Junk Bonds

Credit risk is based on a multitude of factors, many of which are linked to performance in the past. Some of the largest corporations, such as IBM and General Motors, and even the U.S. government were at times below investment-grade rating. Today many companies that are household names, including Time Warner and Duracell, fall into this category.

The bonds of 95 percent of U.S. companies with revenues over $35 million—and of all companies below that amount—are rated noninvestment grade or junk. This means that the companies must pay higher rates of interest on their bond issues than other corporations pay on investment-grade bonds. That is why non-investment-grade bonds also go by the name of high-yield bonds.

Until the late seventies all new bonds sold publicly to large groups of investors were investment grade. The only publicly traded junk bonds were ones that originally carried investment-grade ratings and had subsequently been "downgraded" because the financial strength of the issuing companies had deteriorated. Up until then, companies with ratings below investment grade raised new money by borrowing from banks or through what are called private placements. A private placement is the sale of bonds directly to an investor such as an insurance company. Because private placements are not registered with the Securities and Exchange Commission, the original purchasers cannot easily resell them to other investors. Interestingly, though, no one labeled such bonds as junk. Publicly issued bonds, on the other hand, can be traded freely.

The debt market in the United States changed dramatically after 1977, when Bear Stearns and Company, a New York investment house, underwrote the first original-issue junk bond (that is, the first public sale of new bonds with a junk rating). Soon thereafter, Drexel Burnham Lambert financed seven companies that had previously been shut out of the corporate bond market. By 1983 over a third of all corporate bond issues were non-investment grade, two-thirds of which were new issues.

What explains this explosion in the issue of junk bonds? For one thing, they held enormous appeal for borrowing companies because publicly issued bonds typically carry lower interest rates (because they are more easily resold) than private placements, and they also tend to impose fewer restrictions on the actions of the borrowers (known in the argot of finance as restrictive covenants). For another, research by economists showed that junk bonds ought to have great appeal to investors. W. Braddock Hickman, T. R. Atkinson, O. K. Burrell, and others examined the bond-rating systems and their impact on bond pricing. These academics were the first to quantify the actual risk premiums (the higher interest rates) paid to various bond investors. They were particularly struck by the fact that low-rated debt earned a high risk-adjusted rate of return. In other words, the interest-rate premium on low-rated debt was higher than was justified by the added risk of default. Therefore, someone who bought a diversified portfolio of these risky bonds would do better than someone who bought investment-grade bonds, even after deducting losses on the bonds that defaulted. Michael Milken of Drexel Burnham trumpeted these insights to his firm and his customers, with stunning success.

For many companies facing major structural economic changes in the eighties—foreign competition, technological shifts, deregulation—a missing element for economic adjustment was capital. Bank loans, restrictive private placements, or dilutive stock offerings were the only source of capital prior to the rise of the high-yield market. But suddenly the high-yield market was liquid enough to provide cost-effective funding alternatives.

That golden age of junk financing lasted roughly a decade and built to a virtual frenzy of new bond issues in 1988 and 1989. That resulted, in 1989 and 1990, in an unprecedented number of defaults by junk bond issuers and the bankruptcy of Drexel Burnham. Almost overnight the market for newly issued junk bonds disappeared, and no significant new junk issues came to market for more than a year.

In the wake of that shakeout and the scandals involving Drexel Burnham, junk bonds have been blamed for a broad range of troubles in the economy, including huge losses by commercial banks, the savings and loan crisis, high unemployment, low productivity growth, and almost everything else that seems amiss in the U.S. financial world. The facts do not support such assertions, but a handful of major bankruptcies of companies that went through leveraged buyouts or made acquisitions with junk bonds has fostered the general impression that they are responsible for many economic woes.

In fact, researchers have found that issuers of high-yield debt as a group have outperformed industrial averages in many important measures of industrial performance, including employment growth, productivity, sales, capital investment, and capital spending. Overall, high-yield firms increased employment at an average annual rate of 6.7 percent, compared with 1.4 percent for industry in general, from 1980 to 1987. High-yield firms also outperformed their industrial counterparts in productivity. In output per hour of labor, industries with higher utilization of high-yield securities were more productive. In sales per employee, high-yield firms averaged 3.2 percent growth annually, compared with an industrial average of 2.4 percent. The total invested capital of high-yield firms grew at an average annual rate of 12.4 percent, compared with 9.9 percent for industry in general. New capital expenditures for property and plant and equipment grew more than three times as fast among high-yield firms as they did for industry in general (10.6 percent vs. 3.8 percent).

The rise of high-yield securities accompanied the general growth of so-called debt securitization—the combining of loans into packages and the issuance of securities that represent claims on the interest and repayment of principal on those loans. Debt securitization has made marketable investment instruments out of such everyday borrowings as home mortgages and credit card debt. Studies indicate that throughout the eighties junk bonds were very profitable investments for S&Ls, second only to credit cards.

Why, then, have junk bonds gotten such a bad reputation? For one thing, top managers of investment-grade companies have been arguing for years that they are the embodiment of reckless excess on Wall Street. They may take that position because junk bonds gave corporate raiders access to the public debt market and enabled them to mount assaults on the largest corporations in the United States. Less dramatically but also of importance, junk bonds make it possible for weaker companies to compete more successfully with investment-grade companies for financing. In addition, it is likely that a herd instinct on Wall Street helped make junk bonds anathema, at least for a while. By 1988 and 1989 Wall Street firms were financing deals that many observers said were bound to fail. But investors went on buying even the shakiest junk bonds. When the poorly structured deals did fail, investors shunned even the strongest junk bonds. But by the summer of 1991, it appeared that junk bonds were on their way back to filling a very useful role in financing U.S. business.