High Yield Junk Bonds Business - Research Paper Example

?High Yield Bonds Overview Is it wise to allocate a portion of one’s portfolio to junk bonds? Since the 1930s, bank regulators have issued regulations that restrain banks from investing in securities that can be classified as precursors of junk bonds (White, 2010, p. 213). Banks were asked to invest only to investment grade bonds that are equivalent to “BBB” or better on the Standard and Poor’s scale (White, 2010). Junk bonds are corporate bonds with highly unfavorable ratings from major rating agencies (Becketti, 1990, p. 46). The corporate bonds with good or highly favorable rating grades are classified as “investment-grade bonds” while those with low ratings are called “low-grade” or “speculative” bonds or by their less formal term, “junk bonds” (Becketti, 1990). In other words, based on Becketti (1990), junk bonds, low-grade bonds, and speculative bonds are synonyms. According to Becketti (1990), a bond may be classified as a junk bond for three reasons. First, the outlook for the company may be highly unfavorable. Second, the issuing company for the bonds may have large or significant debts. Finally or third, is that the company’s legal claim on another firm’s assets which is in default or has serious risks of default may be behind the legal claims of other companies. However, Taggart (1987, p. 5) pointed out that despite their low-investment grade status, junk bonds are nevertheless classified as “high yield bonds” by “those wishing to avoid pejorative connotations.” It is very important to state, however, that although junk bonds experience more default, they also tend to have higher returns (Taggart, 1987, p. 12). More recent data are not immediately available. However, for 1974-1985, the default on junk bonds stood at 1.53% compared to 0.09% for all bonds (Taggart, 1987, p. 12). The 1.53% may be high compared to 0.09% but certainly 1.53% seems low enough. Further, various reports also suggest that annual return for junk bonds was 12.4% compared to 9.7% for all long-term government bonds (Taggart, 1987, p. 12). In the 1990s, many economic observers have attributed the country’s economic ills to junk bonds (Becketti, 1990, p. 46). Many observers believed that junk bonds and economic ills simultaneously emerged in the 1980s (Becketti, 1990). However, on the observation, the appropriate interpretation is that the market for junk bonds actually became only popular in the 1970s and 1980s but they have been in the US economy for some time (Becketti, 1990). In 1977, new issues of junk bonds in the United States were close to zero but they steadily climbed up to around US$33 billion in 1986 and to around US$30 billion in 1989 (Becketti, 1990). Becketti (1990, p. 48) argued that despite their size in the US economy for close to two decades, “junk bonds are too small a part of the debt market to account for the growth in corporate debt.” Further, Becketti (1990, p. 48) also argued that although junk bonds are riskier than investment-grade bonds, they are “less risky than equities.” Becketti (1990, p. 48) also clarified that “junk bond returns lie between those of investment-grade bonds and equities.” In addition, “junk bonds are more liquid than bank loans and private placements but less liquid than equities” (Becketti, 1990, p. 48). Junk bonds can also provide investors “more control over corporate management” than investment-grade bonds but less control than many financial instruments like equities (Becketti, 1990, p. 48). If one examines the descriptions of Becketti (1990), it should be easy to conclude that junk bonds aren’t too bad after all. Based on the literature that will be examined by this work on the nature of junk bonds and issues related to the acquisition of junk bonds, there is a genuine case for investing in junk bonds as well as improving the situation of the junk bonds market. Junk bonds are risky investments but they can be part of one’s investment strategy for increased wealth. Further, contrary to the view that our country’s crisis can also be traced partly to junk bonds, what appears more plausible is that the issue of junk banks is response to crisis and an attempt to address a specific crisis and, thus, its issue can be considered as an attempt to avoid a crisis. Philosophical, Constitutional, and Other Issues on Junk Bonds In the literature, there seems to be no significant pertaining to the constitutionality of junk bonds. However, Yale and Galle (2007) revealed that there is a common practice among states of exempting one’s municipal bond from taxation while imposing the same tax on municipal bonds issued by other states. According to Yale and Galle (2007), the practice has been challenged in court for violating the commerce clause under the US Constitution. However, according to Yale and Gale (2007), the most recent court rulings do not confirm the unconstitutionality of the practice. The decision to buy junk bonds may be