A non-investment grade or high yield bond is referred to as a junk bond. As the name suggests, these bonds have a credit rating of BB or low, and are fixed income instruments. They may carry a rating even lower than BB, as per the Standard & Poor’s Rating or Ba, or low as per the Moody’s Investors Service ratings. Since these bonds have a high risk of default when compared to investment grade bonds, therefore, they are named junk bonds.
They may be a risky investment; however, they have a speculative appeal to them since they offer much higher yields than the bonds that have a high credit rating. Investors demand that they be paid a higher yield as a form of compensation because of the risk associated with investing in these bonds. If the financial performance of a junk bond is turned, and it sees an up gradation in its credit rating, there can be a substantial appreciation in the price of the bond. This way, a junk bond may also prove to be beneficial for investors.
The revenue generated to make interest, and principal payments is the key factor that is used to rate a bond. It is also based on the assets that are pledged to make a bond secure. Secured bonds have collaterals that can be used to make interest, and principal payments. On the other hand, the unsecured bonds are backed simply by the ability of the issuer to pay. The existence of collateral, and the ability to generate revenue, both determine the rating that is given to a bond.
A bond is considered to be in default if it misses the interest or principal payment. Since junk bonds have a lack of sufficient collateral, and an uncertain stream of revenue, they have a higher risk associated with them. In cases when the economy is performing poor, the default risks for bonds increase, and among all these bonds, the default risk of junk bond is the highest. Junk bonds are purchased by investors in order to earn higher interest rates, and speculate on the increase of prices associated with these bonds.