High finance, perhaps more than politics, makes strange bedfellows.
That might explain why, among the multibillion-dollar insurance companies, corporate raiders, and other big-league financial backers assembled in ranks behind T. Boone Pickens in his debt-financed takeover run on Unocal, one finds the pension fund of the American Lutheran Church.
"From a financial viewpoint I don't think there was anything wrong with the investment," says John Kelly, the church's director of investment. "Unfortunately, some of the reaction I've had from some of our members shows they were not very happy with our backing this group."
The Lutherans' brief flier in takeover speculation--Kelly says it was the first such investment and, given the public reaction, probably the last--amounted to a commitment to buy $10 million of the $3 billion in bonds Pickens would float if his bid succeeds. For that the church will receive a $750,000 "commitment fee."
But the investment also shows how far so-called "junk-bond" financing has come from the days when such bonds were considered highly speculative instruments suitable for only a select group of strong-hearted investors. The bonds were often securities in failing or struggling companies with uncertain futures.
Junk bonds--or "high-yield" bonds in more formal nomenclature--now fall roughly into two categories. Not only are they older bonds in companies whose credit ratings have slipped, but they may be newly issued by companies whose credit ratings are so low that the bonds must be floated at relatively high interest rates to attract buyers.
In both guises, junk bonds are turning up in some unusual spots. Pickens's bid for Unocal, like his similar runs on Phillips Petroleum and Gulf Oil, is financed through a shell corporation that would borrow money to take over the company; if the bid is successful, the shell's bonds would be assumed by Unocal and covered by its considerable assets. But because the shell has no assets itself, the bonds technically fall into the junk category.
Used this way, junk bonds magnify the financial potency of market entrepreneurs such as Pickens. That has given the securities an exceptional and not entirely rewarding visibility, provoking talk of congressional investigations, moratoriums on their use, and so on.
"The fears of high-yield takeover financing are overblown because large companies are vulnerable for the first time," says Frederick H. Joseph, senior executive vice president of Drexel Burnham Lambert, the Wall Street firm that all but reinvented the junk bond a few years ago and now dominates the market it created with about 69% of total underwritings.
Yet, the debate over junk-bond takeovers, which involve less than 15% of the total volume of such bond issues, Joseph says, has obscured some far more significant--and to a small number of analysts, disturbing--changes in that market.
With the inexorability of every Wall Street vogue one can name, junk-bond sales have expanded from a boutique market for risk-oriented institutions to one broadly merchandised, even to the small investor.
In 1974, there were three mutual funds specializing in high-yield corporate bonds, with combined assets of $400 million. Last year, there were more than 30, with assets of $6 billion. Earlier this year, one of these laid claim to being the first to cross the $1-billion threshold.
The public owns junk bonds in expanding quantity in other ways. Some insurance companies have loaded up on the instruments, meaning that life insurance policies for hundreds of thousands of individuals and families are partially backed by bonds ranked by the major credit-rating services as investments with speculative properties and thus less than "investment grade."
Also in the market are savings and loan associations, whose depositors' dollars are themselves insured by the U.S. government. Officials of the Federal Home Loan Bank Board, which oversees the thrift industry, say $5 billion in junk bonds are held by S&L;'s--mostly by about a dozen institutions.
Attracted by Rates
These buyers are attracted not by the securities' credit, which is rated low by the rating firms of Moody's and Standard & Poor's, but by their high interest rates. While an investment-grade bond issued by a well-capitalized company with good credit might pay somewhere between 10% and 11% in today's market, a Drexel-underwritten high-yield bond issued by a young company with no earnings or credit record might pay 15% or 17%.
The market in these securities has been given the imprimatur of several academic studies showing that the yield on junk bonds more than offsets the relative increase in risk.