influenced by business philosophy. On a review of the investment philosophies applied or utilized by many of the investment firms in the United States, however, it seems that many have taken the position of opting for a “diversified portfolio of below-investment grade and/or non-rated municipal revenue bonds” because they have “the potential to provide a high level of tax-free income with limited fluctuation of the principal value” (Invesco Investment Philosophy, 2010). The controversial dimension in junk bonds does not lie in the philosophical and constitutional aspects but on matters related to buyouts and takeovers (Taggart, 1987, p. 12). Taggart (1987, p. 14) noted that the only legislative and regulatory action that had been taken against junk bonds was that one by the Federal Reserve who decided in January 1986 to apply margin regulations to stock purchases by shell corporations (Taggart, 1987, p. 14). In 1984, about US$17 billion in publicly issued junk bonds was linked with acquisitions and buyouts (Taggart, 1987, p. 14). However, the Federal Reserve’s figure is that only about US$6.5 billion but consisting about 84% of 1984’s junk bond issues was related to mergers and acquisitions (Taggart, 1987, p. 14). The mergers, however, which may or may not be correctly associated with junk bonds are not actually related to increasing corporate debts (Taggart, 1987, p. 17). Economic Aspect Junk bonds can be viewed as tradeoff between security and returns. One may value security but low returns are associated with less risky investments. On the other hand, returns can be high or has the potential of being high but this can come at the expense of being exposed to higher risks. Junk bonds, therefore, are not actually junks because while junks have fixed low values, junk bonds have prospects of higher returns although they may be risky to hold. They are not really junks at all because earlier figures suggest that they perform almost just as good as the other types of bonds. For example, in 1985 the default rate was 1.68% and in 1986 it was 3% from the earlier average default figure of 1.53% of 1975-85 (Taggart, 1987, p. 12). In 1986, the returns on junk bonds were 12.4 percent (Taggart, 1987). Thus, while junk bonds are risky, the risk is not really very large at all in the early time periods of United States of America. In some cases, the so-called risk on the junk bonds are not statistically significant at all, like that one cited by Taggart (1987, p. 12) for the period 1982 to 1984. A basis for investing in junk bonds can be found in the portfolio theory of financial economics. Boshnack (2006, p. 1) pointed out that the father of modern portfolio theory, Harry Markowitz, warned investors that “holding securities that move in concert with each other does not lower risk.” Markowitz pointed out a “diversified portfolio comprised of non-correlated assets can provide the highest returns with the least amount of volatility” (Boshnack, 2006, p. 1). For this finding, Markowitz was awarded the Nobel Prize and this provides good evidence of the soundness of this theory (Boshnack, 2006, p. 2). It follows from Markowitz’s work that accumulating only what seems to be the most risk-free assets will not be the best way to accumulate wealth (Boshnack, 2006, p. 2). For best results towards wealth accumulation, Markowitz recommended that an individual or investor combine assets of dissimilar price movements (Boshnack, 2006, p. 3). Diversification will reduce risk when assets that move inversely at different times are combined in one portfolio (Boshnack, 2006, p. 3). In other words, Boshnack (2006, p. 3) pointed out that “a diversified portfolio of uncorrelated assets can provide the highest returns with the least amount of volatility.” Citing several works, Berberis et al. (2006, p. 284) pointed out that investors usually group assets into categories of investment grades and allocates fund to the categories rather than based on the individual characteristics of the bonds. One category of the investment grade to which an investor allocate funds is the category of junk bonds (Berberis et al., 2006, p. 284). In a relatively recent work, Ghysels et al. (2004, title) acknowledged the correct perspective of the modern portfolio theory by acknowledging that “there is a risk-return tradeoff after all.” The Ghysels et al. (2004) work studied the relations over time between a measure of average and variability on stock market returns. They found that there is a statistically significant positive relation between risks as measured by variability and returns to assets. More important, they also found that the correlation is consistent in various samples. Thus, there is not only a theoretical but also an empirical foundation to modern portfolio theory of finance economics. There is therefore a good foundation in theory and empirical research for the inclusion of junk bonds in one’s portfolio proportionate to one’s ability to bear