What it means
Credit rating agencies score borrowers on a scale, and anything below the BBB-/Baa3 boundary is classed as speculative. Bonds from those issuers are junk bonds, whether the borrower is a struggling retailer or a fast-growing business that has simply borrowed heavily to expand.
The label describes probability, not certainty. Most junk bonds pay exactly as promised, and the market demands extra yield only to compensate for the minority that do not.
For a finance team, this is the price of borrowing when the balance sheet is stretched. A company that slips from investment grade to junk can see its interest cost rise by several percentage points, and some institutional investors are barred by their own mandates from holding its paper at any price.
The gap between a junk bond's yield and a government bond of similar maturity is the credit spread, quoted in basis points, which are hundredths of a percentage point. Spreads widen when investors turn cautious, which makes them a useful early warning of stress in the wider economy.
Two nuances are worth carrying into a meeting. Junk bonds usually carry covenants and call features that change their economics, and expected return is not the same as yield, because part of that yield is paying for defaults that are genuinely expected to happen.
In practice
Real-world examples.
Example
A private equity sponsor finances a $700,000,000 buyout partly with high-yield bonds at a 9.5% coupon. The interest bill is far higher than bank debt would have been, but the bonds carry looser covenants and no amortisation, which gives the business room to invest during the first three years.
Example
A well-known supermarket group is downgraded to junk after two poor years. Several pension funds are forced to sell the bonds because their mandates permit only investment grade holdings, the price falls further, and the company's next refinancing costs it an extra 2.5 percentage points.
Example
An income fund allocates 15% of its portfolio to junk bonds to lift the yield it can offer savers. The fund holds around 90 separate issuers so that any single default costs it roughly 1% of the allocation rather than a damaging share of the whole fund.
Think of it
“Junk bond is high-risk, high-yield debt-below investment grade.
Formula
Calculation
Approximate Yield to Maturity = [Annual Coupon + (Face Value - Price) / Years to Maturity] / [(Face Value + Price) / 2]
A bond has a face value of $1,000, a 9% coupon paying $90 a year, a market price of $920 and five years left to maturity.
Annual pull to par: ($1,000 - $920) / 5 = $16
Numerator: $90 + $16 = $106
Average of face value and price: ($1,000 + $920) / 2 = $960
Approximate yield to maturity: $106 / $960 = 11.04%
A five-year government bond yields 4.00%, so the credit spread is 11.04% - 4.00% = 7.04%, or 704 basis points.
Now allow for defaults. If the annual probability of default is 5% and lenders recover 40 cents on the dollar, the expected annual credit loss is 5% x 60% = 3.00%, which leaves an expected return of roughly 11.04% - 3.00% = 8.04%. That 8.04%, not the 11.04% headline, is the number worth comparing against other investments.Case study
Seen in the real world.
Talbot Grove Leisure is an illustrative, fictional operator of holiday parks that funded an expansion with $180,000,000 of high-yield bonds at an 8.75% coupon, rated two notches into speculative territory. Management viewed the coupon as expensive but acceptable given that bank lenders had wanted tighter covenants and faster repayment.
Three years in, occupancy fell and earnings dropped by a fifth. The bonds still paid, but their market price fell to $84 per $100 of face value and the yield demanded by new buyers rose above 13%, which meant refinancing at maturity would be considerably more expensive than the original issue.
In this illustrative example Talbot Grove responded by selling two underperforming sites, using the proceeds to buy back $30,000,000 of its own bonds at a discount, and publishing a clear deleveraging plan. The buyback both reduced the interest bill and signalled to the market that management understood the position, which helped the price recover before the refinancing window opened.
Watch out
Common mistakes.
- Treating the quoted yield as the return you should expect, when part of it is compensation for defaults that will happen somewhere in a portfolio of similar bonds.
- Assuming every junk-rated issuer is in trouble, when many are simply young, highly leveraged or too small to justify the cost of a strong rating.
- Buying a handful of high-yield bonds directly, which concentrates default risk in a way that only diversification across many issuers can manage.
Questions
People also ask.
What is the difference between a junk bond and a high-yield bond?
None in substance, since they describe the same below-investment-grade instrument, with high-yield being the term issuers and fund managers prefer.
Why do junk bond spreads matter to companies that never issue them?
Because widening spreads signal that lenders are pulling back, which usually shows up shortly afterwards in bank lending appetite and deal financing.
Can a junk bond be safer than it looks?
Sometimes, particularly if it is secured on specific assets or sits ahead of other debt, since the recovery rate on default matters as much as the probability of default.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%