Definition and Rating Criteria
A junk bond is the collective term for bonds rated speculative grade - BB+ or below by S&P and Fitch, or Ba1 or below by Moody's. Also called high-yield bonds, they offer higher yields than investment-grade bonds to compensate for greater credit risk. Typical issuers include financially weaker companies, startups, and firms carrying heavy debt from leveraged buyouts (LBOs).
The dividing line between investment grade and speculative grade is BBB- (S&P/Fitch) or Baa3 (Moody's). Bonds that are downgraded from investment grade to speculative grade are called 'fallen angels,' while those upgraded in the opposite direction are known as 'rising stars.'
Yield and Default Rate Examples
High-yield bonds typically offer 3-6 percentage points more than investment-grade bonds. As of 2024, the average yield on U.S. high-yield bonds is roughly 7-8%, compared with about 5% for investment-grade corporates - a spread of 2-3 percentage points. This spread is the price of credit risk and can widen to 8-10% or more during recessions.
Default rates for junk bonds run about 1-2% per year during expansions and 5-10% during downturns. In the aftermath of the 2008 financial crisis, the default rate spiked to roughly 13%. However, the average recovery rate is 40-50%, so actual loss rates are lower than headline default rates. Diversification through a high-yield bond fund is the standard approach to mitigating individual default risk.
Common Misconceptions and Investment Considerations
The biggest misconception stems from the name itself: 'junk' does not mean worthless. High-yield bonds occupy a risk-return space between equities and investment-grade bonds and can enhance portfolio diversification. Over the past 30 years, their average annual return has been roughly 7-8%, above investment-grade bonds (about 5%) and approaching equities (about 10%). Analytical methods for high-yield bonds can be found on Amazon
The key to investment decisions is assessing individual default risk. Beyond credit ratings, examine the issuer's free cash flow, interest coverage ratio, and debt maturity profile. For retail investors, high-yield bond ETFs or mutual funds are recommended for diversification. Because spreads widen sharply in the early stages of a recession, awareness of the business cycle is also important for timing.