Junk bonds are high-yield, high-risk bonds that are issued by companies or governments with poor credit ratings. They are also known as high-yield bonds, non-investment grade bonds, or speculative grade bonds.
Junk bonds offer investors the potential for higher returns than traditional investment-grade bonds, but they also come with a higher risk of default. This is because the companies or governments that issue junk bonds are more likely to go bankrupt and default on their debt payments.
Junk bonds are often used by companies to finance mergers and acquisitions, or to invest in new projects. They are also used by governments to finance infrastructure projects or to cover budget deficits.
Junk bonds are a popular investment for some investors because they offer the potential for higher returns than other types of bonds. However, it is important to note that junk bonds are a risky investment and should only be considered by investors who have a high tolerance for risk.
Beginnings
Junk bonds, also known as high-yield bonds, have a relatively short history, dating back to the 1970s. Prior to that, most bonds were issued by investment-grade companies with good credit ratings. However, in the early 1970s, interest rates began to rise, making it more expensive for companies to borrow money. This led to a decline in the demand for investment-grade bonds.
At the same time, a number of new financial firms emerged, such as Drexel Burnham Lambert, which were willing to underwrite and sell bonds from companies with lower credit ratings. These bonds, which came to be known as junk bonds, offered investors higher yields to compensate for the increased risk of default.
The junk bond market grew rapidly in the 1980s, fueled by a number of factors, including:
- The leveraged buyout boom: Junk bonds were often used to finance leveraged buyouts (LBOs), in which a company was acquired using a large amount of debt.
- The rise of Michael Milken: Michael Milken was a junk bond salesman at Drexel Burnham Lambert who was instrumental in the growth of the junk bond market.
- The deregulation of the financial industry: The deregulation of the financial industry in the 1980s made it easier for companies to issue junk bonds
Michael Milken and Drexel Burnham Lambert
Michael Milken was a junk bond salesman at Drexel Burnham Lambert who was instrumental in the growth of the junk bond market. He was known for his aggressive sales tactics and his ability to find investors for even the riskiest bonds.
Under Milken's leadership, Drexel Burnham Lambert became the leading underwriter of junk bonds in the 1980s. The firm helped to finance many of the leveraged buyouts (LBOs) that took place during that time period. LBOs are a type of corporate acquisition in which a company is acquired using a large amount of debt.
Milken's success in the junk bond market made him one of the richest men in the world. However, his aggressive tactics also led to accusations of fraud. In 1989, Milken was convicted of six counts of securities fraud and sentenced to 10 years in prison.
Drexel Burnham Lambert was also convicted of securities fraud in 1990 and was forced to file for bankruptcy. The collapse of Drexel Burnham Lambert was a major blow to the junk bond market, but the market has since recovered.
Milken and Drexel Burnham Lambert played a major role in the development of the junk bond market. They helped to make junk bonds a more mainstream investment product and helped to finance many of the corporate acquisitions that took place in the 1980s. However, their aggressive tactics also led to accusations of fraud and the eventual collapse of Drexel Burnham Lambert.
Here are some specific examples of what Milken and Drexel Burnham Lambert were doing:
- Milken developed a new way of pricing junk bonds that made them more attractive to investors.
He used his extensive network of contacts to find investors for even the riskiest bonds. - Drexel Burnham Lambert underwrote many of the largest and most complex LBOs of the 1980s.
Milken and Drexel Burnham Lambert were also involved in a number of other financial transactions, including initial public offerings (IPOs) and mergers and acquisitions. - Milken's and Drexel Burnham Lambert's activities in the junk bond market had a significant impact on the US economy. The junk bond market helped to fuel the leveraged buyout boom of the 1980s, which led to a wave of corporate consolidation. The junk bond market also helped to finance the growth of many new and innovative companies.
Crash of Junk Bonds
The junk bond market peaked in the late 1980s, but it crashed in the early 1990s. This was due to a number of factors, including:
- The recession of the early 1990s: The recession led to an increase in corporate defaults, which hurt the junk bond market.
- The collapse of Drexel Burnham Lambert: Drexel Burnham Lambert was forced to file for bankruptcy in 1990, which was a major blow to the junk bond market.
- The fraud conviction of Michael Milken: Michael Milken was convicted of fraud in 1989 and sentenced to 10 years in prison. This further damaged the reputation of the junk bond market.
Despite the crash of the early 1990s, the junk bond market has survived and thrived. Today, the junk bond market is a multi-trillion dollar market that plays an important role in the global financial system.
Here are some of the key events in the history of junk bonds:
- 1977: Bear Stearns underwrites the first new-issue junk bond in decades.
- 1980: Michael Milken begins working as a junk bond salesman at Drexel Burnham Lambert.
- 1984: Drexel Burnham Lambert becomes the leading underwriter of junk bonds.
- 1986: The leveraged buyout boom begins.
- 1989: Michael Milken is convicted of fraud.
- 1990: Drexel Burnham Lambert files for bankruptcy.
- 1991: The junk bond market crashes.
- 2000s: The junk bond market recovers.
- 2008: The global financial crisis hits the junk bond market hard.
- 2010s: The junk bond market recovers again.
Junk Bonds in the 2020s
Junk bonds are still used today in the world of finance, but their role has changed somewhat since the 1980s. Today, junk bonds are more likely to be used to finance corporate restructurings and mergers and acquisitions, rather than leveraged buyouts.
Wall Street banks play a number of roles in the junk bond market. They underwrite new junk bond issues, they trade junk bonds on the secondary market, and they advise companies on how to use junk bonds to finance their operations.
Here are some of the specific ways that junk bonds are used today:
- To finance corporate restructurings: Junk bonds can be used to finance corporate restructurings, such as Chapter 11 bankruptcies and debt exchanges.
- To finance mergers and acquisitions: Junk bonds can be used to finance mergers and acquisitions, especially when the acquiring company has a lower credit rating than the target company.
- To finance growth: Junk bonds can be used to finance the growth of companies with lower credit ratings.
- To provide liquidity: Junk bonds can provide liquidity to companies with lower credit ratings, allowing them to borrow money more easily.
Wall Street banks play a number of important roles in the junk bond market:
- Underwriting: Wall Street banks underwrite new junk bond issues, which means that they help companies to raise money by selling junk bonds to investors.
- Trading: Wall Street banks trade junk bonds on the secondary market, which means that they buy and sell junk bonds from investors.
- Advising: Wall Street banks advise companies on how to use junk bonds to finance their operations.
Here are some specific examples of how Wall Street banks use junk bonds:
- Goldman Sachs underwrote the new junk bond issue for Tesla in 2023.
- JPMorgan Chase trades junk bonds on the secondary market.
- Morgan Stanley advised Kraft Heinz on how to use junk bonds to finance its acquisition of Unilever in 2017.
The junk bond market is a vital part of the global financial system. It provides a source of capital for companies with lower credit ratings, and it allows investors to earn higher returns on their investments.
Pros and Cons
Here are some of the pros and cons of investing in junk bonds:
Pros:
- Potential for higher returns than other types of bonds
- Can be used to diversify a portfolio
- Can be used to invest in companies with high growth potential
Cons:
- Higher risk of default
- More volatile than investment-grade bonds
- Less liquidity than investment-grade bonds