Any finanical adviser will tell you bonds are nice, safe investments. The basic ``vanilla'' bond is an IOU from a corporation or government. For example, when you buy a bond issued by DataHacks Inc., in effect you lend the company $1,000. It gives you a certificate agreeing to pay 10 percent interest. Every six months you get a check for $50. When the loan matures, you get your $1,000 back.
The risk is minimal. No sleepless nights spent scrutinizing the financial pages for pending doom. DataHacks has put up its WOW/2001 computer as collateral on your loan. Also, Standard & Poor's has given DataHacks a gold-star credit rating: AAA. And you know if this company goes belly up, you'll be paid before the stockholders.
But not all bonds are as safe, simple, and sweetly assuring as the vanilla variety. Lately, junk bonds -- more of the chocolate-bubble-gum genre -- have become fashionable.
Junk bonds, or high-yield bonds, as professionals are wont to call them, are much riskier. Investors can get an idea of the risk involved from one of the two major credit-rating services, Standard & Poor's and Moody's. Ratings range from AAA (or Aaa) -- the best -- to C -- the worst. Junk bonds fall in the category of speculative issues which carry a rating of BB (Bb) or below.
To compensate for the higher risk and attract buyers, companies pay higher returns. A company issuing a junk bond often pays interest rates 2.5 to 4.5 percentage points higher than government bonds. Recent BB corporate bonds carried coupon rates of 13 percent.
A further attraction to risk-oriented investors is potential gains upon sale of the bond. The price of a junk bond fluctuates, behaving more like a stock than a bond. If progress is made toward solving the problems that made the company a risky investment, then the market price of the bond may rise.
What has brought junk bonds into vogue (and created more liquidity) is their use in financing friendly and unfriendly mergers. It is not uncommon for T. Boone Pickens Jr. and other takeover captains to ask Drexel Burnham Lambert, the leading junk bond dealer, to round up a $1 billion or more in junk bond financing.
To do this, Drexel sets up a new company on paper. Then it finds investors and gets multimillion-dollar commitments to buy the high-yielding bonds in the merged company. If the takeover is successful, the corporate raider sells off pieces of the company to pay for the bonds.
In the last year or two, such junk bond deals have proliferated. Currently, junk bonds are an estimated $60 billion to $80 billion chunk of the $425 billion in corporate bonds outstanding. But many see junk bonds as the catalyst for the hackle-raising takeovers. Also, there is some concern that savings-and-loans are developing an unhealthy appetite for these risky bonds. So Congress and state legislators are contemplating steps to curb junk bond financing.
Before the recent merger blitz, junk bonds came in only two forms, according to Robert Dow, portfolio manager of the Lord, Abbett Bond-Debenture mutual fund.
``The traditional high-yield bonds were issued by companies turned sour,'' Mr. Dow says. ``Their credit rating had been downgraded to the point where they had to sell junk bonds.''
Utilities struggling to complete construction of a nuclear plant often use junk bonds to raise funds. And Dow cites International Harvester Company, the tractormaker, as a ``fallen angel'' that at one point has had to sell bonds at 18 percent interest. Dow's portfolio contains some I-H bonds yielding 15 percent.
The second type of ``original'' junk bond is the start-up company bond. A short history, less-than-spectacular earnings, and a dried-up credit line may force young companies to resort to high-yielding bonds to attract funds for expansion.
About 60 percent of Dow's mutual fund portfolio is in bonds rated B or lower. But for ``philosophical'' reasons he avoids the hostile-takeover securities.
Investors interested in purchasing junk bonds can get them through a brokerage firm just as they would any stock or bond. Larger-denomination bonds, $25,000 to $100,000, are more common. Small investors can buy shares in about 40 mutual funds holding junk bonds.
Drexel's rise to prominence as the preeminent junk bond dealer is predicated on Michael Milken's championing of these securities. Mr. Milken co-chairs Drexel's corporate finance department. He contends (successfully, it appears) that studies show that low-grade, high-yield bonds have a better performance record than high-grade, low-yield bonds. (A pamphlet, ``The Case for High Yield Bonds,'' is available from Drexel Burnham Lambert, 9560 Wilshire Boulevard, Beverly Hills, Calif. 90212.)
Nonetheless, these are speculative issues. A company in trouble could be hit with more trouble, and those fat dividend payments could stop arriving. The bond itself might become valueless.
Mr. Dow's advice: ``First, do your homework.'' Thoroughly research the company and be well aware of the risks.
``Second, diversify,'' Dow counsels. ``Diversify because you are going to get nailed. We get nailed. Every once in a while it happens. But it hurts a lot more if you've only got four bonds than it does when you've got hundreds.''