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A junk bond, commonly referred to as a speculative grade bond, is a fixed income debt instrument issued by a corporation or government with an insufficient credit rating to render the bond investment grade. Just as commercial lenders use a FICO score credit rating to determine the risk of a borrower defaulting on a loan, investors may use a bond’s grade to determine the likelihood of the bond issuer defaulting on repayment.
When a government, municipality, or corporation issues a bond, it trades its debt to an investor. Junk bonds carry a higher risk of default, and credit rating agencies believe that the issuer may be subject to additional market risks and financial uncertainties, which do not warrant investment grade status. Some companies may choose to purchase bond insurance for their junk bonds as a strategy to increase the rating of that bond.
Credit Rating Agencies
Credit rating agencies such as Standard & Poor, Moody, and Fitch grade bonds depending on the risk that the bond issuer defaults. Bond grades generally range from AAA to D, although there is slight variation between the credit rating agencies. Bonds with AAA, AA, A, and BBB ratings are investment grade bonds. Bonds with lower grades are junk bonds, which present enough risk to investors that credit rating agencies will not condone their purchase.
Junk bonds are typically regarded as unsafe investments. Despite the fact that junk bonds are deemed riskier than investment grade bonds, some investors have increasingly considered whether that asset’s risk presents an opportunity for asymmetrical upside. Some investors see the risk, volatility, and high yield potential of a junk bond as an effective method for diversifying a portfolio.
Junk bonds can outperform credit rating agency expectations. For example, Tesla issued a fixed-rate bond in 2014 that received a grade of B-, which is low enough to be considered a junk bond. At the time, the bond’s face value was $100. By 2020, that same bond was valued at nearly $600.