Understanding Junk Bonds

Bonds are categorized based on their credit ratings, which reflect the issuer's ability to repay the debt. Bonds rated BB or below are termed as "Junk Bonds," indicating a higher risk of default. Bonds rated BBB and above are "Investment Grade," meaning they are considered to be safer investments.

Analyzing Historical Default Rates

On the Bond Analysis page, you'll see a "Historical Default Rate" column. We take Moody's historical 5-year default rates, that is, the likelihood that a bond, with a given rating such as BBB, will default on its debt in the next 5 years. We then annualize this to come up with an annual default risk. Furthermore, we assume that in a bankruptcy, bondholders will recover 40% of their investment. For example, according to Moody's data, 2.5% BBB-rated companies have defaulted in the next 5 years, averageing 0.5% per year. Assuming bondholders recover 40% of their investment, and future defaults match the historical data, default risk reduces a BBB bond's expected return by approximately 0.3%. At the time of writing, BBB yields are 5.55%, for an expected return of 5.25%.

This is just an expectation; in a good economy, defaults may be significantly less than this, and a poor economy, defaults may be significantly greater. For example, Moody's found that during the great depression, there were several years where approximately 2% of BBB bonds defaulted.

BBB vs. BB Bonds

Compared to BBB bonds, BB bonds carry a significantly higher expected default rate of 1.76%. While they yield 6.3%, after we account for default risk, we get an expected return of 5.24%, close to that of BBB bonds. BB bond investors are taking additional risk, but they may not be getting compensation for this risk.

The Financial Crisis

As we see in the above chart, in the past, the spread (difference) between BBB and BB yields has frequently been higher. For example, in Nov 2008, during the financial crisis, the spread was 5.98%. Since the economy was poor, investors were fearful that bankruptcies would surge. Suppose the default rate was expected to be three times normal. Then, BB bonds would have a default rate of 1.76% * 3 = 5.28%, while BBB bonds would have a default rate of 0.5%*3=1.5%. BB bonds would then default 5.28% - 1.5% = 3.78% more often. Additionally, in poor economic times, recovery rates could be lower; bankrupt companies might have a harder time selling their assets, so they might not be able to pay as much to bondholders. If the recovery rate was 20%, bankruptcies would cause BB bonds to return (3.78*(1-20%)) = 3.02% less. Subtracting this from the spread of 5.98%, we would expect BB bonds to return 2.96% more than BBB bonds. In a financial crisis where safe assets are valued, investors had to decide whether that 2.96% premium was worth the risk.

Concluding Thoughts

Junk bonds are considerably riskier than investment grade bonds, and they are not a typical investment for most investors. Sophisticated investors must weigh the potential for higher returns against the increased likelihood of defaults. As of writing, if default rates match historical levels, junk bonds do not look appealing from a risk/reward perspective.