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WIKI ANALYSIS| This article is part of WikiProject Definitions. Consider editing to improve it. View articles referencing this definition. |
High Yield Bonds, often referred to as "junk bonds," are bonds that carry a high risk of default and, as a result, offer a higher yield than investment grade bonds. A high yield bond is classified as having a rating of BB+ or lower, while bonds with rating of BBB or higher are known as investment grade. Debt instruments are the converse of equity instruments, or stocks, and generally perform better than equities during economic downturns. This generality holds because debt holders have the first claim on a company's assets. In recessionary periods when cash flows are short companies must pay their bond holders before their shareholders receive anything.
High yield bonds can be bought individually through a broker or in bulk through mutual funds. A high yield mutual fund is considered to be a safer way to invest in high yield instruments because the risk is spread over a larger number of contracts. That is, while any single bond within the fund may have a high probability of default, when many are grouped together the risk that all, or even most, of the bonds defaulting is much lower.
From a purely technical standpoint, junk bonds aren’t any different from regular bonds, since they act as the professional equivalent of an IOU. Entwined with every junk bond is an agreed principal (the amount the company will pay back), maturity date (the date it will pay back the amount), and coupon or interest it will pay on the borrowed amount.
The reason that a junk bond stands out from the everyday, run-of-the-mill bond is due to the credit quality of the issuers. Since all bonds are “graded” on the same scale - and there are only two grades they can fall under - junk bonds are anything that don’t meet the Investment Grade restrictions: i.e. issued by low or medium-risk lenders.
Junk bonds are the ones that usually pay a high yield because their credit ratings aren’t stellar. So if they want the privilege of borrowing money from outside sources, they need to make it worth their while.
Essentially, it’s very much like purchasing stock with a small biotech company testing out a new drug. It could lead to worthwhile rewards or it could leave you with nothing. So proper research is always an important precursor to getting involved in any junk bond.
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