High-yield debt

A junk bond is a business term referring to a debt instrument that has little chance of being redeed. They typically pay high yields in order to make them attractive to investors. The term is considered slightly pejorative and is often referred to by the euphemisms high yield bond and non-investment grade bonds.

In modern economies, debt is bought and sold in the form of bonds traded in organized markets. The price of a bond is determined by numerous factors, including the interest rate, the term, and the degree of risk associated with the underlying assets.

The risk of a bond is a measure of the ability of the debtor to pay the interest payments (or coupons) and eventually pay off the complete debt when the bond matures. Companies with financial difficulties will find this more difficult, and are considered a more risky investment than bonds issued by, say, the US treasury which are considered risk free. The risk of a bond is determined by one of serveral credit rating agencies such as Standard and Poors and is expressed by a rating such as 'AAA' (where 'A' is better than 'B' and 'AA' is better than 'A').

For a bond to be considered 'Junk' it must have a risk rating lower than a certain level. This lower rating typically implies a higher yield, making junk bonds attractive investment vehicles for certain types of financial portfolios and strategies. Many pension funds and other investors, however, are prohibited in their by-laws from investing in bonds which have ratings below a particular level.

Unlike investment grade bonds, the value of junk bonds is affected by the possibility of default. For example, in a recession interest rates tend to drop, this tends to increase the value of investment grade bonds, however a recession increases the possibility of default in junk bonds.

Junk bonds were popularized in the 1980s by Michael Milken as a financing mechanism primarily for mergers and acquisitions. In a leveraged buyout (or LBO) an acquirer would issue junk bonds to pay for a corporate acquisition and then use the cash flow of the target company to pay off the debt over time.