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 __BODY__.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.

JUNK BONDS

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