What Is a Junk Bond ETF?

A junk bond ETF is a mutual fund that can be bought and sold by investors through a market exchange and focuses on high-yield bonds known as junk bonds. Junk bonds are so named because the companies that issue them are at a more significant risk of default than other, more stable bond issuers. As a result, these companies must compensate for the risks attached to them by offering higher interest rates on their bonds. By using a junk bond ETF, investors can eliminate some of the default risks of junk bonds through the diversification inherent in any investment structured like a mutual fund.

Many investors looking for diversification are drawn to mutual funds, which contain multiple securities in a single investment. These funds are managed by investment professionals, and all of the investors in the fund share in the profits by receiving capital gains. An exchange-traded fund (ETF) is a type of mutual fund that is bought and sold just like equities are bought and sold on the stock market. One particular type of ETF offering the potential for high returns is a junk bond ETF.

The main lure of a junk bond ETF is the fact that it can offer investors high returns compared to other funds devoted to bonds. Junk bonds have excellent interest rates compared to safer bonds like Treasury bonds. As a matter of fact, junk bonds are often measured in terms of Treasury bonds, with the difference between the performances of the two types of bonds known as the yield spread.

Unfortunately, the high yield that accompanies a junk bond ETF often comes at the price of high risk. Issuers of junk bonds are often companies that have poor credit ratings. This means that they run a greater risk of defaulting on their bond payback obligations than other issuers of bonds. They have no choice but to offer high interest rates on their bonds, because investors would stay away from them if that weren't the case.

One of the main benefits of a junk bond ETF is that it eliminates some of that default risk through the diversification it offers. Since a fund will invest in multiple junk bonds all at once, it is not that damaging to the overall investment if one or even a few defaults take place. Even with several defaults, the possibility remains that other high-yield bonds included in the fund will keep the overall yield for the fund competitively high.