What Are Junk Bonds & How Do they Work?

Junk bonds, also known as high-yield bonds, are a type of corporate bond with a lower credit rating than investment-grade bonds, positioning them on the riskier side of the bond market. While government bonds and highly-rated corporate debt are generally viewed as safer investments, junk bonds offer higher interest rates to compensate investors for the increased risk of default. These bonds are typically issued by companies with weaker financials, unproven business models, or those undergoing restructuring.

Within the broader bond market, junk bonds play a distinct and essential role. They provide crucial financing to companies that may not qualify for traditional funding, offering investors an opportunity to pursue higher returns—especially during periods of economic growth when default rates are lower. However, this higher yield comes with increased credit risk and heightened sensitivity to economic cycles. Junk bonds tend to outperform when markets are stable or improving but are often among the first to sell off in times of recession or uncertainty. As a result, they are frequently viewed as a barometer for investor risk appetite, sitting at the intersection of fixed income and equity-like risk.

Junk bonds function much like other corporate bonds: investors lend money to a company in exchange for regular interest payments—known as coupons—and the return of the bond’s face value at maturity. What sets them apart is their credit rating. Typically rated below BBB- by S&P or Baa3 by Moody’s, junk bonds carry a higher risk that the issuer may default on its obligations.

To offset this added risk, junk bonds offer higher yields than their investment-grade counterparts. These elevated returns are what attract investors, especially during periods of low interest rates or strong economic growth. Companies may issue junk bonds to fund expansion, refinance existing debt, or shore up liquidity in times of financial strain.

Because of their lower credit quality, junk bonds often respond more sharply to changes in economic conditions. When the economy is strong and defaults are rare, investor appetite for yield can drive prices up. But during economic downturns or periods of market stress, junk bonds are often hit hard as credit fears take center stage. This makes them more volatile than investment-grade bonds and more responsive to macroeconomic sentiment—sometimes trading more like equities than traditional fixed income.

Credit ratings are independent evaluations of a borrower’s ability to repay debt, issued by agencies that help investors assess the risk associated with a particular bond. In general, the higher the credit rating, the lower the perceived risk of default. Junk bonds fall on the lower end of this spectrum, carrying ratings below investment grade—signaling that the issuer is more likely to default compared to stronger, more stable companies.

The three major credit rating agencies are:

• Standard & Poor’s (S&P)

• Moody’s Investors Service

• Fitch Ratings

In the world of junk bonds, these ratings play a crucial role. Bonds rated below investment grade are considered “speculative” or “high-yield” and tend to attract investors who are willing to take on greater risk in exchange for potentially higher returns. When a company is downgraded into junk territory—a so-called “fallen angel”—its borrowing costs typically rise, and the bond may see a selloff, particularly if institutional investors are barred from holding non-investment-grade debt. In this way, credit ratings directly affect both market access and investor demand.

Credit ratings are broadly classified into two categories: investment-grade and junk (also known as high-yield). Investment-grade ratings indicate relatively low credit risk and are typically awarded to financially sound corporations or sovereign entities. These ratings range from AAA to BBB for S&P and Fitch, or Aaa to Baa for Moody’s. Bonds in this category are often favored by conservative investors such as pension funds, insurance companies, and other institutions with low risk tolerance.

Junk bonds sit below this threshold, beginning at BB+ (S&P/Fitch) or Ba1 (Moody’s) and descending through increasingly speculative grades. These ratings suggest a higher likelihood of default, so issuers must offer elevated yields to entice buyers. At the lowest end of the spectrum—ratings like CCC, CC, or D—bonds are often associated with companies in deep financial distress or outright default.

The critical dividing line is BBB-/Baa3. Bonds rated below that are considered high-yield. For investors and traders, this boundary is more than symbolic—it often triggers significant market moves. Companies on the verge of being upgraded to investment-grade or downgraded into junk status can see sharp fluctuations in bond prices. That said, credit ratings are just one lens through which risk is assessed, and markets frequently anticipate these changes before rating agencies make them official.

Despite the name, junk bonds can present compelling opportunities—particularly for income-focused investors and traders willing to take on greater risk. The main draw is yield. Because these bonds carry a higher risk of default, they offer elevated interest payments compared to safer, investment-grade debt. In a low-rate environment, that additional income can be especially appealing—especially when the issuer shows signs of financial improvement or potential for a credit upgrade.

Junk bonds also attract speculative and opportunistic investors looking to capitalize on mispriced risk. If a bond is trading at a steep discount due to market pessimism—but the issuing company stabilizes or improves its credit profile—there’s potential for both capital gains and income. In this way, junk bonds can behave more like equities, offering higher volatility alongside the chance for outsized returns.

However, that upside comes with real risk. Junk bonds may not be suitable for risk-averse investors or those prioritizing long-term capital preservation. Their performance is closely tied to the health of the economy, and in downturns, they’re often among the first assets to suffer.