risks. The Ghysels et al. (2004) empirical study benefitted from the use of new estimator of conditional variance known as the Mixed Data Sampling or MIDAS. The MIDAS is actually an estimator that forecasts the monthly variance with a weighted average of the lagged daily squared returns (Ghysels et al., 2004, p. 1). The data that the researchers used came from the monthly and daily market return data from 1928 to 2000 and, thus, it is easy to easy that the scope of data covered pre-World War II, post-World War II, and the period wherein there has been internationalization and globalization. This is the basis why the results of the empirical study of Ghysels et al. (2004) have been described as “robust” by the authors. It is also noteworthy to point that the authors have surmounted the difficulties confronted by earlier studies on the topic. For instance, they have handled “specification errors” that were present in earlier studies (Ghysels et al., 2004, p. 4). Economic Literature on Junk Bonds In dissecting the United States economy, Carr and Lucas-Smith (2011) identified five features of the ongoing crisis. First, Carr and Lucas-Smith (2011) pointed out that foreclosures will be unavoidable. Second, the bailout of banks have not fully succeeded in ending the crisis. Third, the recession was not an equal opportunity recession in the sense that communities of color were more badly affected. Fourth, efforts to prevent foreclosures are failing. And fifth, government can still take steps to bolster economy recovery by mitigating damages from unavoidable or strategic defaults, promoting the safety and soundness of financial products, and by linking job creation with the efforts to rebuild communities. However, the most relevant aspects of Carr and Lucas-Smith (2011) assessment is that junk bonds played a role in the creation of the current crisis. According to Carr and Lucas-Smith (2011, pp. 9-10), the ongoing crisis partly arose from “inadequate oversight of the bond rating agencies.” According to the Carr and Lucas-Smith, the bond agencies stamped investment grade on bonds that were actually junk bonds. Einhorn (2010, p. 5) reported that corporate issuers of junk bonds continue to grow in the 2010s. Citing reports from news wire, Einhorn (2010, p. 5) reported that junk bonds constitute a large part of the US$1.4 trillion refinance wave. Einhorn noted (2010, p. 7) that junk bonds continue to be used for leverage in acquisitions. Kenney (2009, p. 58) reported that during the 1980s, junk bonds were instrumental for corporate takeovers. Originally, however, junk bonds were not used for corporate takeovers and, thus, the 1980 takeovers using junk bonds was unprecedented (Kennedy, 2009, p. 58). Michael Milken stood out in the corporate takeovers of 1984 who had “tapped his network of junk buyers---saving and loans, insurance companies, corporation, other raiders---and began to form multibillion-dollar blind pools.” In other words, junk bonds rather than piles of junk can be really profitable to hold in quantities and volumes proportionate to risks. Asquith et al. (1990) examined 102 public junk bond issuers and found that companies with complex public debt structures are more likely to go bankrupt. The Asquith et al. (1990) study declared what appears obvious: firms that are more successful in dealing with financial distress are less likely to go bankrupt, sell assets, or reduce capital expenditures. Taken, therefore, in the light that junk bonds are attempts of a firm to deal with financial distress, it seems reasonable to view that junk bonds need not be seen as the source of economic difficulties but rather as a route through which firms address their financial difficulties. The other routes through which issuers of junk bonds address their financial difficulties are through assets sales, debt restructuring, and reducing capital expenditures (Asquith et al., 1991, p. 2). In addressing their financial difficulties, issuers of junk bonds do not mobilize much the banks and, thus, banks play only a limited role in addressing the problems confronted by the issuers of junk bonds. Thus, to the extent that the findings of Asquith et al. (1990) apply, it does not appear reasonable to say that junk bonds contribute to financial crises. The work of Becketti (1990, p. 49) argued two main points. First, junk bonds are not different from other securities. Second, they have been too small in the US economy to have caused the 1980s boom in mergers boom. Becketti argued further that the popularity of the junk bonds in the 1980s may have been triggered by the mergers boom and not the other way around. In other words, Becketti pointed out that the mergers boom in the 1980s helped create the junk bonds market and it is not the case that the junk bonds market created the mergers market. Becketti (1990, p.50) also said that given the corporate debt increase of US$1,322 billion from end 1979 to end 1989, the outstanding junk bonds increased