Junk Bond: High-Yield Bonds with Higher Default Risk

Types

• Fallen Angels: Bonds that were once investment-grade but have been downgraded to junk status due to the issuer’s deteriorating creditworthiness.
• Original Issue High-Yield Bonds: Bonds that were speculative-grade from the time of issuance.

Detailed Explanation

Junk bonds are rated below “BBB” by rating agencies like Standard & Poor’s or below “Baa” by Moody’s, indicating higher credit risk. To compensate for this risk, they offer higher yields compared to investment-grade bonds.

Mathematical Models

The yield of a junk bond can be expressed as:

Importance

Junk bonds play a crucial role in corporate finance, enabling companies with lower credit ratings to access capital. They also offer high returns to investors willing to accept higher risk.

Example

A company with a speculative credit rating might issue a 10-year bond with an 8% yield compared to a similar investment-grade bond yielding 3%. This 5% difference is the risk premium.

Related Terms

• Leveraged Buyout (LBO): The acquisition of another company using borrowed money.
• Credit Rating: An assessment of the creditworthiness of a borrower.
• Credit Spread: The difference in yield between a corporate bond and a risk-free government bond.

Jargon

• Default: Failure to meet the legal obligations of a loan.
• Yield: The income return on an investment.

Slang

• Junk: Informal term for high-yield bonds.

FAQs

Q1: What are junk bonds? A: Junk bonds are bonds with lower credit ratings that offer higher yields to compensate for higher default risk.

Q2: Why do companies issue junk bonds? A: To raise capital when they have lower credit ratings and can’t issue investment-grade bonds.

Q3: Are junk bonds a good investment? A: They can be, depending on the investor’s risk tolerance and market conditions.