The junk bond market is a market for the buying and selling of bonds rated below investment grade and, therefore, considered risky investments. These bonds are considered to be "junk" because they carry a higher than normal risk that the companies issuing the bonds may default on their payback obligations to investors. For this reason, bonds in the junk bond market are characterized by higher interest rates than the ones attached to investment grades bonds, so that investors may be compensated for the increased risk. Investors can judge how the market for junk bonds is performing by studying yield spreads, which measure junk bonds against safer fixed income instruments, and default rates, which show the rate at which issuers of junk bonds are defaulting on their payback obligations.
Bonds are used by issuers such as corporations or governments to raise money. In return for purchasing a bond, an investor is promised regular interest payments as well as the eventual return of the principal paid for the bond. Interest rates offered on bonds often move in inverse proportion to the reliability of the issuer. The junk bond market offers the highest interest rates to investors, but those rates come at an increased risk.
Issuers of bonds are assigned credit ratings by different financial companies based on their ability to repay investors. High credit ratings go to government bonds and other issuers with a proven history of strong earnings and no defaults. By contrast, companies in the junk bond market have low ratings. This may be because they have fallen on hard times, or it can be due to no proven track record.
As a result, these companies involved in the junk bond market have no choice but to issue their bonds with high interest rates attached. In this way, investors wary of possible default can be lured with the potential of higher return on investment over time. Institutional investors generally dominate the market for junk bonds, with individual investors often getting involved through junk bond funds which lessen the risk but still provide good return potential.
Should an investor wish to become involved with the junk bond market, there are certain statistics he or she can consult to see how the market is faring. The yield spread measures the difference between what junk bonds are yielding and what risk-free investments like Treasury bonds are returning. Another good metric to watch is the default rate, which shows the percentage of junk bond issuers that have defaulted over a period of time. A high default rate is a warning sign to investors, since a bond default often means no return of principal or remaining interest payments to the investors holding the bond in question.