Junk Bonds aren’t quite as toxic as the name given to this investment class suggests. However, we must analyse the crisis once we know about them.
Junk Bonds are high yield corporate bonds, issued by companies whose credit rating is below investment grade. They possess a high risk of the underlying company defaulting as the companies issuing such bonds are typically start-ups or companies that are financially struggling. These bonds carry risk since the investors are unsure regarding the repayment of principal amount and regular interest earnings, however, to compensate for such risks the companies are willing to pay the high yield. They are basically as speculative as penny stocks and became infamous during the 1980s because of the ‘junk bond king’ Michael Milken who later went to jail for his mischief.
To increase the clarity of the concept, let's talk about a recent junk bond. We have all heard of Tesla, right? Tesla Inc. in 2014 issued a fixed rate bond with a maturity date of March 2021 and a fixed coupon rate of 1.25%. The debt received a credit rating of B when it was issued, implying that the company’s adverse financial conditions might impair its payment capability. As a result, the higher yield compensates the investors for the added level of risk.
The Status Quo in the 1980s Ever since Bearn Sterns and Company, a New York investment house underwrote the first original issue of junk bonds in 1977, the debt market in the US changed theatrically. Investment banking firm Drexel Burnham Lambert financed seven companies that had previously been shut out of the corporate bond market. Soon, by 1983 over one-third of the bonds issued were non-investment grade. The market grew from a bare 10 billion dollars in 1979 to a whopping 189 billion dollars by 1989.
The sudden surge in its market can be credited to its enormous appeal due to its offering high-interest rates and the freedom from restrictions on the borrowers. The research found out that a diversified portfolio of such bonds could make a person better off than buying investment-grade bonds even after deducting the losses on default. This result was utilised by Michael Milken of Drexel Burnham trumpeted these insights to his firm and his customers, with striking triumph.
The Downfall of Junk Financing
The junk bonds provided an easy route to raise capital for companies struck with difficulties as the high yield market was liquid enough to provide cost-effective funding. The golden era lasted for roughly a decade until there was an unprecedented number of defaults by junk bond issuers. This was due to the 1989 political movement involving Rudolph Giuliani and others who had dominated the corporate credit markets prior to the rise of high yield bonds caused the market to temporarily collapse resulting in Drexel Burnham’s bankruptcy. In a transformation that took less than 24 hours, new junk bonds basically disappeared from the market with no rebound for about a year.
The Consequences of The Fall
The scandals and the downfall of the market involving Drexel Burnham brought about a broad range of troubles in the economy including heavy losses incurred by commercial banks, the surge in unemployment, low productivity, and savings and loan crisis. It also brought about major bankruptcies of companies that went through leveraged buyouts or made acquisitions with junk bonds.
Despite the bad reputation of these bonds, the research 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. Studies even indicate that throughout the eighties junk bonds were very lucrative investments for S&Ls, second only to credit cards. There exist arguments supporting the idea that everyone must have some of their retirement portfolios in a high-yield bond fund.
This argument is supported by the bond of Tesla that we earlier talked about. The current price of the Tesla offering is $103, slightly higher than its 2014 $100 face value, which represents the extra yield that investors are getting above the coupon payment. In other terms, despite the B- rating, the bond is trading at a $3 premium to its face value, which is likely due to the high yield of 7% being offered.
Despite the follies of these bonds, they are indeed a lucrative option for higher yields. As for including them into your portfolio, it may just do the trick for you as it did in the 80s. That said, invest to the best of your capabilities, and make the most out of it, for at times even junk may turn out to be the diamond you were looking for.