Like a regular bond, a junk bond is a loan to the company or government entity that issues the bond. The issuer agrees to pay back the money loaned, or principal, at an agreed upon date called the maturity date. The issuer also pays interest at specified intervals, perhaps once every six months.

Ratings

Junk bonds are different because they have low ratings from credit rating agencies such as Moody’s, Standard & Poor’s and Fitch. These rating agencies make a judgment about the likelihood that a bond will be able to pay interest or repay the principal on the bond’s maturity date. They assign ratings ranging from AAA for the strongest bonds to D for the riskiest. Junk bonds are those rated BB or lower by Standard & Poor’s, Ba or lower by Moody’s.

Background

Originally, the term "junk" was used for bonds from formerly strong companies experiencing financial difficulties and downgraded credit ratings. It was not until the late seventies that the first new bonds issued with a junk rating were made available for sale to the public. Today, junk bonds are usually issued by newer companies with no long-term track record.

Return

Because junk bonds are so risky, they offer a higher rate of return and are sometimes referred to as "high yield bonds." They usually have an interest rate that is three to five percentage points higher than AAA rated bonds in order to attract investors.