Definition

• Junk bonds are also known as high-yield bonds or non-investment grade bonds. They are issued by corporations with credit ratings below the lowest investment grade level of BBB. Non-investment grade bonds have a higher risk of default. To compensate for the risk, junk bond issuers pay a much higher rate of interest than on bonds with investment grade credit ratings. In 2010, the very safe Treasury bonds were paying yields of under 3 percent and junk bond investors were earning 7 percent or more.
  
  

Credit Ratings

• Credit ratings on debt issuers are given by the rating companies, Standard & Poor's and Moody's. S&P's ratings are on a letter scale starting a AAA for the highest then down through AA, A, BBB, BB, B, CCC, CC, C and D for in default. Moody's scale is a little different. It uses lower case a's: for example, Aa instead of AA or Baa instead of BBB. The companies regularly review the financial condition of bond issuers and may upgrade or downgrade individual ratings.
  
  

Investment Potential

• In addition to obtaining higher yields, high-yield bond investors have additional potential for capital gains. If a high-yield debt issuer receives a credit rating upgrade, the value of the company's bonds will increase to bring the yield in line with the new credit rating. High-yield bonds are good investments when the economy is expanding or coming out of a recession and corporate profits are improving. Default rates on junk bonds will increase if the economy slows or enters a recession.
  
  

How to Invest in Junk Bonds

• For most individual investors, the best avenue to invest in high-yield bonds is through some type of fund. Junk bond funds will usually have the term high-yield in their name or description. High-yield funds are available as mutual funds, closed-end funds or exchange-traded funds (ETFs). It is difficult for individual investors to evaluate the return vs. default potential of an individual junk bond. Managed products provide professional evaluation of high-yield bonds and diversification across a portfolio that includes a relatively large number of non-investment grade bonds.