As a beginning investor you may frequently hear the term ‘junk bond’ and a variety of opinions regarding their value and worth. On the best end of the spectrum junk bonds can be the source of a high return.

Unfortunately, junk bonds have earned a bad reputation as a close relation to investment scams. How do you know whether junk bonds are the right investment vehicle for you? 

First, it is important to understand a little of the background of junk bonds. Really, a junk bond isn’t any different than a regular bond. They are a debt obligation from an organisation or corporation that agrees to pay you back the principal of the loan while stipulating other terms such as the maturity date and the interest to be paid on the loan.

The main difference between a junk bond and any other type of bond is the credit risk of the issuers. Because the credit quality of the borrowers can vary there are two different categories of bonds.

They are investment grade and junk bonds. Investment grade bonds are those that are issued to lenders that are considered to be low to medium risk. Their bond rating will usually range from AAA to BBB. Of course, there may still be some level of risk involved it won’t be as high as a junk bond. 

With a junk bond, there is the potential for high yields generally because the borrowers have less than wonderful credit ratings and therefore fewer options for obtaining capital. These are borrowers with ratings of BB/BA or less. 

The bond rating is sort of the equivalent of a your credit score, on a corporate level. Whereas individual credit scores are reflected in a numeric value, such as 680, corporate credit scores are represented in alpha values.

Companies with the lowest risk have the highest bond ratings. According to Standard & Poor’s, their rating would be AAA. A slightly higher risk company, but still low risk might have an AA or an A rating.

Medium risk companies fall at BBB. Junk grade begins at BB and B reflected at a high risk. The highest risk companies have ratings of CCC, CC and C. Companies that are in default have a rating of D. 

Junk bonds are sometimes attractive to investors because of the potential for high yields. Over time, junk bonds have averaged yields that range between 4 and 6% higher than other comparable investments.

If you are considering the purchase of a junk bond, you should know that there is always an element of high risk involved with this type of investment. There is a good chance you will never be paid back all of your money.

Before investing in a junk bond always make sure you know the default rate by doing your research ahead of time.

Finally, realise that because there is such a high level of risk involved in investing in junk bonds, it is best not to allocate all of your assets using this one investment vehicle.