to take the risk can earn high returns—if the company stays afloat. If not, bondholders may lose most or all of their investment.
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Example #2
A young tech company with strong revenue but no profits yet might issue junk bonds to fund expansion. While it's not failing, it lacks the credit history for investment-grade status.
Investors here are betting that future success will allow the company to repay its debts—and reward them with a juicy yield in the meantime.
In both cases, investors are compensated for risk with higher yields, but also face the possibility of default.
Why Are Junk Bonds Considered High-Risk Investments?
Junk bonds carry higher risk primarily because they’re issued by entities with weaker financial health or unstable business models.
This includes companies with too much debt, inconsistent cash flow, or those operating in highly competitive or declining industries. These factors raise doubts about their ability to make timely interest payments or repay principal.
In addition, junk bonds are more sensitive to market volatility.
In times of economic stress, investors flee risky assets, causing junk bond prices to drop sharply. This makes them less stable than traditional bonds.
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Junk Bonds vs. Treasury & Corporate Bonds: Risk-Return Comparison
Bond Type | Typical Issuer | Risk Level | Average Yield | Default Risk |
|---|---|---|---|---|
Junk Bonds | Low-rated companies or startups | High | 7–12%+ | High – issuer may default |
Corporate Bonds | Established corporations (investment-grade) | Moderate | 4–6% | Moderate – depends on rating |
Treasury Bonds | U.S. Government | Very Low | 3–4% | Very Low – backed by Treasury |
Pros and Cons of Investing in Junk Bonds
Investing in junk bonds can be rewarding, but it’s not without risks. Here’s a quick look at the key pros and cons.
Pros | Cons |
|---|---|
Higher yields than most other bonds | Greater risk of issuer default
|
Potential for capital appreciation | More sensitive to economic downturns
|
Diversification benefits for aggressive portfolios | Lower credit ratings and higher volatility
|
Some recoveries can outperform equities | Limited liquidity in certain markets
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Can offer attractive returns in strong economic cycles | Requires careful credit risk analysis
|
- Higher yields
Junk bonds offer significantly higher interest payments than investment-grade or government bonds, appealing to income-seeking investors.
- Capital appreciation
If a company’s financial condition improves, its bond prices may rise, offering both income and price gains.
- Outperformance potential
In bullish markets, junk bonds can sometimes outperform safer fixed-income options and even stocks.
- Cyclical upside
During economic recoveries, the default risk often drops, increasing junk bond performance.
- Default risk
Issuers may fail to make payments, especially during downturns, leading to loss of principal.
- Economic sensitivity
Junk bonds tend to drop sharply in recessions or periods of market stress.
- Credit instability
Ratings may be downgraded further, which can lower market value even if defaults don’t occur.
- Liquidity risk
Some junk bonds, especially from smaller issuers, may be hard to sell quickly at a fair price.
Ways To Get Exposed to Junk Bonds
You don’t have to buy individual junk bonds to gain exposure. Many investors prefer diversified vehicles that reduce risk while still offering access to high yields. Whether you’re conservative or aggressive, there’s a way to fit junk bonds into your strategy.
High-yield bond ETFs: Funds like iShares iBoxx $ High Yield Corporate Bond ETF (HYG) provide broad exposure to junk bonds with low investment minimums and high liquidity.
Mutual funds: Active managers can filter out riskier issuers and focus on junk bonds with stronger upside potential.
Bond ladders with junk exposure: Some advisors build custom ladders mixing investment-grade and junk bonds, balancing yield with risk.
Junk bond index funds: These passively follow indices like the ICE BofA US High Yield Index, offering a simple way to invest across the junk bond market.
How to Buy Junk Bonds
If you want to buy junk bonds directly, you can do so through a brokerage account that offers access to the corporate bond market.
Platforms like Fidelity, Charles Schwab, and E*TRADE list both investment-grade and speculative-grade bonds. You’ll typically search by credit rating (BB or lower), yield, or issuer.
For example, an investor might use a bond screener, select “high yield,” and find a BB-rated energy company bond offering 9% annual yield. After reviewing the issuer’s credit profile, they can place an order just like a stock.
New investors may prefer ETFs or mutual funds initially, as buying individual junk bonds requires more credit risk analysis and due diligence.
Always factor in potential default risks and check liquidity before making a purchase.
FAQ
Typically, companies with lower credit ratings, startups, or firms in volatile sectors issue junk bonds to raise capital when traditional financing is unavailable.
They can, but only as a small portion. Their high risk may not suit conservative retirement strategies unless balanced with safer assets.
Yes, rising interest rates can hurt junk bond prices, especially for longer maturities. However, they are often more sensitive to credit risk than rates.
Investors may lose part or all of their principal. Recovery depends on bankruptcy proceedings and whether the bond is secured or unsecured.
Most pay semiannual interest (called a coupon), but payment consistency depends on the issuer’s financial stability.
Yes, interest income from junk bonds is generally taxed as ordinary income, not at the lower capital gains rate.
They often perform well when the economy is strong, as default risk decreases and investor appetite for yield increases.
Yes, global high-yield bonds are accessible through certain ETFs and mutual funds, though they may carry added currency or geopolitical risk.
Yes, many junk bonds are callable, meaning the issuer can repay early if market conditions improve, potentially limiting investor gains.
Absolutely. If a company’s financial health improves, ratings can rise, leading to price appreciation and stronger demand.
