A look at two schools of thought on putting your money in bonds. Despite their name and greater risk, `junk bonds' from corporations have good returns for the savvy investor
Boston — To begin with, their name constitutes two strikes against them: ``Junk bonds.'' They get the credit -- or blame -- for everything from the tidal wave of mergers and takeovers in the United States in recent years to the alarming growth of corporate debt.
Use of junk bonds appears to be accelerating. An estimated $14 billion in high-yield, high-risk debt was issued last year, bringing the total on the market to $100 billion, according to Drexel Burnham Lambert, a leading specialist in high-yield bonds.
That total is expected to reach $125 billion by the end of this year. Some $60 billion of that amount was straight debt -- i.e., high-yield ``junk'' bonds -- and the rest includes preferred stock, high-premium convertible bonds, private placements with registration rights, etc. (For the record, DBL estimates total outstanding corporate debt in 1984 at $450 billion.)
Many economists and financial specialists worry about the junk-bond trend. All this high-risk debt, they say, could be imperiled if the economy were to hit a formidable recession or if inflation were to surge. Highly indebted corporations could fail, and bondholders -- many of which, increasingly, are banks and thrifts -- could be faced with bond defaults.
``The danger,'' says Michael Keenan, a finance professor at New York University, ``is that these businesses have not come through serious business-cycle fluctuations, and it's not clear what the quality of the bonds is. . . . Unfortunately, the industry has a very bad history of predicting the profit implications of a downturn.''
His colleague, NYU finance professor Edward I. Altman, has studied the bankruptcy risk of high-yield bonds for Morgan Stanley & Co. Although he remains ``fairly positive'' about junk bonds overall, Dr. Altman points out that a serious recession could cause the default rate to increase markedly. Between 1974 and '84, he says, the default rate on high-yield bonds averaged 1.5 percent a year. But during the 1982 recession, the default rate hit 4 percent.
``That could happen again as early as 1987 if there is a recession,'' Altman says. ``And without a recession you can still have losses.''
But the traffickers in junk bonds contend they have produced a new and much-needed form of corporate finance. They also argue that the use of these bonds in corporate takeovers is actually rather modest. And an economic downturn that would cause junk-bond defaults, they say, would have to be so serious that many other types of investments would be affected as well.
James Balog, Drexel Burnham's vice-chairman, was in Boston last week in part to try to convince the investment community here that these debt instruments are neither dangerous nor unhealthy.
In a press briefing, Mr. Balog said that high-yield bonds serve as an important means of corporate finance, especially for companies that don't have a superior credit rating. Of some 19,000 American companies with assets of $25 million or more, he says, only 600 have bonds rated ``investment grade'' (Bbb or higher) by agencies such as Moody's or Dun & Bradstreet.
Unrated, high-yield bonds are a way small to medium-size companies -- and even big companies that have fallen on hard times -- can raise capital. Over the past 50 years, Balog says, only 3 percent of all corporate capital has come from common stock. The rest comes either from retained earnings or debt.
Balog says 88 percent of all junk bonds finance corporate growth. Of the remaining 12 percent, he says, 8 percent went to finance friendly takeovers and only 4 percent to hostile takeovers.
Richard B. Hoey, DBL's chief economist, concedes that the development of junk bonds has ``created a faster speed of change'' in the trend toward corporate restructuring by helping ``shift debt for equity.'' Dr. Altman of NYU figures that, although junk bonds have helped fund the takeover wave, without them ``the wave would have happened anyway.''
As might be expected, Mr. Hoey and Mr. Balog agree that legislation restricting the use of junk-bond financing in corporate takeovers is a bad idea. They appear to have little to worry about: Although Sen. Alfonse M. D'Amato (R) of New York has put together a bill to curb takeover abuses, it is unlikely to sail through Congress.
DBL's Hoey considers junk bonds good for the troubled savings-and-loan industry. Those thrifts holding junk bonds are actually much more diversified than those with large real estate portfolios.
Hoey notes that before a thrift or any other institution buys a junk bond, it must perform a ``due diligence'' check. Moreover, he contends, unlike real estate or business loans, a bond must stand the test of the marketplace; the thrift owns only a piece of the loan (hence is diversified); and the bond can be sold on the secondary market.
Junk bonds generally yield 3 to 5 percent higher interest than most other fixed-income investments. ``There is sufficient income to compensate for the risk'' of a possible default, Hoey says.
``The marketplace will reject a deal if it's too stupid,'' says Balog. He adds, ``The reputation of DBL is on the line'' in these deals.
Up to now, says Altman at NYU, the ``risk-return rate has been very favorable; an investor has significantly higher returns on high-yield bonds.''
He recommends that an investor keep two points in mind, however, when dealing with the bonds:
First, diversify. With 40 to 60 different issues, he says, a default would be compensated for by the returns on other bonds. Second, he says, aim to buy ``quality junk'' -- that is, be very selective.