Ted Turner's multibillion dollar bid for CBS Inc. would not have been possible in the go-go years of the 1960s when megabucks needed for large acquisitions could be raised only by giant corporations.
But in the deregulated climate of the 1980s, the Wall Street investment bank of Drexel Burnham Lambert Inc. developed a financing tool that makes it possible for selected individuals and certain small companies to launch hostile takeover bids for America's largest corporations. That powerful tool is the junk bond, a high-yield security dubbed "junk" because of the low or nonexistent rating it gets from the credit-rating agencies.
By selling these largely unsecured, high-yielding bonds to a group of wealthy investors, including some West Coast savings and loans that are comfortable with the risks they entail, Drexel has enabled Mesa Petroleum Co. Chairman T. Boone Pickens Jr. to launch raids on several oil companies. Until yesterday, when Turner announced that E. F. Hutton was representing him in his bid to acquire CBS, only Drexel had managed the major junk bond offerings.
The argument for investing in junk bonds is simple. Studies years ago concluded that over long periods of time, even after deducting for bankruptcies, low-quality bonds yield better returns than high-quality bonds. Some portfolio managers say they are overcompensated, through high interest rates, for the amount of risk they take; they are overcompensated, they say, because many institutional money managers do not 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.
Some portfolio managers in New York and Los Angeles are investing billions of dollars in junk bonds, confident that by taking advantage of market imperfections, they have found a way to consistently achieve superior returns. These bonds typically pay 300 to 400 basis points (100 basis points equals 1 percentage point) above government and high-grade corporate bonds.
Junk bonds also have been used to finance management buyouts of public companies. The managment of Metromedia Broadcasting Corp., owner of WTTG-TV (Channel 5) and WASH-FM in Washington, used junk bonds to take the company private in a $1.3 billion buyout, the most ever raised in a junk offering.
While Wall Street's love affair with junk continues and Drexel continues to dominate what has become a $100 billion market, Congress and some investment bankers are voicing their concern about the enormous debt being added to corporate balance sheets as a result of these bonds. Observers are concerned that if the economy slows and companies are unable to make the high interest payments these bonds carry, many corporations will be in financial trouble.
One Wall Street investment banker who worries about junk bonds is Felix Rohatyn, a senior partner of Lazard Freres & Co. Rohatyn believes investors are failing to assess the high risk of junk bonds. He proposes that federally and state-insured financial institutions should be sharply limited in their ability to invest in junk bonds.
Unocal Chairman Fred Hartley, now fighting a takeover bid by Pickens, has suggested that those using junk bonds to finance hostile takeover bids not be allowed to deduct the bonds' interest expenses on their tax returns.