A lively corpse - junk bonds

National Review, May 28, 1990 by Ed Rubenstein

REPORTS OF a "collapse" in the junk-bond market are highly exaggerated. First Boston reports that during the first three months of 1990 the high-yield market grew by $4.2 billion, to $230.4 billion. This is far below the growth of recent years, but about in line with what's happening to total credit-market debt, which is currently growing at the slowest pace in twenty years. Junk bonds now account for about 22 per cent of all corporate bonds outstanding; in 1985 they accounted for 14 per cent; in 1979, 4 per cent. Junk-bond prices have tumbled sharply over the past few months, what with the demise of Campeau and Drexel Burnham. But all security prices have suffered during this year's credit crunch. And because of the higher interest rates on junk bonds, their first-quarter return of (-2.6 per cent (based on First Boston's index of 349 issues) exceeded the return on ten-year Treasuries (-2.8 per cent) and the S&P 500 (-3.0 per cent). Yet no one speaks of a "collapse" of Treasury bonds or the stock market. The first-quarter standings are not anomalous. Over the past ten years junk bonds have produced a 13.0 per cent average annual rate of return, outperforming high-grade corporate bonds, U.S. Government bonds, and common stocks, while showing far less variability of return from year to year. In forcing S&Ls to sell off their junk-bond holdings Congress eliminated one of the few profitable investments the thrifts made.

Of course, the U.S. Government never defaults on its bonds. Junk-bond issuers do, to the tune of $8.1 billion in 1989. While many in the media interpreted this dismal performance as evidence of Drexel Burnham's weakened ability to prop up failing companies, junk-bond defaults are nothing new. In 1987 $9.1 billion of them went belly up, and the default rate-defaults as a percentage of total junk bonds outstanding-have exceeded 1989's 4 per cent level three times since 1970. Still, 1989 shook investors' confidence. Many are asking: "If junkbond defaults are up now, what's going to happen when we're in a recession?" But corporate profits from which interest payments are made-were at recession levels in 1989, slipping 13 per cent from 1988.

In any case, the inherent riskiness of these investments is well known to investors. The risk posed by a 4 per cent default rate is more than compensated for by junk-bond interest rates, which currently exceed those offered on U.S. Treasury bonds by more than eight percentage points. And defaulted bonds are not exactly worthless: senior obligations of the Campeau corporation trade at more than fifty cents on the dollar.

If junk bonds are a good long-term deal for investors, what about for corporations? The traditional view is that higher interest payments siphon off corporate cash which would otherwise have gone for R&D, new-product development, and other research yielding long-term results. But this paradigm is based on a fanciful notion of what corporations actually do with their spare cash. Harvard economist Michael Jensen argues that a heavy load of debt is good, precisely because it leaves managers little slack. Spare cash is often frittered away on perks, managerial salaries, and investments aimed at increasing sales (on which managers' salaries are based) rather than profits. A financial structure that keeps companies on the edge of default forces managers to focus on efficiency and profits. Financial markets seem to agree with his analysis, as evidenced by the sharp subsequent increase in share prices of companies taken over in LBOs.

More than two thousand companies have issued junk bonds. Thirty-three of them defaulted last year. For every Campeau and Resorts there are hundreds of successful, growing concerns like Compaq Computers, Calvin Klein Industries, Safeway Stores, and Computerland, that still do not have the financial strength to be classified investment grade and so must issue high-yield bonds. These companies and their bonds are anything but junk.