You hear all the time about ‘junk bonds’, but what are they? Most bonds are rated by the two major credit rating agencies, Moody’s and Standard and Poors. Their methodology differs a bit, but essentially they rate the bonds from AAA (highest) down to D (in default). The four highest ratings are AAA, AA, A, and BBB. These are what known as investment grade bonds. Any other bonds, the ones rated BB, B, CCC, etc. are considered high yield, speculative, or junk bonds.
What does that all mean? Well Moody’s and S&P look at the financials of each company and decides what the level of risk is for someone who buys a company’s bonds. The real dividing line is right in-between BBB (lowest investment grade) and BB (highest speculative grade). The differences are significant. On average, a BBB rated bond has an average default rate in the neighborhood of 4.5%. But the average default rate for a BB rated bond is in the neighborhood of 20%. B rated? 30%.
Now a default does not mean all the investor’s money is lost. But it does mean that some, and maybe much of it will be. And recovering the money may take months or years.
Yields on BB and lower rated bonds will be of course much higher than for an AAA rated bond (AAA rated bonds have historical default rates of under 0.50%), because the risk of losing your investment is much higher.
Pay close attention to the bond ratings if you’re buying a bond. An extra 1 or 2% yield might sound great, but it’s not worth much if your bond goes into default.