Where to Buy Junk Bonds and How to Get Started

Junk bonds are debt instruments issued by companies with lower credit ratings, often referred to as high-yield bonds. These securities offer the potential for higher returns compared to investment-grade bonds, which compensates investors for the increased risk involved. Companies issue these bonds to raise capital, promising to pay interest and return the principal at maturity.

Characteristics of Junk Bonds

Bonds are categorized as “junk” or “high-yield” when major credit rating agencies, such as Standard & Poor’s (S&P), Moody’s, and Fitch, assign them a rating below investment grade. For instance, S&P and Fitch rate bonds below BBB-, while Moody’s rates them below Baa3. This lower rating signifies a higher risk of the issuer defaulting on its interest or principal payments, and the higher potential yield offered attracts investors willing to accept this elevated default risk.

Companies that issue junk bonds often include younger firms, highly leveraged businesses, or those operating in distressed industries. Sometimes, these bonds are issued by “fallen angels”—companies whose credit ratings have declined from investment grade due to financial challenges. Unlike investment-grade bonds, which are issued by companies with stronger financial health and a lower likelihood of default, high-yield bonds carry a higher risk. The average default rate in the U.S. high-yield sector has historically been around 5% over the long term, underscoring this elevated risk profile.

Purchasing Channels for Junk Bonds

Individual investors can access high-yield bonds through several channels.

Direct Purchase

Directly purchasing individual junk bonds typically involves using a brokerage account. After opening an an account, investors can navigate the firm’s bond trading platform to search for specific high-yield corporate bonds. These platforms allow investors to view available bonds, their yields, maturities, and credit ratings, and then place buy orders for the desired securities.

High-Yield Bond Mutual Funds

High-yield bond mutual funds offer another avenue, allowing investors to gain diversified exposure. These funds pool money from many investors to create a portfolio of various high-yield bonds managed by a professional fund manager. Investors can purchase shares directly from fund companies or through their existing brokerage accounts. Mutual funds typically have expense ratios, which are annual fees charged as a percentage of the fund’s assets, and may also have sales loads.

Exchange-Traded Funds (ETFs)

ETFs that focus on high-yield bonds provide a third option. High-yield bond ETFs are similar to mutual funds in that they hold a basket of high-yield bonds, but they trade on stock exchanges like individual stocks throughout the day. To invest in a high-yield bond ETF, investors use a brokerage account and place buy orders. ETFs also have expense ratios, but generally do not have sales loads, and their intraday tradability can offer more liquidity than traditional mutual funds.

Key Factors Before Investing in Junk Bonds

Consider credit ratings before investing in high-yield bonds. Credit rating agencies like S&P, Moody’s, and Fitch assign letter grades that reflect an issuer’s ability to meet its debt obligations. For junk bonds, ratings typically range from BB+ (or Ba1 by Moody’s) down to C or D, with lower grades indicating a higher risk of default. A rating of CCC or lower, for example, suggests a very high risk of default, while a BB rating is just below investment grade.

Diversification is important when investing in high-yield bonds, as it helps mitigate the significant risk associated with individual issuers. Spreading investments across multiple companies, industries, and geographic regions can reduce the impact of a single bond issuer’s default on an overall portfolio. This diversified approach helps protect against substantial capital loss from any one security. For individual investors, achieving sufficient diversification often makes high-yield bond funds or ETFs a practical choice.

Liquidity is another consideration, referring to how easily a bond can be bought or sold without significantly affecting its price. High-yield bonds generally have less liquidity than investment-grade bonds, meaning there might be fewer buyers or sellers at any given time, and wider bid-ask spreads. This can make it more challenging to sell high-yield bonds quickly without incurring a discount, especially during periods of market stress. The cost to trade a distressed bond can be as high as 5% and may take weeks to execute.

Thorough due diligence and research into the bond issuer’s financial health are necessary. This includes analyzing financial statements like the balance sheet, income statement, and cash flow statements to assess the company’s profitability, debt levels, and ability to generate cash. Investors should also examine the industry outlook and the issuer’s competitive position. Reviewing bond covenants, which are legally binding clauses in the bond agreement, provides insight into the protections afforded to bondholders, such as restrictions on the issuer’s ability to incur additional debt or pay dividends.

Finally, investors should assess whether the offered yield adequately compensates for the risk involved. High-yield bonds offer higher returns precisely because of their increased risk. It is important to compare the yield of a specific junk bond or high-yield fund against its perceived risk level. This evaluation helps determine if the additional yield provides sufficient compensation for the potential for default or price volatility.