Of their figures demonstrating that a diversified portfolio of low-rated bonds is less volatile--that is, less risky--than a basket of investment-grade paper, Donald B. Keim and Marshall E. Blume of the Wharton School wrote, "This result is somewhat surprising. . . . If (true), a portfolio of such lower-quality bonds may represent a conservative investment." Keim and Blume did allow that one reason junk-bond prices apparently hold steadier than those of high-rated corporate bonds may be that the junk is so infrequently traded that its prices lag more behind bad news (or good).
With the changes in junk bond ownership, there has also been a sea-change in the kind of corporation that issues them.
In more traditional times, a corporation could not issue a junk bond; very few bonds rated below investment grade would make it to market. Instead, the typical junk bond was a formerly investment-grade credit issued by a company that had fallen upon hard times, whether by managerial ineptitude or malaise in the economy or both.
Junk bonds were made, not born. A classic example, one institutional investor says, is Western Union, which by the steady decline in its fortunes and in its credit "over a two decade period has created a billion dollars in junk."
Those who played this market were following the old investment saw of buying on bad news, on the theory that if and when the issuer recovered, appreciation in the bond price would produce a satisfying jolt in capital gains.
One characteristic of these bonds was their low rates of interest. The lower that rate, the better the recovering company's chance of covering its debt payments--particularly in the high inflation 1960s and 1970s, when the assets behind the debt were appreciating sharply and rising interest rates diminished the market value of the old debt and thus enabled companies to buy in their old debt at a discount.
Today, a typical junk bond is issued at a high interest rate to counteract the presumed risk. This creates a heavier interest burden for a company to carry. If inflation remains low in the future and market interest rates drift down, the high-interest junk debt will rise in value and become more expensive to retire or refinance.
Thus, when Chrysler--a great junk-bond success story--came near to bankruptcy in 1979, its long-term debt included a lot of bonds paying 7% or 8%, and some as low as 5%. Compare that with a new-style junk issuer such as Wickes Cos., which is just emerging from bankruptcy and recently issued, through Drexel, more than $300 million in bonds and notes with interest of more than 15%.
Resemble Fledgling Firms
Other issuers of today's high-yield paper resemble the kind of fledgling companies that in the past would be forced to resort to private lenders--banks and venture capital firms--for their initial capital.
Drexel argues that many companies issuing high-yield paper are otherwise creditable corporations that have simply shifted from being bank creditors to taking advantage of a more flexible market for public debt. Of the 4,800 U.S. companies with assets of $25 million or more in 1984, Drexel says, only 9% had the credit ratings necessary to issue investment-grade debt in the public market. Thus, they are not exactly junk creditors.
The junk bonds examined by the academic studies are very different from many of those going on the market today--as are the issuing companies, the condition of their balance sheets and the economic environment into which the bonds flutter.
"The explosion has been so great in the last six months that we're on new ground," says James S. Chanos, vice president of Deutsche Bank Capital Corp. in New York and a confirmed bear on junk bonds.
Although junk portfolios of the past have weathered economic downturns relatively well, no one can really predict what will happen when the junk class of 1984-1985 meets its first real recession.
The proliferation of low-rated corporate bonds reflects the expanding role of debt in the U.S. economy. The Congressional Research Service last year noted that the debt-to-net-worth ratios of U.S. manufacturing firms has been rising steadily since 1960 to an average 30% from 20%.
A vastly increasing proportion of this debt falls into the junk category. In just the last four years, for example, the annual volume of speculative-rated corporate debt issues has risen to $17.1 billion in 1984 from $3.5 billion in 1981, according to the investment house of Salomon Bros. In the same period, junk debt grew to 27.2% of newly issued corporate debt from 10.3%.
This growth unnerves traditionalists who argue that a healthy balance sheet--that is, light on debt and heavy on equity--is the best way to weather the recessions that inevitably loom ahead.
"People in finance have always said that debt ratios of 30% or 35% were prudent, because nobody knows what the future brings," says Nicholas F. Brady, chairman of Dillon Read & Co., the investment bank defending Unocal from the Pickens onslaught. "Now we're talking about companies that are leveraged 100% or 85% or 90%.. . . This is hit-and-run driving on the financial highways."
