Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Junk Bond

What it is:

A junk bond is a fixed-income security that is rated below investment grade by one or more of the major bond ratings agencies. 

How it works (Example):

A junk bond works the same as most other bonds -- an investor purchases a bond from a bond issuer with the assumption that the money will be paid back when the bond reaches its maturity date. The difference between an "investment grade" bond and a "junk" bond is that the junk bond issuer may not be able to repay the original principal.

Bonds often receive this type of low rating when the corporation, municipality or other entity that issued the bond is facing financial trouble. In these cases, the credit risk on the bonds is fairly high -- in other words, there is a relatively decent chance that the junk bond issuer will have trouble fulfilling its repayment obligations (including interest and principal). However, many junk bonds also pay higher yields than investment-grade bonds in order to attract investors.

Why it Matters:

Junk bonds are usually purchased as speculative investments. Although investors rake in higher yields, they risk the chance that they never get their money back.

While junk bonds can actually be a savvy addition to a portfolio, they're not for everyone. The junk bond market is largely dominated by institutional investors, so an individual would need to be willing to spend time researching and analyzing. Investors wanting to diversify their portfolio with junk bonds might also want to consider investing in a junk bond fund.