by only by US$189 billion, implying that “junk bonds accounted for only 14 percent of the growth in corporate debt.” Becketti (1990, p. 51) also criticized the view that the junk bond market contributed to the increased in market volatility in 1987. Becketti reasoned that if such were the case, stock market volatility should have been high throughout the 1980s and not only in 1987. Thus, Becketti asserted that the junk bonds market cannot be blamed for the financial volatility of the market. Basically, Becketti (1990) acknowledged that the junk bonds market was being blamed for three things: the increase in corporate debts, the increases in mergers, and the increases in financial market volatility. Becketti (1990) argued however that the blame is unwarranted. Taggart (1987, p. 5) also noted that the growth of junk bonds has been “bitterly denounced.” Quoting several works, Taggart pointed out the critics have singled out junk bonds as partly responsible for destroying the “fabric of the American industry.” Citing the work of (Wynter 1985), Taggart also noted that earlier writers criticized that junk bonds supposedly divert financial resources away from productive uses. However, Taggart (1987, p. 20) pointed out that the junk bonds market was merely “spawned by the forces of interest rate volatility, competition in financial services and industrial structuring.” Further, the junk bonds market actually “enabled many corporations to raise funds quickly and on better terms than would otherwise have been available” (Taggart, 1987, p. 20). In the modern era, the emergence or revitalization of the junk bonds market was precipitated by the desire of corporations for “reducing the cost of raising external funds” given economic uncertainties (Taggart, 1987, 6). Thus, “even firms with little or no overseas operations, such as public utilities, have raised funds” from the junk bonds market (Taggart, 1987, p. 6). Corporations have used the junk bonds market “to raise funds directly from investors, thus avoiding the administrative and regulatory costs implicit in borrowing from financial intermediaries” (Taggart, 1987, p. 6). Thus, through the junk bonds market, “commercial and industrial loans from large banks fell from 34 percent of nonfinancial business borrowing in 1978 to 28 percent in 1985” (Taggart, 1987, p. 7). The competitive environment resulting from the “effects of regulatory change, foreign competition, volatile commodity prices, and new technology” as well as the need for mergers, divestitures, and new investments “have placed a premium on the ability to mobilize large amounts of capital quickly,” a concern that is addressed by the junk bonds market (Taggart, 1987, pp. 7-8). Before 1977, the junk bonds market consisted mostly of “fallen angels” or firms that used to be attractive (Taggart, 1987, p. 8). However, given volatilities, competition, and regulatory changes discussed in the two earlier paragraphs, even the “non-fallen angels” became part of the junk bonds market as firms sought direct access to investors (Taggart, 1987, pp. 8-9). Further, the growth of junk bonds is “analogous to commercial banks’ pursuit of nonprime customers in an attempt to maintain profitability” (Taggart, 1987, p. 9). According to Taggart (1987, p. 10), the junk bonds are actually substitute for bank loans and private placements. Based on the figures of Morgan Stanley, junk bonds amounted to US$59.1 billion in mid-1985. Nevertheless, while junk bonds have been important in the economy they do not threaten nor overwhelm the market (Taggart, 1987, p. 15). Taggart cited the work of Becketti (1986) that provided evidence that corporate debt does not decrease with junk bonds. Overall, given the findings, junk bonds need not be associated with a worsening economy and may be viewed as an effort by firms to improve their financial conditions and prevent an economic crisis or the worsening of an economic crisis. Conclusion As discussed in many parts of this work, this work considered that junk bonds are positive rather than negative aspects of the economy. They are not really junks but rather unpolished jewels. As unpolished jewels, they are unattractive to buyer but nevertheless valuable. Typically, they are underrated in the market and this is what they are basically. They can be risky assets but their risks are not very bad and they remain to have high potential returns, just like many assets. Essentially, junk bonds are not different from the rest of the assets of the economy in which tradeoffs between security and potential returns are operative. They are not really valueless junks because their returns are respectable. Junks have close to zero value but this is not the case for junk bonds. Unfortunately, however, junk bonds have been associated with risks. As discussed elsewhere in this work, economic observers have link junk bonds with crises. On the contrary, junk bonds merely reflected the crises taking place in the