Yet the question of how much debt is prudent is one with as many facets as a theological mystery and as many answers as, say, the issue of whether corporate takeovers are beneficial or baleful.
"I think corporations in the United States are generally under-leveraged," says Drexel's Joseph.
Drexel contends that American firms take on far less debt than those in some other industrialized countries, notably Japan. Joseph argues that Drexel's deals are generally structured so that a company's cash flow is adequate to service its debt.
"I abhor the idea of paying for debt by liquidating assets," Joseph says.
Affect Tax System
Ripples from the proliferation of junk debt spread throughout the economy. They affect the federal corporate tax system, which by allowing deductions for debt interest encourages accumulation of debt capital at the expense of equity.
The impact of tax considerations can be seen most vividly in Carl Icahn's unsuccessful plan for the recapitalization of Phillips Petroleum. Icahn would have saddled Phillips with $11.9 billion in long-term debt and preferred stock, producing a debt-to-equity ratio of 14 to 1, by far the highest of any major oil company. Icahn's proposed new debt of $8.7 billion, however, would have given Phillips tax savings of $600 million a year.
Moreover, targets of junk-financed takeovers argue that the financing schemes undermine the stock market by evading margin regulations. These rules require that any buyer of stock put up 50% of its value in cash; junk-bond financing, it is suggested, allows raiders to borrow virtually 100%--1929-magnitude level of leveraged speculation.
Of all these considerations, the one that may embrace the most uncertainties is that many issuers of junk bonds are companies adding expensive debt to already highly leveraged balance sheets--hence their low credit ratings. Critics say such companies may be incurring debt that will be difficult to pay off at high interest rates--particularly in the teeth of a recession.
Blueprints for Liquidation
Some celebrated junk deals of the last two years, in fact, involved such heavy debt-service requirements that pessimistic analysts say they amounted to blueprints for their issuers' liquidation. Among these is Metromedia, which encumbered its seven television stations last December with $1.9 billion in debt in the largest junk-bond issue in history.
The Metromedia underwriting is significant not only for its size but for the chilling candor of its prospectus, in which the company frankly stated its doubts that it could muster the cash to pay off the bonds on schedule (beginning in 1988). Had the bonds been issued at the beginning of 1983, the company said, its cash flow would have fallen short of debt service that year by $122.4 million and a comparable amount in 1984.
Even if the company grew sufficiently to cover debt service in 1988 and beyond, it said, those payments would "consume all or substantially all" cash flow.
What makes the deal even more poignant was Metromedia's assertion that it was floating the bonds to retire $1.2 billion in bank debt (borrowed to finance the buy-out of the company by its chairman, John W. Kluge). The terms of the bank loans required Metromedia to sell at least one TV station by this June. This was a move, Kluge opined in a disclosure document, that would lead to "deterioration of employee morale." Now, of course, the TV stations are being sold to Rupert Murdoch and Denver oilman Marvin Davis, who will assume the debt, and Hearst Corp.
"The irony of the situation is that it now looks like the whole of the broadcasting company will be sold," says Brian Doyle, a high-yield bond analyst for Donaldson Lufkin & Jenrette Securities.
Still Valued Highly
To be sure, the bond market still values those bonds highly. "The Metromedia bonds I bought are selling at 15% more than what I bought at," says one institutional investor. "That looks to me like good security analysis."
Some buyers argue that underwriting skills, particularly at Drexel, have advanced so far that, in the words of Fred Carr, chairman of Los Angeles-based First Executive Corp., a major institutional investor in junk bonds, in the last year and a half, the overall quality of high-yield paper "has been upgraded."
Nevertheless, some investment professionals argue that junk-bond defaults may rise in the next recession simply because the public debt market is less flexible in hard times than such private lenders as banks, the chief source of borrowed capital for companies with little operating history--today's junk candidates.
