JUNK BONDS

JUNK BONDS. Michael Milken, the notorious investment banker of the 1980s, allegedly coined the term "junk bonds" to describe the portfolio of low-grade bonds owned by one of his early clients, Meshulam Riklis. Companies issue low-grade, also called "high-yield," bonds at high interest rates because of the associated high risk of nonpayment. Unlike investment-grade bonds, the low-grade variety is not backed by assets or cash-flow statements. Companies frequently issue these bonds as a way of borrowing money. An outside, third-party credit rating agency, such as Moody's Investors Service or Standard and Poor's Corporation, judges the creditworthiness of such companies and then ranks them from least to most likely to default. The more financially secure the company, the less risky the debt, or bond. A bond's rating can be downgraded to "junk" status if the company gets into financial trouble. Historically, the use of junk bonds has been a minor part of Wall Street's activity because of the high risks. In the 1920s, however, high-yield bonds flourished. Tempted by the skyrocketing stock market in the 1920s, companies issued bonds with high interest rates in order to raise money by cashing in on booming stock profits and the robust economy. When the market collapsed in 1929, many companies defaulted on the low-grade bonds, and many investment-grade bonds were downgraded to junk status.

For forty years, Wall Street shunned high-yield bonds. In the late 1970s, Milken, as an investment banker with Drexel Burnham, rediscovered their potential. He encouraged his clients, largely fringe players on Wall Street, to issue junk bonds, and within a few years he, his company, and his clients became very successful. Milken's success bred imitators, and junk bonds became a popular way to raise money. In 1984 companies issued close to $16 billion in high-yield bonds—ten times the amount in 1981. In 1986 more than $33 billion worth of high-yield bonds were issued. Profits from the sale of junk bonds frequently financed mergers and acquisitions through leveraged buyouts and hostile takeovers. The transactions involved high fees, which induced investment bankers to underwrite increasingly risky bonds and to engage in fraud. Companies lured by the successes of earlier junk-bond deals took increasingly greater risks in issuing bonds. Enticed by the high interest rates, buyers continued to purchase the risky bonds.

The frenzy lasted until 1989, when the junk-bond market collapsed as the economy went into a recession and companies could no longer generate profits to pay their debts. In 1990 companies issued a mere $1.4 billion in high-yield bonds. Defaults totaled $20 billion. Milken and his imitators, such as Ivan Boesky, were disgraced, and many went to jail for fraud. Milken himself served time and paid fines for six counts of securities fraud.

Junk bonds left a dual legacy. They provided financing for the cable television and computer industries and encouraged companies to emphasize efficiency to realize profits to pay off the high interest on the bonds. On the flip side, the unchecked and frantic pace of the junk-bond market led to fraud, overspeculation, layoffs, and lost fortunes.

In the 1990s, the junk-bond market partially recovered despite the scandals of the previous decade. The high returns possible on such risky deals continue to make them attractive to daring investors. Some less adventurous investors, however, have attempted to temper the risks of purchasing junk bonds by placing their money in special mutual funds that deal solely in high-yield bonds rather than buying junk bonds directly themselves. This approach allows them to depend on the investment savvy of specialists in the field of low-grade bond trading.

BIBLIOGRAPHY

Auerbach, Alan J., ed. Mergers and Acquisitions. Chicago: University of Chicago Press, 1988.

Platt, Harlan D. The First Junk Bond: A Story of Corporate Boom and Bust. Armonk, N.Y.: M.E. Sharpe, 1994.

Stein, Benjamin. A License to Steal: The Untold Story of Michael Milken and the Conspiracy to Bilk the Nation. New York: Simon & Schuster, 1992.

Yago, Glenn. Junk Bonds: How High Yield Securities Restructured Corporate America. New York: Oxford University Press, 1991.

ErikBruun/a. e.

See alsoCrime ; Financial Services Industry ; Leveraged Buyouts ; Scandals ; Wall Street .

JUNK BOND

A security issued by a corporation that is considered to offer a high risk to bondholders.

Junk bond is the popular name for high-risk bonds offered by corporations. A bond is a certificate or some other evidence of a debt. In the world of corporate finance, a corporation may sell a bond in exchange for cash. The bond contains a promise to repay its purchaser at a certain rate of return, called a yield. A bond is not an equity investment in the corporation; it is debt of the corporation.

A corporate bond is essentially a loan to a corporation. The loan may be secured by a lien or mortgage on the corporation's property as security for repayment.

To determine the level of the default risk for potential bondholders, financial experts analyze corporations and rate them on a number of factors, including the nature of their business, their financial holdings, their employees, and the length of their existence. The higher the risk for bondholders, the lower the risk rating given the corporation.

Because their ventures are considered risky, low-rated corporations must offer bond yields that are higher than those of high-rated corporations. High-rated corporations have less need for income from bonds, so they do not need to offer high yields. Bonds from these companies are called investment-grade bonds. Low-rated corporations have the need for bond income, so they offer high-yield bonds. These high-yield bonds are junk bonds.

When a corporation fails, bondholders may lose all or part of their investment if the corporation has declared bankruptcy or has no assets. This possibility is more real for junk bonds because they are, by definition, issued by unproven or unhealthy corporations.

For some persons, the high yield of a junk bond can be worth the increased risk of default. Junk bonds can increase in value if the corporation's rating is upgraded by private bond-rating firms. Junk bonds are also favored by some persons precisely because they contribute capital to young or struggling corporations. Whether to buy a junk bond depends on the investor: conservative investors do not favor them, but speculators and others seeking a quick profit find them attractive.

further readings

Boyer, Allen. 1989. "For the Love of Money." Georgia Law Review 23.

JUNK BONDS

Junk bonds are bonds issued at higher yields than investment grade bonds. The higher the yield, expressed as a percentage rate, the higher the risk of the bond. Two major rating services, Standard and Poor's, and Moody, have slightly different bond rating scales. Bonds rated lower than BBB on Standard and Poor's, or Baa on Moody are considered junk bonds. In comparison, Standard and Poor's rates investment grade bonds at BBB up to AAA.

Junk bonds, issued by companies without long track records of sales and earnings and/or with shaky credit ratings, must pay higher yields to off-set the real risk of nonpayment. They attract risk-oriented investors willing to gamble that companies issuing the higher interest rate bonds will be able to meet the terms of the bonds. The junk bond market is volatile and investment institutions with fiduciary responsibility, charged with investing wisely for a beneficiary's benefit, generally avoid junk bonds.

Racing into the U.S. investment scene in the 1980s, junk bonds allowed companies to raise funds cheaply. Legendary junk bond guru Michael Milken of the investment company Drexel Burnham Lambert had dazzling success raising enormous sums of capital for companies through the sale of high-yield junk bonds. Milken and Drexel were behind many junk bond finance attempts at company takeovers. In 1988, interestingly, the fortunes of many unsuspecting buyers were lost when the Securities and Exchange Commission charged Milken and Drexel with insider trading and stock fraud, which drove the company out of business.

In the late 1990s junk bonds underwent a reincarnation of sorts; they became a more acceptable part of a highly diversified investment portfolio. A number of professionally managed high yield junk bond funds emerged and offered investors a safer route than buying individual issues.

See also: Bonds, Investment, Standard and Poor's