Explaining Junk Bonds vs. Other Bonds
So what is a junk bond? A junk bond is like a regular bond – in that it promises to pay coupons on the borrowed money and reissue your principal on the maturity date. However, these bonds differ heavily on the basis of the underlying credit quality of the issuers.
The credit-quality of the borrower forms the basis of bond rating. It signifies the risk of default by the borrower. When the underlying default risk of the issuer is between low and medium, the bond meets the requirements of the investment grade category. The 'AAA' bond rating reflects low risk while the 'BBB' rating reflects medium risk. The letters, ‘AAA’, or ‘BBB" signify grades that indicate the credit worthiness of a company. Blue-chip companies normally considered safe investments get high ratings, whereas risky companies get low ratings. Though these bonds may not offer huge returns, they are attractive due to the low risk of default on interest payments.
Junk bonds, on the other hand, offer high yields in order to compensate bondholders for the default risk. Their rating grades at 'BB', 'B', 'CCC', 'CC', and 'C'. Such low rating makes it extremely difficult for the issuers to obtain capital at low costs.
The indices where junk bonds trade include Citigroup US High-Yield Market Trade Index, CFSB High Yield II Index (CSHY), Bear Stearns High Yield Index (BSIX), the Merrill Lynch High Yield Master II (H0A0) and the Barclays High Yield Index. However, if you want to trade only in 'BB' or 'B' rated junk bonds, you can trade on specialized indices, such as the Merrill Lynch Global High Yield BB-B Rated Index.