Junk Bond

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Junk Bond

A security issued by a corporation that is considered to offer a high risk to bondholders.

Junk bond is the popular name for high-risk bonds offered by corporations. A bond is a certificate or some other evidence of a debt. In the world of corporate finance, a corporation may sell a bond in exchange for cash. The bond contains a promise to repay its purchaser at a certain rate of return, called a yield. A bond is not an Equity investment in the corporation; it is debt of the corporation.

A corporate bond is essentially a loan to a corporation. The loan may be secured by a lien or mortgage on the corporation's property as security for repayment.

To determine the level of the default risk for potential bondholders, financial experts analyze corporations and rate them on a number of factors, including the nature of their business, their financial holdings, their employees, and the length of their existence. The higher the risk for bondholders, the lower the risk rating given the corporation.

Because their ventures are considered risky, low-rated corporations must offer bond yields that are higher than those of high-rated corporations. High-rated corporations have less need for income from bonds, so they do not need to offer high yields. Bonds from these companies are called investment-grade bonds. Low-rated corporations have the need for bond income, so they offer high-yield bonds. These high-yield bonds are junk bonds.

When a corporation fails, bondholders may lose all or part of their investment if the corporation has declared Bankruptcy or has no assets. This possibility is more real for junk bonds because they are, by definition, issued by unproven or unhealthy corporations.

For some persons, the high yield of a junk bond can be worth the increased risk of default. Junk bonds can increase in value if the corporation's rating is upgraded by private bond-rating firms. Junk bonds are also favored by some persons precisely because they contribute capital to young or struggling corporations. Whether to buy a junk bond depends on the investor: conservative investors do not favor them, but speculators and others seeking a quick profit find them attractive.

Further readings

Boyer, Allen. 1989. "For the Love of Money." Georgia Law Review 23.

West's Encyclopedia of American Law, edition 2. Copyright 2008 The Gale Group, Inc. All rights reserved.
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