What Is a Junk Bond?
A junk bond is debt issued by a company whose credit rating falls below the investment grade cutoff of BBB- at S&P and Fitch or Baa3 at Moody's. The industry's preferred term is high-yield bond, and the asset class funds everything from leveraged buyouts to companies in turnaround.
Issuers end up in high-yield territory for different reasons: some are heavily leveraged after an acquisition, some operate in cyclical or declining industries, and some are fallen angels, former investment grade companies that were downgraded.
How Junk Bonds Work
Because default risk is higher, investors demand a larger yield spread over Treasuries. That spread widens when the economy weakens and tightens when conditions improve, making high-yield spreads a closely watched barometer of risk appetite across all markets.
High-yield bonds usually carry stronger investor protections than investment grade debt, including covenants that restrict additional borrowing, asset sales, and dividend payments. Recovery in a default depends on where the bond sits in the capital structure, with senior secured bonds recovering more than subordinated notes.
Example
Suppose the 10-year Treasury yields 4.0 percent and a B-rated company issues a bond at 9.0 percent. The credit spread is 9.0 - 4.0 = 5.0 percentage points, or 500 basis points, which is the annual compensation investors receive for bearing the default risk.
If a recession hits and investors flee risk, that same bond's price might fall until its yield reaches 12 percent, a spread of 800 basis points. Bondholders who bought at issue would be sitting on a paper loss even if the company never misses a payment.
Why It Matters
The high-yield market is the financing engine behind private equity buyouts and much of corporate America's riskier growth, so its health directly affects deal activity. When high-yield markets freeze, LBOs stall and refinancing risk spikes for leveraged companies.
Leveraged finance groups at investment banks structure and sell these bonds, and high-yield research is one of the most analytically demanding seats in credit, since a single default can wipe out years of coupon income.
