Junk Bonds Demystified: An Interactive Learning Guide
High yield debt, also known as "junk bonds," are bonds rated below investment grade (BB+/Ba1 or lower). They're called "high yield" because they pay higher interest rates to compensate investors for taking on more default risk.
Think of it like this: Would you lend money to your friend with perfect credit at 3% interest, or to your unreliable cousin at 8%? High yield bonds are the "unreliable cousin" of the debt world – riskier borrowers who must pay higher rates to attract lenders.
Companies with weaker credit profiles, higher leverage, or more volatile businesses
Coupons typically 5-10% (vs 2-4% for investment grade) to compensate for risk
Most high yield bonds are senior unsecured – no specific collateral backing them
Typically 7-10 years, providing extended refinancing runway
AAA to BBB-
Low default risk
Yields: 2-5%
Government bonds, blue-chip companies
BB+ and Below
Higher default risk
Yields: 5-12%+
Leveraged companies, LBOs, riskier credits
The cutoff between investment grade and high yield is BBB-/Baa3. Bonds rated BBB- are the lowest tier of investment grade. Drop one notch to BB+/Ba1 and you're in high yield territory. This single rating change can dramatically affect a bond's price, liquidity, and investor base.
High yield bonds sit below secured debt but above equity – unsecured but still senior to stockholders
Credit rating agencies (Moody's, S&P, Fitch) assess default risk and assign letter grades. These ratings determine whether a bond is investment grade or high yield.
| Rating | Category | Default Rate (Annual) | Who Buys |
|---|---|---|---|
| AAA-A | Investment Grade | 0.01-0.10% | Insurance companies, pension funds, conservative investors |
| BBB | Investment Grade | 0.15-0.30% | Most institutional investors |
| BB | High Yield | 0.50-1.50% | High yield funds, aggressive investors |
| B | High Yield | 2.0-5.0% | Specialized high yield funds, hedge funds |
| CCC and below | Distressed | 10-30%+ | Distressed debt funds, vulture investors |
Moody's uses: Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C
S&P and Fitch use: AAA, AA, A, BBB, BB, B, CCC, CC, C, D
Within each category, they add modifiers: +/- (S&P/Fitch) or 1/2/3 (Moody's)
Example: BB+ is one notch above BB, which is one notch above BB-
High yield bonds have unique characteristics that distinguish them from investment grade bonds and bank loans.
Interest rate is locked in at issuance (e.g., 7.5%) and paid semi-annually. Unlike floating rate loans, investors bear interest rate risk.
Most high yield bonds are senior unsecured – no specific collateral. Rank below secured debt but above subordinated debt and equity.
Longer tenor than bank debt (5-7 years), providing extended refinancing runway and reducing near-term maturity walls.
Bullet structure – entire principal due at maturity. No quarterly principal payments, preserving cash for operations.
Non-call period (typically 3-5 years) prevents early redemption. After that, bonds callable at premium (e.g., 105% declining to par).
Requires issuer to offer to repurchase bonds at 101% upon ownership change, protecting bondholders from LBO risk.
| Feature | Investment Grade Bonds | High Yield Bonds | Bank Loans |
|---|---|---|---|
| Credit Rating | BBB- and above | BB+ and below | Typically BB/B |
| Interest Rate | Fixed (2-5%) | Fixed (5-12%) | Floating (SOFR + 4-6%) |
| Security | Unsecured | Usually unsecured | Secured (first lien) |
| Maturity | 10-30 years | 7-10 years | 5-7 years |
| Covenants | Light incurrence | Incurrence | Maintenance |
| Amortization | None (bullet) | None (bullet) | Yes (1-2%/year) |
| Investor Base | Broad institutional | HY funds, retail | Banks, CLOs, funds |
| Typical Size | $500M - $2B+ | $300M - $1B | $100M - $500M |
| Default Rate | 0.1-0.3% | 2-5% | 1-3% |
Bond cannot be redeemed by issuer (hard call protection). Investors protected from refinancing risk.
Issuer can redeem bonds but must pay 105% of par value ($1,050 per $1,000 bond)
Call premium steps down to 102.5% of par value
Can redeem at 100% (par value) with no premium
If interest rates fall from 8% to 5%, the issuer wants to refinance at the lower rate. Call protection prevents this for several years, ensuring investors earn their expected return. After the non-call period, call premiums compensate investors if bonds are redeemed early.
The most important difference between high yield bonds and bank loans is the covenant structure. Understanding this is crucial.
Used in: Bank loans, credit facilities
Used in: High yield bonds
Limits on dividends and distributions. Often uses "builder basket" that grows with net income over time.
Can only borrow more if Fixed Charge Coverage Ratio exceeds threshold (typically 2.0x) or through carved-out baskets.
Proceeds from selling assets must be reinvested in business or used to pay down debt within 360-450 days.
Transactions with sponsors or related parties must be on arm's length terms and may require board approval.
Must offer to repurchase bonds at 101% if company ownership changes hands (protects against LBOs).
Material subsidiaries must guarantee the bonds, providing additional credit support.
EBITDA drops 30% due to recession. Leverage ratio deteriorates.
Quarterly test failed! Technical default. Must negotiate waiver or amendment with lenders. They may demand fees, higher rates, or equity warrants.
No quarterly test! Company can continue operating normally. Only restricted if trying to take new actions like borrowing more or paying dividends.
Incurrence covenants provide a crucial cushion during difficult times. Companies with high yield bonds can weather storms without immediately triggering defaults, as long as they don't try to take aggressive actions. This is why issuers prefer high yield bonds despite the higher interest cost – the flexibility is worth it.
Calculate expected yields and understand pricing dynamics based on credit rating and market conditions.
Risk-free rate – what the U.S. government pays on 10-year bonds. Currently around 4-5%.
Additional yield above Treasuries to compensate for default risk. Higher risk = higher spread.
Total expected return: Treasury + Spread. This is what investors demand to buy the bond.
The spread compensates for both expected losses from defaults AND risk premium for uncertainty.
Company: Leveraged retailer, B rating
Treasury Rate: 4.5%
Credit Spread: 7.0% (700 bps for B rating)
Coupon: 11.5% (4.5% + 7.0%)
Annual Interest: $46M on $400M bond
Investor Logic: "I'll earn 11.5% per year. Even if there's a 3% annual chance of default with 40% recovery, my expected return still beats investment grade bonds at 5%."
Spreads widen (yields ↑) when:
• Economic outlook deteriorates
• Default rates increase
• Investors become risk-averse
• Company-specific bad news
Spreads tighten (yields ↓) when:
• Strong economic growth
• Low default environment
• Investors "reach for yield"
• Company improves credit profile