Speculative-Grade Bonds (Junk Bonds)
The term speculative-grade bond is used to describe securities deemed to not be of investment quality by a credit rating agency. Since the risk of default is higher with speculative grade bonds, investors will demand they pay a higher rate of interest too.
The three credit rating agencies (Moody’s, Standard and Poor’s, and Fitch Ratings) examine the financial outlooks of corporations, and assign a credit rating to their debt. Generally, these ratings range from high quality debt (AAA/aaa) through what are considered extremely speculative bonds (C/CCC/Ca).
Investment-grade bonds are those carrying some of the highest creditworthiness ratings. This includes securities with ratings of Baa3 (Moody’s) and BBB- (S&P / Fitch) or better. Securities with ratings of Ba1 (Moody’s) and BB+ (S&P / Fitch) are considered non-investment grade or speculative-grade bonds.
Also known as junk bonds, speculative-grade bonds carry a higher risk of default relative to investment-grade securities. Junk bonds will provide investors with higher yields, which compensate them for the additional risk they take when lending these corporations funds. In fact, some institutional investors have policies prohibiting them from holding non-investment grade debt. If the issuing entity eventually improves its financial outlook, and is rewarded with an upgraded rating, the value of this debt can increase substantially, thereby providing holders with a capital gain too.