Junk Bonds Have the Following Features: Key Factors to Know

Junk bonds are a type of corporate debt that offer higher yields but come with increased risk. Investors are drawn to them for their potential returns but must also consider the possibility of default. These bonds are issued by companies with lower credit ratings, making them more speculative than investment-grade bonds.

Several key characteristics define junk bonds and influence their market performance. Understanding these features helps investors weigh both risks and rewards before deciding whether to include them in a portfolio.

Classification by Ratings

Junk bonds are rated below investment grade by credit agencies such as Moody’s, S&P Global Ratings, and Fitch. These agencies assess a company’s financial health, debt levels, and ability to meet obligations before assigning a rating. Bonds rated BB+ or lower by S&P and Ba1 or lower by Moody’s fall into the speculative category. The lower the rating, the higher the risk of default.

Within the junk bond category, distinctions exist. Higher-rated junk bonds, often in the BB or Ba range, belong to companies with relatively stable operations but temporary financial difficulties. In contrast, bonds rated CCC or lower signal a high likelihood of default, often issued by companies with weak cash flow or excessive debt. These lower-tier bonds frequently trade at steep discounts due to repayment concerns.

Credit rating changes significantly affect junk bonds. A downgrade increases borrowing costs and weakens investor confidence, while an upgrade to investment grade—known as a “rising star”—can boost demand and improve pricing. Investors closely track these shifts, as they influence both perceived risk and market value.

Higher Coupon Rates

Junk bonds offer higher coupon rates to compensate for their elevated risk. These interest payments attract investors willing to accept uncertainty in exchange for greater returns. The yield reflects market demand for compensation against the risk of nonpayment.

Coupon rates vary based on the issuer’s industry, financial stability, and market conditions. Companies in volatile sectors like energy or retail often issue high-yield bonds to attract buyers during economic downturns. Firms undergoing restructuring or leveraged buyouts also rely on junk bonds to finance operations, further driving up interest rates.

Compared to investment-grade bonds, junk bonds typically yield several percentage points more than government securities or blue-chip corporate debt. This difference, known as the credit spread, fluctuates with investor sentiment and economic conditions. During periods of market stress, spreads widen as investors demand even higher returns for holding riskier debt.

Market Price Volatility

Junk bonds experience significant price swings due to their sensitivity to economic conditions and investor sentiment. Because they are issued by companies with weaker financial positions, any signs of economic trouble or industry-specific challenges can trigger sharp declines in value.

Interest rate movements also impact junk bond prices. While all bonds react to rate changes, junk bonds are more influenced by credit risk than by shifts in benchmark yields. However, rising borrowing costs can make it harder for lower-rated companies to refinance debt, raising concerns about their ability to meet future obligations. This can lead to price drops as investors demand higher yields.

Supply and demand dynamics further contribute to volatility. In low-rate environments, investors seeking higher returns drive up junk bond prices. Conversely, during market downturns or periods of heightened risk aversion, sell-offs can cause prices to plunge. This cyclical nature makes timing a key factor for buyers and sellers.

Call Features

Many junk bonds include call provisions, allowing issuers to redeem debt before maturity. This benefits companies but creates uncertainty for investors. If market conditions improve or the issuer’s creditworthiness strengthens, it may refinance at a lower rate, repurchasing outstanding bonds and issuing new ones with reduced costs. While this helps the company manage debt, it disrupts investors’ expected cash flow and total return.

Callable bonds often include a call premium, compensating bondholders if early redemption occurs. This premium is typically highest in the early years and declines over time. For example, a 10-year junk bond might allow the issuer to call it after five years at 105% of face value, decreasing to par value as the call date nears. Investors must assess these terms carefully, as calls become more likely when interest rates drop or the issuer’s financial position improves.

Liquidity Factors

The ease of buying or selling junk bonds without significantly affecting their price depends on market conditions, issuer reputation, and investor demand. Liquidity plays a major role in determining how easily these bonds can be traded. Unlike government bonds or highly rated corporate debt, which have deep and active markets, junk bonds can suffer from low trading volume, making it difficult to exit positions without incurring losses.

Market liquidity is influenced by factors such as issuance size, investor sentiment, and economic conditions. Larger bond issues from well-known companies tend to have more active secondary markets, while smaller issuances or those from distressed firms may struggle to attract buyers. During economic uncertainty, liquidity can dry up as investors become more risk-averse, leading to wider bid-ask spreads and increased price volatility. This lack of liquidity can be particularly challenging for institutional investors managing large portfolios, as selling sizable positions without significantly impacting market prices becomes difficult.