Wall Street is having a love affair with junk.
The new romance in the investment world is with "junk bonds," and it extends 3,000 miles, from Wall Street, where investment banking firms are scrambling to get into the business, to Beverly Hills, where Drexel Burnham Lambert Inc. has established a highly profitable junk bond operation, which the other firms are scrambling to emulate.
Portfolio managers in New York and Los Angeles are investing billions of dollars in junk bonds, confidently insisting that by taking advantage of market imperfections, they have found a way to consistently achieve superior returns. Junk bonds are high-yield securities, dubbed "junk" because of the low ratings they get from the credit-rating agencies. These bonds typically pay 300 to 400 basis points -- 100 basis points equals 1 percentage point -- above government bonds and high-grade corporate bonds.
The junk bond market is changing rapidly. It used to consist mainly of bonds issued by corporations and public utilities that were considered to be investment grade before financial difficulties led to their downgrading.
But the dramatic growth in the market recently has come from bonds issued by young, emerging companies and bonds issued to finance hostile takeover bids by corporate raiders, such as the current bid by Mesa Petroleum Chairman T. Boone Pickens Jr. to take over Phillips Corp.
The growth in junk bonds also has come from their popularity with large corporations, including Metromedia Broadcasting Corp., owner of WTTG-TV Channel 5 and WASH-FM in Washington, which has issued the new type of bonds to increase its financial flexibility. Metromedia used the money it raised to replace bank borrowings from a leveraged buyout it used to take the company from public to private ownership. Its $1.3 billion junk bond offering was the most ever raised.
A few years ago, most prestigious corporations and investment banking firms wanted nothing to do with issuing, underwriting or trading securities that experts referred to as junk. It just did not seem to fit with their gilt-edged reputations. But after Drexel Burnham made millions selling and trading junk bonds, Wall Street's envy turned to action, and almost all the major firms have announced plans to enter the market, estimated by Drexel Burnham at $100 billion.
The argument for investing in junk bonds is simple. Academic studies years ago concluded that even after deducting for bankruptcies, over long periods of time, low-quality bonds yield better returns than high-quality bonds. According to portfolio managers, they are overcompensated, through high interest rates, for the amount of risk they take by investing in junk bonds. The reason they are overcompensated, they say, is that many institutional money managers do not really understand the market, and are afraid that if they invest in junk bonds and suffer losses, they will be sued for failing to be prudent managers.
Furthermore, they explain, most money managers avoid the market because it is not as liquid as the market for highly rated bonds and because reliable information on transactions is not always widely available.
"The risk in this inefficient market is that if you assume securities can be bought cheaper than they should be, it means you can buy things that are overpriced, too," said Howard Mark, vice president of Citicorp Investment Management, who manages more than $500 million in junk bonds. "If you are in an inefficient market with people who are better informed than you, they will eat you for lunch."
The key to the superior returns achieved by the handful of managers who invest heavily in junk bonds is diversification. By diversifying their portfolios, they achieve superior yields, even after deducting for defaults, because they limit the impact of any single bad investment.
But Citicorp's Mark says those risks do not go away completely. "You go into these riskier investments because they offer higher returns, but if you have adverse selection, you end up in the sewer," Mark said. "There are going to be winners and losers among bonds in the high-yield universe, and you have to distinguish between the two," he said, adding that he invests mostly in the junk bonds of young, growing companies.
The junk bond market developed after a Wharton MBA named Michael Milken turned his master's thesis on the topic into a profitable business for Drexel Burnham. Milken runs Drexel's junk bond operation in Beverly Hills, for which, according to Forbes magazine, he earned an estimated $15 million last year.
The key to Drexel Burnham's credibility in the market has been its willingness to maintain the liquidity of junk bonds of troubled companies by providing capital to trade these securities. This gives nervous investors a way to dispose of the troubled bonds in their portfolios. Several portfolio managers also said Drexel has demonstrated a commitment to working with the management of troubled companies to avoid bankruptcies whenever possible.
Savings and loan associations are becoming big investors in junk bonds. While the greatest investment in junk bonds so far has been by West Coast S&Ls, experts say thrift institutions throughout the nation, which only recently gained the right to invest significantly outside of the housing industry, will invest heavily in junk bonds once they recognize the opportunity for increased returns.