economy. Further, junk bonds are in fact a route through which the economy can overcome its crises. As the costs of financial intermediation skyrocket because of a crisis, junk bonds are one of the means through which struggling firms can acquire financing at low costs. As mentioned in one of the paragraphs of this work, junk bonds are attempts of firms to access funds locally instead of tapping funds internationally. To a certain extent, it can be stabilizing. Essentially, junk bonds are actually attempts by firms to eliminate the need for bailouts from public or international funds. In view of the foregoing, the perspective of this paper is to support the growth of the junks bond market and to point out that there is wisdom in allocating a portion of one’s portfolio for junk bonds. What appears to be needed is for more accuracy, transparency, and more fair assessments by rating agencies on the firms availing junk bonds. It is fairly well-known in economics that negative prophecies or “forecasts” can be realized even when the fundamentals are not present to warrant a negative economic forecast or economic assessments. For example, if a relatively credible rating agencies rate a bank to be on a bank-run, it will be highly likely for that bank to go on a bank run even if the fundamentals are good. Bank depositors can respond to the negative forecasts and assessments and can withdraw their deposits from that bank to transfer their funds elsewhere. Similarly, rating badly a firm when in fact the firm is doing good has the potential of initiating a withdrawal of investments by investors from that firm thereby initiating a process of self-destruction as the firm suffers from shortage of capitalization to finance transactions. As indicated by the work of Carr and Lucas-Smith (2011), as shown by the ongoing crisis in the United States, rating agencies can also err in the classification of junk bonds as investment grade. Carr and Lucas-Smith even attribute the emergence of the ongoing United States crisis to be a product of such a misclassification. A key recommendation of this work therefore is that government and non-government groups must also rate the rating agencies so that accurate assessments of investment grades can be done better by the rating agencies. If rating agencies fail too much or misclassify too much the investment grade of bonds, a potential for crisis is created. If a rating agency misclassifies too much the investment grade of bonds then the public must nip in the bud the credibility of the rating agencies and classify them according to their ability to grade investment grades correctly or soundly. As a concluding note, let it be pointed out that we must not underestimate the capacity of junks bonds in producing benefits other than potential returns provided risks are handled correctly: junk bonds can facilitate acquisitions and mergers and junks bonds are also sources of funds for a struggling company. Thus, other than the private benefits of junk bonds, junk bonds have actually social benefits. However, it is important to correctly assess its risks and to acquire portfolio proportional to our ability to handle risks. References Asquith, P., Gertner, R., and Scharfstein, D. (1991). Anatomy of financial distress: an examination of Junk Bond issuers. Working Paper 3942, NBER Working Papers. Massachusetts: National Bureau of Economic Research. Becketti, S. (1986). Corporate mergers and the business cycle: Federal Reserve Bank of Kansas City. Economic Review, 71 (May), 13-26. Becketti, S. (1990). The truth about junk bonds. Economic Review, July/August, 45-52. Berberis, N., Shleifer, A., and Wurgler, J. (2005). Comovement. Journal of Financial Economics, 75, 283-317. Boshnack, B. (2006). Modern portfolio theory: dynamic diversification for today’s investor. Vision L. P. Carr, J. and Lucas-Smith, K. (2011). Five realities about the current financial and economic crisis. Suffolk University Law Review, XLIV (7), 7-30. Einhorn, T. (2010). Current trends in the corporate debt market and credit derivatives. Written talk before the American Bar Association, April. Ghysels, E., Santa-Clara, P. and Valkanov, R. (2004). There is a risk-return tradeoff after all. Working Paper 10913. National Bureau of Economic Research. Invesco. (2010). Investment Philosophy and Process. INVESCO. Kennedy, D. (2009). Current conditions and economic outlook for 2008-2010. Connecticut Labor Department: Office of Research. Taggart, R. (1987). The growth of the “junk” bond market and its role in financing takeovers. National Bureau of Economic Research, 87 (1), 5-24. White, L. (2010). The credit rating agencies. Journal of Economic Perspectives, 24 (2), 211-226, Wynter, L. (1985). US Agencies, SEC object to Fed plan to curb junk bond used in takeovers. The Wall Street Journal (December 24). Yale, E. and Galle, B. (2007). Muni bonds and commerce clause after United Haulers. US Tax Analyst Document Service Doc 2007-14387. Read More