What is a Junk Bond

“Junk bond” is a casual but very common term for bonds issued by corporations (or, more rarely, governments) who are in a very poor financial situation and therefore, very likely, will not be able to pay back their bondholders on schedule. Typically, junk bonds are considered extremely risky investments, and attempt to attract investors by offering the promise of unusually high interest rates. Thus, investing in junk bonds means an unusually high prospect of losing one’s entire investment, balanced by the prospect of unusually high rewards if the company in question turns out to be capable of turning a profit, after all.

Bonds, along with stocks, are among the most common investment vehicles. However, where stocks (or equity) are literally shares of the ownership of a company, bonds are loans given to that company. The “bond” itself is merely the contract which specifies the amount of money loaned, the date at which the principal will be repaid, and the interest payments which will be made in the meantime. In general, bond prices fluctuate like any other good or service in the free market: more corporate bonds may be issued when prevailing interest rates are relatively low (because companies are attracted to cheap credit).

In practice, shifting interest rates in the bonds market reflect but do not entirely correspond to the interest rates set by the central bank (or the Federal Reserve, in the U.S.). Instead, different corporations and governments issue bonds with interest rates based on the expected likelihood that they will be able to make their promised re-payments. For large institutions, these rates are typically determined by ratings published by specialized bond ratings agencies, like Standard & Poor’s, Moody’s, or Canada’s Dominion Bond Rating Service (DBRS). Corporate ratings function analogously to consumer credit ratings: those with a better score can generally convince the markets to reward them with lower interest rates.

On the other side of the spectrum, however, are a large number of companies who have not performed well in the market, have encountered cash flow difficulties, and have received low ratings from the bond rating agencies. Much the same is true of governments, although in practice governments are almost always more stable than corporations, and, so long as they maintain control of their own currency through a national central bank, in theory are incapable of involuntarily defaulting on loans.

For these corporations, which the bond rating agencies believe have a realistic likelihood of collapsing in the future and thus becoming unable to pay back bondholders, issuing bonds at normal interest rates is unlikely to be successful, because few investors will purchase the bonds. Instead, they must offer very high interest rates, in effect rewarding investors for taking on greater risk by promising the chance of even greater returns on the investment.

It is these bonds, from risky corporations and unstable governments, which are commonly referred to as “junk bonds.” The name refers to the fact that there is a very real chance the bonds will ultimately be worthless. This does not necessarily mean that junk bonds are truly worthless to investors: those willing to take on high risk may still purchase junk bonds, in the expectation that at least some poorly performing companies will experience dramatic growth in the near future and thus be able to repay their bonds after all. It does mean, however, that junk bonds are an extremely high-risk investment which many people will prefer to stay well clear of.