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Beyond Junk BondsExpanding High Yield Markets$

Glenn Yago and Susanne Trimbath

Print publication date: 2003

Print ISBN-13: 9780195149234

Published to Oxford Scholarship Online: November 2003

DOI: 10.1093/0195149238.001.0001

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(p.223) Appendix A The Many Definitions of “Junk Bond”

(p.223) Appendix A The Many Definitions of “Junk Bond”

Beyond Junk Bonds
Oxford University Press

Reference Books and Publications

Business Encyclopedia (Knowledge Exchange)

Junk bond: A bond with a rating lower than investment grade.

The high‐yield debt market dates back to the beginning of the securities market. Many of our nation's best known corporations were initially financed with junk bonds. Prior to 1920, U.S. Steel, General Motors, and Computing‐Tabulating‐Recording (which would later be known as IBM) all used high‐yield debt to finance the expansion of their operations.

Until World War II, junk bonds accounted for 17 percent of all publicly issued straight corporate debt. The greatest increase occurred during the Depression due to the large number of companies that were downgraded from their original investment‐grade ratings.

Spiraling inflation and increasing interest rates in the 1970s created a need for new financial products, which would provide investors with higher yields and companies with affordable, fixed‐rate funding. The result was the birth of the new‐issue junk bond market, which experienced its most explosive growth during the 1980s and continued to grow into the 1990s. According to the Securities Data Corporation, the high‐yield market raised more than $50 billion in new underwritings for companies in its peak year 1993, up from about $1 billion in 1980.

Encyclopedia of Business, Second Edition (Crown Books)

Junk bonds are corporate debt securities of comparatively high credit risk, as indicated by ratings lower than Baa3 by Moody's Investor Service or lower than BBB–by Standard & Poor's. This usually excludes obligations that are convertible to equity securities, although the bonds may have other equity‐related options (such as warrants) attached to them. Junk bonds are also known as high‐yield, noninvestment‐grade, below‐investment‐grade, less than investment‐grade, or speculative‐grade bonds.

The term “junk bonds” dates to the 1920s, apparently originating as traders' jargon. Financial publisher John Moody applied the less pejorative (p.224) label, “high‐yield bonds,” as early as 1919, but non‐investment‐grade debt received little attention outside a small circle of professional specialists prior to the mid‐1980s.

Financial Literacy for a Changing Market (Houghton Mifflin)

Junk Bond: A high‐risk, high‐yield debt security that, if rated at all, is graded less than BBB. These securities are most appropriate for risk‐oriented investors. When LTV Corporation filed for bankruptcy in the summer of 1986, it listed liabilities of nearly $4.25 billion of debentures qualifying as junk bonds. LTV had been a major issuer of debentures qualifying as junk bonds. These high‐yielding debentures suffered very large price declines immediately before and after the firm's bankruptcy filing. For example, its 5% subordinated debentures due in 1988 declined from a price near $700 on July 16 to $350 two days later. By October, the debenture sold for only $200. Other LTV debentures suffered similar large losses. In addition to sustaining the loss in market value, the owners of the securities received no interest income during the reorganization. The LTV junk bonds offered investors a high yield only for as long as the firm remained able to pay interest on the securities.

The Handbook of International Financial Terms (Oxford University Press)

Junk bond (USA). A high‐yield bond with a credit rating below investment grade at issue which has become popular as means of financing corporate takeovers and management buyouts. In theory, it differs from the fallen angel bond in that the issuer was below investment grade at the time of issue (hence the idea of a junk bond credit). The term has come to mean all speculative grade bonds whether they were speculative or not at issue. The junk bond market was popularized by Drexel Burnham Lambert and Michael Milken in the USA in the 1970s, although many other securities firms have become active in the market. Milken found when looking at the experience of the fallen angel bond market that the risk (and liquidity) spread such issues commanded over investment grade bonds of a similar class were higher than the historical default record. Building on this finding, Drexel was able to build up large‐scale distribution in such securities to yield‐hungry investors. Many innovations have been tried out in an attempt to increase marketability, including payin‐kind bonds and deep discount issues as well as step‐up and convertibles. Also sometimes called speculative grade securities or non‐investment grade securities.

