Junk bond is a business term referring to a debt
instrument (bond) that has a higher risk of defaulting. They typically
pay high yields in order to make them attractive to investors. The
term "junk" is considered pejorative, and these instruments are
more often referred to as high yield bond or non-investment
In modern economies, debt is bought and sold in the form of bonds
traded in organized markets. The price of a bond is determined by
numerous factors, including the interest
rate, the term (amount of time before the bond is paid back
in full, also known as the time to maturity) and the degree
of risk associated with the underlying assets.
The risk of a bond is a measure of the ability of the debtor to pay the interest
payments (or coupons) and eventually pay off the complete
debt when the bond matures. Companies with financial difficulties
will find this more difficult, and are considered a more risky investment
than bonds issued by, say, the US treasury which are considered risk
free. The risk of a bond is determined by one of several credit
rating agencies such as Standard
and Poor's and is expressed by a rating such as 'AAA' (where 'A'
is better than 'B' and 'AA' is better than 'A').
Bonds rated below 'BBB' are called 'junk' bonds. Bonds rated 'BBB'
and higher are called investment grade bonds. This lower rating
typically implies a higher yield, making junk bonds attractive investment
vehicles for certain types of financial portfolios and strategies.
funds and other investors, however, are prohibited in their
by-laws from investing in bonds which have ratings below a particular
level. In some cases this can lead to a dismal cycle in that a company
with financial difficulties will have its bond rating lowered which
will make it harder to raise money thereby deepening its financial
This cycle was one (but not the only) factor that accounts for the sudden collapse of several high profile companies such as Enron and WorldCom, whose bonds were not initially rated junk.
The value of junk bonds is affected to a higher degree than investment
grade bonds by the possibility of default. For example, in a recession
interest rates tend to drop, this tends to increase the value of
investment grade bonds, however a recession increases the possibility
of default in junk bonds.
Junk bonds were popularized in the 1980s by Michael
Milken as a financing mechanism primarily for mergers
and acquisitions. In a leveraged
buyout (or LBO) an acquirer would issue junk bonds
to pay for a corporate acquisition and then use the cash
flow of the target company to pay off the debt over time. However
new regulations and better strategies on the parts of the companies
have reduced the use of LBO's since the 1980s.
However, junk bonds are still used to finance capital intensive
industries such as telecommunications. Interestingly the bonds of
companies such as Enron and WorldCom were not rated as junk, partly
because the companies hid much of their debt in off balance-sheet
transactions, so that the financial instability of the company wasn't
known to credit rating groups.