What is a junk bond?

NEA Today, May 1999

Let's start with a bond. A bond is an investment that gives you income at a specified rate and then returns your principal at a specified time. It's similar to a bank loanexcept you are the bank.

The borrower promises to pay you a set rate of interest-and agrees to repay the principal at a specified time. Your concerns as a bond investor are the same as those of the bank that loans you money. The first is the ability or willingness of the issuer to repay the money.

Bonds are assigned letter grades that indicate the creditworthiness of the borrower as measured by Moody's Investor Service and the Standard & Poor's Corporation. The top rating goes to the U.S. government, then come corporations with an AAA rating, and on down to those classified as NR because they have no rating. The higher the credit rating, the lower the risk for the investor, but the higher the credit rating, the lower the interest rate the investor gets.

Junk bonds, or "high-yield bonds" as they are often called, are bonds that have a low credit rating or no rating at all. Junk bonds are appealing because they pay a higher rate of interest. But junk bonds are risky because a borrower may default, and then you won't get your money back. Like most investments, junk bonds require that you weigh the trade-off between risk and return.