Webster's Ninth New Collegiate Dictionary (Merriam‐Webster)

The first time the term “junk bond” appeared in Webster's Ninth New Collegiate Dictionary was in the 1990 edition, page 655.

junk bond n (1976): a high‐risk bond that offers a high yield and is often issued to finance a takeover of a company.

(p.225) Internet Sources

Cornerstone Investment Consultants (http://www.stonecorner.com)

Junk bonds, also known as high‐yield bonds, are bonds rated noninvestment grade by a major bond rating agency, such as Moody's or Standard & Poor's. The ratings . . . reflect an opinion of the bond issuer's ability to meet the required interest and principal payments.

Junk bonds became popular during the 1980s, when firms such as Drexel Burnham Lambert utilized them to finance large leveraged buyouts. Before Michael Milken became the poster boy for junk bonds, they were known by only the most sophisticated investors.

Investors purchase junk bonds because their yields are higher than investment grade bonds. The reason for this is simple: companies that issue them are generally perceived to have a greater risk of default.

Dow Publishing Company (http://www.dows.com)

Bonds are generally classified into two groups—“investment grade” bonds and “junk” bonds. Investment grade bonds include those assigned to the top four quality categories by either Standard & Poor's (AAA, AA, A, BBB) or Moody's (Aaa, Aa, A, Baa).

The term “junk” is reserved for all bonds with Standard & Poor's ratings below BBB and/or Moody's rating below Baa. Investment grade bonds are generally legal for purchase by banks; junk bonds are not.

Encyclopedia.Com (http://www.encyclopedia.com)

Junk bond: A bond that involves greater than usual risk as an investment and pays a relatively high rate of interest, typically issued by a company lacking an established earning history or having a questionable credit history. Junk bonds became a common means for raising business capital in the 1980s, when they were used to help finance the purchase of companies, especially by leveraged buyouts; the sales of junk bonds continued to be used in the 1990s to generate capital.

Financial Pipeline (http://www.finpipe.com)

A high yield or “junk” bond is a bond issued by a company that is considered to be a higher credit risk. The credit rating of a high yield bond is considered “speculative” grade or below “investment” grade. This means that that chance of default with high yield bonds is higher than for other bonds. Their higher credit risk means that “junk” bond yields are higher than bonds of better credit quality. Studies have demonstrated that portfolios of high yield bonds have higher returns than other bond portfolios, suggesting that the higher yields more than compensate for their additional default risk.

High yield or “junk” bonds get their name from their characteristics. As credit ratings were developed for bonds, the credit rating agencies created a grading system to reflect the relative credit quality of bond issuers. The (p.226) highest quality bonds are “AAA” and the credit scale descends to “C,” and finally to the “D” or default category. Bonds considered to have an acceptable risk of default are “investment grade” and encompass “BBB” bonds and higher. Bonds “BB” and lower are called “speculative grade” and have a higher risk of default. . . .

Underwriters, being creative and profit‐oriented, soon began to issue new bonds for issuers that were less than investment grade. This led to the Drexel‐Burnham saga, where Michael Milken led a major investment charge into junk bonds in the late 1980s, which ended with a scandal and the collapse of many lower rated issuers. Despite this, the variety and number of high yield issues recovered in the 1990s and is currently thriving. Many mutual funds have been established that invest exclusively in high yield bonds, which have continued to have high risk‐adjusted returns.

The Investing Guys (http://www.investopedia.com)

Junk bonds: These are bonds that pay high yields to bondholders because the borrowers don't have any other option. Their credit ratings are less than pristine, making it difficult for them to acquire capital at an inexpensive cost. The measuring stick for junk bonds is typically a bond rating of BB/Ba or less.

Although junk bonds pay high yields, they also carry higher than average risk that the company will default on the bond. Historically, average yields on junk bonds have been between 4 and 6 percentage points above those on comparable U.S. Treasuries.

Junk bonds can be further broken down into two or more categories:

  1. Fallen Angels—This is a bond that was once investment grade but has since been reduced to junk bond status as a result of poor credit quality of the issuing company.