Junk bonds come with a straightforward trade-off: higher potential returns in exchange for higher risk. The key appeal is yield—these bonds typically offer much higher interest payments than investment-grade debt, making them attractive to income-focused investors, especially when interest rates are low. There’s also the possibility of capital gains if the issuer’s credit profile improves or if market conditions favor riskier assets. During periods of economic growth and stable credit markets, junk bonds can outperform more conservative fixed income investments.

But the risks are significant. Junk bonds are more exposed to economic downturns, rising interest rates, and shifts in investor sentiment. Credit events—like missed payments, downgrades, or restructurings—can lead to steep losses, and liquidity can dry up quickly in times of market stress. Given that these bonds are issued by companies with weaker financial health, the likelihood of default is meaningfully higher.

For these reasons, junk bonds tend to be most popular with investors who are comfortable with volatility, have a solid understanding of credit risk, and actively monitor their positions. While the rewards can be compelling, success in this corner of the market requires discipline, timing, and a strong risk management strategy.

A bond default happens when the issuer fails to meet its payment obligations—either by missing an interest payment (coupon) or by not repaying the principal at maturity. For junk bonds, the risk of default is significantly higher than for investment-grade debt, which is precisely why they offer higher yields—to compensate investors for taking on that added uncertainty. Defaults are therefore a central risk for junk bond investors, with the potential to cause sharp losses or, in extreme cases, a total loss of capital.

A default usually indicates that the issuer is in serious financial trouble—whether due to poor earnings, excessive debt, or adverse economic conditions. When a default occurs, the company may elect to enter bankruptcy, or begin a restructuring process. In such cases, bondholders might recover only a portion of their original investment, depending on the company’s remaining assets and the bond’s seniority in the capital structure.

Consider a scenario where a company issues a $1,000 junk bond with an 8% annual interest rate, attracting investors with the promise of high yield despite elevated risk. Two years in, the company runs into financial trouble—perhaps due to weak earnings, heavy debt, or a broader economic downturn—and misses a scheduled interest payment. The bond is swiftly downgraded by credit rating agencies, and its market value plunges as investors rush to sell. With liquidity drying up and confidence collapsing, the company eventually files for bankruptcy. During the restructuring process, bondholders—who often sit low in the repayment hierarchy—recover just $300 of their original investment. The outcome: a 70% loss that underscores how quickly junk bond investments can deteriorate when default risk becomes reality.

This unfavorable scenario underscores why thorough due diligence is critical when investing in junk bonds. The potential for high returns may be enticing, but the elevated risk of default—and the possibility of steep losses or even total capital erosion—demands a cautious, research-driven approach. Investors must weigh yield against risk, understand the issuer’s financial health, and be prepared for volatility, especially in uncertain economic environments.

Because junk bonds carry elevated risk, their performance can vary dramatically depending on the issuer’s financial health and broader market conditions. Below are two simplified scenarios—one favorable, one unfavorable—that help illustrate the range of outcomes investors may encounter when investing in junk bonds. 

Favorable Scenario – Credit Improvement and Price Appreciation

An investor buys a junk bond from a mid-sized tech company rated BB, with a 7% annual coupon and five years to maturity. The company begins to show strong revenue growth and tightens up its balance sheet. Over the next two years, its credit rating is upgraded to BBB-, pushing the bond into investment-grade territory. As a result, demand for the bond increases, and its market price rises significantly. The investor not only collects the steady coupon payments but also sees the bond’s value appreciate, creating an opportunity for capital gains if sold before maturity.

Unfavorable Scenario – Credit Deterioration and Default

Now consider a different case: an investor purchases a bond from a retail chain rated B, offering a 9% yield. The company, already carrying substantial debt, begins to lose market share and faces rising costs. Six months later, it misses an interest payment. The bond is downgraded further, and the price drops by 40% as panic sets in. The company files for bankruptcy, and after months of restructuring, bondholders recover only 25 cents on the dollar. The investor suffers a major loss—despite the high initial yield.

• Junk bonds are corporate bonds with lower credit ratings, typically below BBB- (S&P/Fitch) or Baa3 (Moody’s), which means they carry a higher risk of default.

• They offer higher interest rates than investment-grade bonds to compensate investors for taking on more credit risk.

• Credit ratings help investors assess risk, with junk bonds falling into the “speculative” category based on ratings from agencies like S&P, Moody’s, and Fitch.

• Junk bonds are more volatile and economically sensitive, often rising in strong markets but falling sharply during downturns.

• Investors buy junk bonds for higher income potential, or in hopes of capital gains if the issuer’s credit outlook improves.

• The biggest risk is default, where the company fails to pay interest or repay principal, potentially resulting in large losses.

• Junk bonds can lose value quickly, especially in times of market stress or if the issuer’s financial condition worsens.

• They may offer strong returns in favorable conditions, but require active monitoring and a willingness to accept losses if things go wrong.

• Junk bonds are best suited for investors with higher risk tolerance, and are generally not appropriate for conservative or long-term income strategies.

• Due diligence and diversification are key, as junk bonds carry higher risk and require careful credit analysis before investing.