Why would any investor want to invest in something known as a junk bond? Certainly, the name alone could put you off, and they are known for having a “risky” reputation, too. However, junk bonds can have unique appeal for newer investors seeking higher yields in today’s environment.
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Despite their name, they historically deliver higher returns than Treasury bonds, according to Robert R. Johnson, PhD, CFA, CAIA, professor of finance, Heider College of Business at Creighton University. He said that junk bonds returned 8.3% annually from 1983 to 2023, compared to 5.8% for Treasury bonds (and even higher yields at other points).
Find out how investing in them strategically may be a great idea for newer investors, if you’re fully apprised of all the risks.
A junk bond isn’t actually a “bad” bond, it’s just a type of corporate bond that has a credit rating below investment grade, which makes it riskier than more stable, highly rated bonds, Johnson said.
Bond rating agencies such as Standard & Poor’s, Moody’s Investors Service and Fitch Ratings assign ratings to bonds just like teachers assign letter grades to students, Johnson explained. Bond ratings range from AAA (the highest rating) down to C and D which refer to bonds that are already in default on some of their payments. Anything below a “BBB” is a “junk bond.”
Some institutional investors are only allowed to invest in investment-grade bonds and are prohibited from investing in junk bonds, Johnson shared. “In fact, if they hold a bond that is downgraded (or if the rating is lowered) from investment grade to below investment grade or junk status, they must sell that bond from their holdings, even if it’s at a sizable loss.”
Despite these downsides, these bonds have a higher return potential compared to investment-grade bonds for those whose portfolios can allow room for risk.
Junk bonds performed especially well during “expansive Fed policy” Johnson said, meaning when the Federal Reserve board does things to stimulate the economy, such as lowering interest rates, making it cheaper to borrow money and buying government securities. In these time periods, junk bonds have returned as much as 11.7%.
“Investors are attracted to junk bonds because of the expectation of higher returns,” Johnson said.
Unsurprisingly, with higher than usual returns often come greater risks. High-yield bonds carry a much higher level of credit risk than investment grade bonds, according to Evan Mann, senior high yield analyst at Gimme Credit.