  2. Rising Stars—The opposite of a fallen angel, this is a bond whose credit rating has been increased by a rating agency because of an improving credit quality of the issuing company. A rising star may still be a junk bond but on its way to being investment quality.

Investment.Com (http://investment.com)

Junk bond: Bond with a credit rating of BB or lower by rating agencies. Although commonly used, the term has a pejorative connotation, and issuers and holders prefer the securities to be called high‐yield bonds. Junk bonds are issued by companies without long track records of sales and earnings, or by those with questionable credit strength. They are a popular means of financing takeovers. Since they are more volatile and pay higher yields than investment grade bonds, many risk‐oriented investors specialize in trading them.

Microsoft Network Money Central Glossary (http://www.moneycentral.msn.com)

A debt security that pays investors a high interest rate because of its high risk of default. Junk bonds aren't for everybody or even most people, but (p.227) they aren't all bad. They provide less than rock‐solid firms with access to credit, and a broadly diversified portfolio can reduce the risk of any one bond's default while providing high portfolio interest. But beware: junk bonds really are risky. In addition to the unusually high credit risk (and the usual interest‐rate risk associated with all bonds), junk bonds are susceptible to the winds of economic fortune. When a downturn is anticipated, many investors shun the bonds of companies that might not be able to pay interest or principal if business should turn sour. Thus, the price of your junk holdings would fall under such circumstances. Given the uncertainties, some junk‐bond investors prefer a good mutual fund, which will do the work of credit analysis and diversification for you.

Oxford English Dictionary (http://www.oed.com)

Junk bond (orig. U.S.), a stock with a high rate of interest and substantial risk, issued esp. to finance a corporate take‐over or buy‐out.

Power Investor Primer (Investors Alliance, http://www.powerinvestor.com)

High yield “junk” bonds were invented to enable smaller companies or big investors to use bonds and bond markets to finance takeovers. The original concept was good and legal; but unbelievably greedy brokers and arbitrageurs, aided by big investment firms, exploited and corrupted it. They used illegal inside information, deliberately planted misinformation, and market rigging to make millions and millions of dollars while, in some instances, destroying profitable old companies. Some of these multimillionaires are now in the penitentiary. Unfortunately, greed is still rampant.

The junk bond market grew exponentially. During the 1990–91 recession many of these bonds defaulted, helping bankrupt the S&Ls throughout the U.S. and helping to saddle U.S. taxpayers with a trillion dollar national deficit.

When the bonds defaulted, many investors complained that their brokers said they would get a 16 percent yield. They chose to ignore the axiom that high risks inevitably accompany high rewards. There are no free lunches, no guarantees.

We recommend avoiding junk bonds. However, if you must buy them, at least buy a junk bond fund; with a fund you have more diversification. In the junk bond fund you may lose only 25 percent of your principal versus 100 percent in an individual bond. We feel that investors have superior and safer opportunities in undervalued common stocks or stock mutual funds.

A research study completed in mid‐1989 by Harvard professor Dr. Paul Asquith found that an incredible 34 percent of all high yield bonds defaulted. He started with bonds issued in 1977 and assumed that if a hypothetical investor bought every high yield bond issue between 1978 and 1986, 34 percent of the bonds would have defaulted by November 1988. Professor Asquith also found that the quality of bond issues has decreased over time, with higher quality issues in the early 1980s versus the late 1980s.

(p.228) Stock Quest Glossary (http://www.stocksquest.thinkquest.org)

Junk bond: A weak bond, rated BB or lower, that has a high default risk, and thus carries a high interest rate.

Other Sources

Professor David Zalewski, Department of Finance, Providence College

Junk Bonds: Although high‐yield bonds existed for years, the term “junk bonds” appeared during the rapid expansion of the market for these securities during the latter half of the 1980s. I am not sure who first coined the term “junk,” although I heard somewhere that the columnist Art Buchwald may have been responsible. The term is most closely associated with Michael Milken and Drexel Burnham Lambert, who exploited the decline of the private placement market, the increase in corporate leverage, and the need to finance acquisitions by providing liquidity for junk bonds and aid to high‐risk borrowers experiencing financial distress.