DEFINITION: “Junk bond” is a colloquial term for a high-yield, high-risk type of tradable financial instrument, or security, known as a “bond.”
A junk bond is more formerly referred to as a “speculative-grade” bond or a “non-investment-grade” bond.
ETYMOLOGY: The word “junk” derives from the Middle English word jonke, meaning scraps of used cordage that are recycled to make a variety of objects, including swabs, mats, and oakum.
For the etymology of the word “bond,” see the linked article.
USAGE: The determination of the level of yield and risk of different securities is made by one or more of the principal credit-rating agencies, notably, Moody’s, Standard & Poor’s, and Fitch.
Thus, a given bond offered for sale on the open market is a “junk bond” if one of those agencies says it is.
The purpose of labeling high-risk bonds as “junk bonds”—and, indeed, the purpose of the very existence of credit-rating agencies—is supposed to be the protection consumers who are considering purchasing high-yield bonds.
Therefore, it is important to keep in mind that the labeling of bonds is only as reliable as the agencies themselves.
The nature of the risk associated with high-yield bonds is by and large the risk of default. Default occurs when a bond issuer is unable to make scheduled interest and principal payments to bond owners.
In plain speech, the risk is that of losing one’s entire investment.
The attraction, of course, is that of making a large profit quickly from a junk bond’s high yield.
Historically, the default rate on junk bonds has averaged about five percent. However, that number may increase during a recession or other period of economic instability.
The largest purchasers of junk bonds are institutional investors, such as insurance companies, banks, pension funds, and mutual funds.
For the most part, individual investors own junk bonds as a portion of their mutual fund portfolios.