Junk bonds - Business in United States of America

Definition: Speculative, high-yield debt instruments that are generally classified as being below investment grade because they are riskier for default than higher rated bonds
Significance: The junk bond industry arose during the 1970’s in response to an increasingly desperate need for capital by American corporations, which issued high-risk bonds that attracted investors tempted by the prospect of high returns. However, the popularity of so-called junk bonds waned during the 1990’s, when some of their major issuers went into default.
Effectively loan contracts with fixed maturity dates that promise to pay back the amount borrowed, along with interest at specified rates, bonds play a major role in the financial world. They are used for a number of financial purposes. Corporations may issue bonds to expand their operations, to acquire other companies, or simply to refinance their existing debt. Government institutions also issue bonds for a variety of reasons, such as financing the construction of bridges, hospitals, or harbors. They generally get authorization for bond issues through special ballot measures.

Classification of Bonds

Some bonds are classified as investment grade, generally rated by Moody’s as BBB- or higher, at the time of their issuance. However, with the passage of time, their credit rating slips because their financial strength deteriorates, resulting in their reclassification as speculative, or junk bonds. Bonds suffering this reclassification are often called fallen angels.
Some bonds are marketed initially as speculative simply because their credit ratings are marginal, based on the borrower’s inability to demonstrate a more promising financial future. Occasionally these speculative instruments become investment grade over time as the corporations involved demonstrate improved results in their business operations. Such bonds, reflecting improved credit ratings, are often termed rising stars.
Often purchasers of bonds are limited in how far down the line they can go in terms of bond credit ratings. Pension funds, banks, and insurance companies, for example, may be prohibited by their charters from purchasing speculative bonds. Junk bonds consequently attract a different type of investor than that attracted by the bonds issued by more conservative financial institutions.
Individual investors who wish to purchase speculative bonds are generally wise to go through high-risk bond funds. Through the funds, investors can avail themselves of the advice of professionals who are aware of the risks involved in each particular issue. Fund professionals research the bond markets constantly and diversify their investments over a number of different types of assets. This spread of risk in a portfolio of speculative bonds can be preferable to concentrating on one or just a few issues.

Bond Credit Ratings by Moody’s Investors Service and Standard & Poor’s

Source: Data from Moody’s Investors Service, Standard & Poor’s, and Bonds Online
Note: Bonds receiving ratings below the double rule are considered junk bonds.

Changing Investment Instruments

A dramatic change in bond investment quality began developing during the 1970’s. Before then, most bonds issued were of investment quality. During the late 1970’s, investment houses began to issue bonds that were speculative from their inception. This change occurred for one compelling reason— the growing need for capital by private industry to meet rapidly changing economic fundamentals. Companies were facing new challenges from foreign competition and technological innovations. Existing bond markets for meeting corporate needs for more capital had failed to meet the challenge. The answer to the problem lay in turning, increasingly, to the issuance of speculative bonds by corporations pressed to acquire additional capital.
Moreover, a number of investment experts determined that the risk to bond purchasers involved in investing in these high-risk instruments was more than offset by the higher yields the bonds offered. Until the late 1980’s, the issuance of high-risk bonds expanded rapidly. However, during the late 1980’s and early 1990’s, the tide turned. An increasing number of high-risk bonds became subject to default. This resulted in the failure of a handful of financial institutions that had invested too heavily in the high-risk category. For example, this activity led to the bankruptcy of the investment house of Drexel Burnham.
Critics of the move into junk bonds complain that these bonds have been used as devices by corporate raiders to seize control of existing companies. Raiders typically employ substantial debt instruments in the acquisition of such control. However, many experts think that these buyouts have led to the ultimate expansion of the targeted companies rather than to their demise.
Despite some negative results, junk bond activity has continued to expand as the mutual fund activity in this category has demonstrated. Figures from 1983 indicated that high-risk bond issues accounted for one-third of the bonds in force. In 2003, issuance of high-risk bonds more than doubled over 2002.

Further Reading
Altman, Edward I., and Scott A. Nammacher. Investing in Junk Bonds: Inside the High Yield Debt Market. Washington, D.C.: Beard Books, 2002. An examination of the pros and cons of junk bonds as investments.
Schilit, W. Keith. Dream Makers and Deal Breakers: Inside the Venture Capital Industry. Englewood Cliffs, N.J.: Prentice Hall, 1991. Discusses the use of high-risk bonds by the venture capital industry.
Shapiro, Eli, and Charles R. Wolf. The Role of Private Placements in Corporate Finance. Boston: Harvard University Press, 1972. Presents an alternative approach to long-term borrowing by smaller, less financially secure companies.
Yago, Glenn. Junk Bonds: How High Yield Securities Restructured Corporate America. New York: Oxford University Press, 1991. Yago looks at how, despite the risks involved, the junk bond industry has played a leading role in American economic expansion.
Zey, Mary. Banking on Fraud: Drexel, Junk Bonds and Buyouts. New York: Aldine de Gruyter, 1993. This critical look at the junk bond industry examines the 1981-1982 recession, the stock market crash in 1987, and the Drexel Burnham Lambert bankruptcy of 1990.
See also: interest rates; Mutual fund industry; Securities and Exchange Commission.

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