After Michael R. Milken`s indictment and Drexel Burnham Lambert Inc.`s humbling, can the collapse of the junk bond market be far behind?
Recent gains in junk bond yields relative to supersafe Treasury bond yields have again set off critics of the high-yield debt securities.
They contend an inevitable economic slowdown will squeeze all those debt- burdened companies, making it harder for them to handle their debt through cash flow or asset sales. And that, they say, means a wave of bond defaults, a collapsing house of cards.
But the cards are still standing. Despite a price shudder earlier this month and a crush of new issues, the nearly $200 billion junk bond market that Milken and Drexel virtually created over the last decade appears to be thriving.
Supporters of the market point out that investors are rewarded amply for the higher risk, even taking defaults into account. And they note that only about 5 percent of American companies are what the bond rating houses consider ”investment grade.”
Wall Street traditionalists still bemoan the transformation of equity into debt in the 1980s, of which junk bonds, in their eyes, are the most glaring example. To them, Milken, Drexel and the junk bond formed an alliance that symbolized the greed of the decade, with a brilliant Milken using Drexel and the high-yielding bonds to fund a frenzy of hostile takeovers.
”Milken explained to us that we can carry more debt than we really should,” said Eugene Lerner, a Northwestern University professor and head of Disciplined Investment Advisers, an Evanston money management firm. ”It`s his legacy in a way.”
But beyond philosophical debate about the use of leverage, particularly in hostile takeovers, and its impact on society is a simple truth: It is a smart business tool at a time when interest on debt is tax-deductible while dividends on stock are not.
However, despite consistently delivering premium returns to investors, the junk bond still must be considered the Rodney Dangerfield of securities:
It gets no respect.
Earlier this month, critics of the junk bond, who had long felt that a collapse in that market was overdue, were having a field day. An unpublished Harvard Business School study by Prof. Paul Asquith revealed that as junk bonds age, they are more prone to default.
There also seemed to be increasing evidence of an economic slowdown, triggering recession fears.
The benchmark spread widened between interest rates issuers were forced to offer on a composite of high-yield bonds and the going interest rate for solid-as-a-rock U.S. Treasury bills.
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New junk bond issues totaling an estimated $8 billion to $9 billion were waiting in the wings-including $4 billion to recapitalize the Kohlberg Kravis Roberts & Co. absorption of RJR Nabisco Inc.
And there were rumors that Drexel, still considered the premier firm in the high-yield arena despite its troubles, was having difficulty placing some issues.
”It`s the nature of the game,” said a bond trader. ”The three Rs:
rumor, risk and recession. The smallest thing can push prices down.”
But the end has not come.
The economy, now in a record seventh year of expansion, may be slowing. The factory utilization rate fell in March, and industrial production was flat. Wholesale prices, after posting a 1 percent gain in both January and February, rose just 0.4 percent. But economists still say there is no recession in sight.
And the Harvard study, as it turns out, considered only the first half of the risk-reward ratio. ”Returns on high-yield bonds need to be analyzed as well,” the study states in its last paragraph.
Also, the conclusion, apparently startling to some, that aging junk bonds are more prone to default, was not news to Edward I. Altman, a New York University professor whose study of the junk bond market revealed the same thing two years ago. An average annual default rate of 2.5 percent, Altman said, extended over a dozen years would produce about the 34 percent cumulative default rate cited in the Harvard study.
Even with that default rate, Altman said, investors are rewarded for the risks they are taking. According to his research, an investor who put $100 in a portfolio of B-rated bonds, which make up about 60 percent of junk bonds, would have received $44.67 more after 10 years than in a like investment in Treasury bills.
And Drexel insists it has had no problems placing bonds. The $4 billion RJR issue, which is to go to market in early May, is ”not an impediment,”
said Drexel spokesman Steven Anreder. ”We`re doing deals ahead of it, and we`ll do deals behind it.” In fact, he added, ”The issues we`ve done have all moved up and are trading at par or better.”
That was confirmed by Robert Levine, president of Kidder Peabody High Yield Asset Management. ”The after-market performance of recent issues has been very good,” he said.
That isn`t to say junk bonds aren`t risky. There is heightened risk whenever a bond issuer is willing to pay an investor a premium of 3, 4 or 5 percentage points over the return on another class of investment.
”They are risky,” said Byron R. Wien, chief investment strategist for Morgan Stanley & Co., ”but you get paid pretty well for that risk.”
Wien believes junk bonds should be looked at as ”equity surrogates”
rather than bonds. That, he admits, confuses people used to thinking of bonds as bonds and stocks as stocks.
If it`s the term ”junk” that puts investors off, Wien said, ”They should take a hard look at the securities they own. The bonds (if any were outstanding) of about 25 percent of the companies in the Standard & Poor`s 500 would be rated below BBB”-or junk.
The spread between junk bond yields and 10-year Treasury bond yields has widenened in recent weeks, though certainly not for the first time. The market has received a number of body blows over the last three years.
Spreads were more than 5 percentage points after the LTV Corp. bankruptcy in the summer of 1986; after the breadth of the insider-trading scandal became known in late 1986 and early 1987; and in the aftermath of the stock market crash of Oct. 19, 1987.
The recent widening in that spread, to 4.81 percentage points Friday, say market observers, has come as a delayed reaction to the rise of other interest rates. ”Junk always lags the Treasury market,” said Margaret Eagle, manager of Fidelity`s High-Income Fund. ”We were due for a correction. The spreads had become untenably narrow.”
”The idea of lending money to less-than-stellar credits (borrowers) has been around since the Phoenicians,” said Raymond Lemanski, director of high- yield research at Prudential-Bache Capital Funding. As a recession nears, he added, ”Risks increase, but that doesn`t mean the premise of investing in junk is invalid.”
Although many believe the junk bond market won`t really be tested until there is a full-fledged recession, Eagle believes the market has ”value regardless of economic conditions.” Even with defaults, your total return doesn`t go to zero, she added.
The key to investing in the junk bond market is diversity. This is primarily an institutional market, and individual investors are well advised, analysts say, to invest in any of the 90 or so taxable high-yield bond mutual funds rather than trying to pick issues on their own.
At the end of last year, those funds had $33 billion in assets, said A. Michael Lipper, president of Lipper Analytical Securities Corp. And for the last 12 months, they were yielding 12.3 percent, compared with 8.7 percent for A-rated corporate bond funds and government bond funds.
”On specific high-yield instruments,” Northwestern`s Lerner said, ”a company that is in an industry that will be particularly hard hit could be sent into bankruptcy in an economic slowdown. A well-constructed and sound company will stand its ground and produce high returns.”