Junk bonds have a reputation. They’re often called “high-yield bonds” to soften the label, but the risks remain clear.

At first glance, they might seem risky and out of place for the typical long-term investor . And that’s fair. Junk bonds don’t always align with conservative, steady growth investing strategies.

But understanding them matters. For all the valid antipathy from the long-term investing community, junk bonds can play a unique role in investing. For some, they offer opportunities to balance risk and reward. For others, they’re part of a diversification strategy.

This article breaks down junk bonds, why they exist, and how they compare to regular bonds. Our goal is to give you clear insights to decide if they’re worth considering in your investing journey.

A refresher: what are bonds?

Bonds are a type of loan. When you buy a bond, you lend money to a government or company for a specific period. In exchange, the issuer agrees to pay you regular interest – known as a “coupon” – and return your original loan amount, or principal, when the bond matures.

For investors, bonds can provide a steady income stream and act as a buffer against the ups and downs of share markets. However, the risk and return vary widely depending on the type of bond you choose.

Bonds come in many forms. Two key categories are government and corporate bonds. Governments issue bonds to fund infrastructure, public services, or other projects. These are often considered low-risk because governments rarely default on their debt. Companies issue bonds to finance growth, manage debt, or fund new ventures. Corporate bonds can offer higher returns, but they carry more risk, as companies can face financial difficulties.

Understanding bonds is a great first step to exploring junk bonds and how they might impact your portfolio.

What are junk bonds?

Junk bonds are corporate bonds issued by companies with lower credit ratings. These ratings reflect higher financial risk.

As mentioned, they’re also called high-yield bonds. This is because they offer higher interest payments to compensate for the increased risk.

Credit rating agencies, like Standard & Poor’s or Moody’s , rate bonds based on a company’s ability to repay its debt. Junk bonds fall below “investment grade” ratings, meaning the company has a greater chance of defaulting – not repaying the loan.

Investors who choose junk bonds typically do so for their potential to deliver higher returns compared to safer bonds. However, the higher yields come with a greater likelihood of losses if the issuer can’t meet its obligations.

As we’ve said, not all bonds carry the same level of risk, and junk bonds sit at the higher-risk end of the spectrum. Understanding why companies issue junk bonds – and what makes them different – can help you decide if they align with your goals and risk tolerance .

Why do people invest in junk bonds?

People often invest in junk bonds because they offer higher returns than most other fixed-income investments. According to The Economist : “when cash deposits pay virtually zero, investors have an incentive to take risks in search of higher returns.”

For some investors, junk bonds provide a way to diversify a portfolio. They don’t always move in step with shares, which can help reduce overall volatility.

Others see junk bonds as an opportunity to take on calculated risk. They’re willing to accept the higher chance of default for the potential rewards.

Junk bonds can also attract investors who believe in the issuer’s potential. A struggling company may have plans for a turnaround, offering the chance to benefit from its recovery.

As we’ve said, junk bonds come with higher risks. However, for investors with a clear understanding of those risks, they can play a unique role in pursuing financial goals.

How do junk bonds compare with regular investment-grade bonds?

Junk bonds and investment-grade bonds both serve as tools for regular passive income . But each comes with distinct risk and reward profiles.

Here’s a side-by-side comparison:

Feature	Junk bonds	Investment-grade bonds
Credit rating	Below investment grade (BB+ or lower)	Investment grade (BBB- or higher)
Risk level	High risk of default	Comparatively lower risk of default
Interest payments	High to compensate for higher risk	Moderate to reflect lower risk
Issuer profile	Financially weaker or unproven companies	Financially stable companies or governments
Price volatility	More sensitive to market and economic shifts	Less volatile in stable market conditions
Liquidity	Can be harder to sell quickly	Easier to sell in secondary markets

As always, understanding the trade-offs and how they align with your financial goals is crucial. The choice between these bonds comes down to your risk appetite and investment strategy.

The risks of investing in junk bonds

As you may have surmised by now, investing in junk bonds comes with several risks. Here’s what you need to consider:

• Default risk : Companies issuing junk bonds often have weaker financial health, increasing the chance they can’t repay their debts.
• Market volatility : Junk bond prices can swing significantly, especially during economic uncertainty or market downturns.
• Liquidity risk : Selling junk bonds quickly can be difficult, particularly in tough markets, and you may need to accept a lower price.
• Interest rate risk : Rising interest rates can reduce the value of junk bonds, as newer bonds may offer better returns.
• Credit risk : A company’s financial situation can potentially worsen, leading to further downgrades in its bond rating and a drop in value.

While these risks don’t make junk bonds inherently bad, they highlight why careful consideration is important. Every investor’s tolerance for risk is different, and knowing your limits helps.

Strategies that might accommodate junk bonds

Junk bonds can be part of a broader investment strategy, especially for those with higher risk tolerance. Here are a few ways they might fit in:

• High-yield focus : Investors seeking higher returns may allocate a portion of their portfolio to junk bonds, aiming for increased yield.
• Diversified bond funds : Some may choose bond funds or bond ETFs that include junk bonds, spreading risk across various issuers and sectors.
• Risk-adjusted portfolio : Junk bonds can complement other assets by providing growth potential, balancing safer investments with a bit more risk.
• Market timing : Some investors attempt to buy junk bonds during market downturns when they’re undervalued, hoping for recovery as conditions improve.

In a portfolio context, junk bonds can play a role in certain market conditions as they behave differently to stocks. They may provide a cushion when share markets are volatile, though not always. It’s crucial to remember that past performance isn’t a reliable indicator of future performance.

The above strategies aim to balance risks with potential rewards, but aligning them with your financial goals is essential.

Junk bonds – is the risk worth the reward?

Knowing how junk bonds work is crucial to recognising the balance between risk and reward. These investments aren’t for everyone, but they can play a role in certain portfolios.

As we’ve explored, their higher returns come with significant risks, so it’s essential to approach them with clarity and a strategy that aligns with your investing goals.

At Pearler, we believe in empowering you to make informed, confident decisions. We want you to feel equipped for whatever comes next in your investing journey.

As always, it’s your journey – make it purposeful.