Junk bonds—also called high-yield bonds—are issued by companies that have weaker financial stability or higher levels of debt. Because these companies are considered riskier, they must offer higher interest rates to attract investors. These higher yields compensate for the increased chance that the issuer might miss interest payments or fail to repay the bond at maturity.
Credit rating agencies such as Moody’s, S&P, and Fitch classify bonds below investment grade (typically below BBB- or Baa3) as junk. Despite the name, many junk bonds do not default, but they do carry more uncertainty than bonds issued by stronger, more stable companies. Junk bonds are widely used by firms looking to finance expansion, restructure debt, or fund acquisitions.
Investors buy junk bonds for the potential of higher income compared to safer bonds. However, they must evaluate company fundamentals, industry conditions, and market sentiment carefully. Economic downturns can impact junk issuers more quickly, often leading to higher volatility in the high-yield bond market.
Junk bonds offer higher returns for taking higher risk. They help companies raise capital when traditional financing is expensive or unavailable, and they give investors opportunities for larger yields—alongside greater potential downside.
Companies with lower credit ratings—often because of high debt, inconsistent earnings, or early growth stages—issue junk bonds to raise money. These firms may not qualify for low-cost borrowing from banks or investment-grade investors. Junk bonds allow them to finance operations, expand business lines, or refinance older debt at terms they can access.
In strong economic environments, junk bonds often perform well because issuers are more likely to meet their obligations. In downturns, they become riskier because financially weaker companies feel pressure first. Junk bonds typically experience more volatility than investment-grade bonds, and spreads often widen when investors become cautious.
Key risks include default risk, credit downgrades, liquidity challenges, and sensitivity to economic conditions. Junk bond prices can drop quickly if investors expect rising defaults or weakening fundamentals. Because these bonds rely heavily on investor confidence, sentiment shifts can lead to sudden price movements. Investors must weigh potential yield against the increased risk.
A heavily leveraged telecom company needs to raise capital for infrastructure upgrades. It issues junk bonds with an 8% yield—much higher than investment-grade bonds. Investors who buy the bonds receive higher income, but they also face greater risk if the company struggles to repay its debt.