The S&L industry has been plagued by a squeeze on profits, a problem described by one industry leader as "too many dollars chasing too few mortgages." Some S&Ls seem willing to accept the increased risk of investing in junk bonds in exchange for the high yields.
"There are two categories of junk, and some of it is real junk," one portfolio manager said. "We try to stay away from the real junk by investing in the bonds of emerging credits, growing companies rated below investment grade because they have no track record. Just don't publicize this too much. It might become a more efficient market and that would narrow the spread we are earning above government bonds."
Another argument in favor of junk bonds is really an argument against investing in high-grade corporate bonds. These bonds, according to Drexel Burnham, have nowhere to go but down. Unexpected events make yesterday's highly rated bonds tomorrow's junk bonds.
On the other hand, by investing in a diversified portfolio of junk bonds, investors get compensated handsomely for taking additional risk and also benefit because some of the bonds of emerging growth companies, which are unrated, will be rated as investment grade once they have a track record.
New York merger lawyer Martin E. Lipton thinks the use of junk bonds to finance hostile takeovers threatens the fabric of American industry by making hostile tender offers too easy. He said that corporate raiders will use the technique to buy corporations and sell off the assets, enriching themselves at the expense of the target company's employes, many of whom may lose their jobs, and the community where the target company has operations, which may lose a key employer.
Despite increasing competition, Drexel Burnham's senior executive vice president, Frederick H. Joseph, believes other firms will find it difficult to match his company's expertise in selling and trading junk bonds and in evaluating which issues to bring to market. "They are not geared up to make these low-grade credit judgments," Joseph said. "We have 130 guys in sales, trading and research. When the others go into this market, they set up a three-man team.
"Milken's thesis at Wharton updated an old study that says the bond market is inefficient. Bond buyers are conservative investors who want their principal back, so they demand a high rate in return for any incremental risk. Milken recognized that a smart investor who could hang on through troubled times would always come out ahead, taking his premium and taking his lumps, because he is getting overpaid for his lumps. Historically, the premium amounts to 2.5 to 5 percent a year."
The performance of high-yield bonds is driven as much by stories as it is by fundamental measures of financial health, according to Mark R. Shenkman, who manages $1.3 billion of junk bonds for First Investors Asset Management Co. Shenkman said the rating agencies do not do a good job rating high-yield bonds because the agencies put a premium on size, ratios and historical financial information. Shenkman said many junk bonds are issued by new companies run by entrepreneurs. These companies lack the characteristics the rating agencies understand well, he said. Consequently, Shenkman said, understanding the stories these entrepreneurs are turning into companies is one of the keys to successful investing.
Experts said individual investors interested in junk bonds should invest in mutual funds to gain the benefit of professional management. The importance of holding a diversified portfolio coupled with the need to track companies closely makes it a dangerous area for individual investors.
Citicorp's Mark explained the fundamental reason he is a believer in junk bonds by using an analogy: "Suppose your boss told you that you were off the financial pages, and instead had responsibility for establishing The Washington Post Automobile Insurance Co.
"You could choose between two strategies. You could compete with GEICO [Government Employes Insurance Co.] and only take on good drivers who are desirable clients. There is rate competition to get their business, so you would have to offer them a low insurance rate. But some of them will not have had an accident in 10 years and when they do, you may find that you did not charge a high enough premium. This strategy is comparable to investing in high-grade bonds. You buy bonds of companies with a good record and hope the good record continues. But most bonds rated AAA 30 years ago are not AAA today.
"The other alternative is to find people with bad records who can't get insurance any other way. That way you are the only game in town. These are people who have accidents a few times a year, or teenagers who have no track record so you worry about them as a class.
"Charge them a premium which assumes they will have lots of accidents. If they do, you still make money. But the statistics show that very few of them total their cars, and some of them will not have accidents. Some of them become better credits.
"This high-risk driver is a profitable driver to write insurance for because you are in an inefficient market. That is our reasoning for investing in junk bonds risky drivers . Over a long period of time, you make 300 to 400 basis points above government bonds.
"With the magic of compounding, that is a lot of money."