Typically, these lenders would protect their investments by imposing strict covenants on the borrowers: they were not permitted to exceed a certain ratio of debt, could not pay dividends for certain periods, had to maintain a given level of income, and so on.
"Over long periods, the bankers and insurers had seen restrictive covenants work in their favor," says H. Dean Benner, managing principal of Chase Investors Management, an institutional money management firm. "These restrictions are not present in the new bond issues."
Worked Out Problems
Benner says the preponderance of such private debt on the ledgers of young companies protected their few public bondholders. "In the event of a problem, a company would frequently have 70% to 80% of its borrowings from banks and insurers, and maybe 20% would be public bonds. The private lenders all had a lot to lose. They would swallow interest, allow payment delays. They'd work it out and be careful that the public bondholders would get their interest in time to avoid a default."
Benner believes that low default rates among low-quality bond issuers of the past partially reflect this willingness by bankers to see things through. A similarly troubled company today, with most of its borrowings in the public market, would find no such flexibility, he argues. The possible result: a higher default rate.
Drexel's Joseph argues that the benefits of such private workouts have been exaggerated. "We've persuaded institutions that covenants don't protect them," he said. "We believe that management ought to run a company, not its lenders."
And to see a company through troubled times, he adds, Drexel has developed state of the art techniques that preserve the bondholders' investment. These include exchange offers, in which an ailing company exchanges new bonds, offering lengthened maturity and interest schedules, for existing securities--much the same way a bank might reschedule a troubled borrower's debt.
Has Drawn Controversy
To a certain extent, Drexel's own dominance of the junk-bond market has drawn controversy. For one thing, some of the largest accumulations of junk bonds are in the hands of the firm's own investment clients, many of whom invest in each other's securities (also generally underwritten by Drexel.)
This has provoked contentions that Drexel's junk-bond trading operation, headquartered in Beverly Hills under the aegis of trader Michael Milken, artificially creates a liquid market that may mask lower values in the securities.
It is certainly true that the firm has benefitted from a cadre of exceptionally loyal customers. One is First Executive Corp., the insurance holding company run by Fred Carr, a former mutual fund manager in the go-go years of the 1960s. Carr, whose insurance-company portfolios are very actively traded, contends that his portfolio success is a function of exploiting the inefficiencies of current bond-rating techniques.
"Investment-grade ratings are not a substitute for portfolio management," he says.
Still, Carr's portfolio shows an exquisite devotion to Drexel-underwritten issues. In 1984, Carr's California life insurance subsidiary bought securities from three out of every four corporate bond issues underwritten by the Drexel firm during the year, for a total of more than $325 million, or about a third of his total corporate bond purchases in 1984. (This included his purchase of $77.6 million face value of Metromedia's epic issue, purchased for $45.5 million at its original market price.) In 1983, the ratio was about two out of three. In both years, most of the rest of Carr's corporate-bond purchases were also made though Drexel.
Had Good Success
Carr ridicules any suggestions of an unholy alliance between his company and Drexel or any other junk buyer. "We've had good success in the high-yield market, and Drexel Burnham accounts for more than half the new issues in that market," he says.
Drexel's Joseph similarly minimizes the interconnection of bond customers. "My bottom line is, so what?" he says. The most publicized purchasers of junk bonds, Joseph says, only buy 4% of the dollar amount of new high-yield bond issues.
Another devoted customer is Columbia Savings & Loan Assn. of Beverly Hills, probably the heaviest plunger in junk bonds among federally chartered S&Ls.; Of Columbia's $1.92-billion investment in corporate securities at the end of 1984, it reported $1.53 billion was in junk-rated or non-rated paper. That comes to more than 10 times its net worth at year-end 1984 and 47% of its total assets.
The thrift's largest investment was $67.3 million in Metromedia Broadcasting; its four next largest stakes, all more than $50 million, were in four other Drexel clients--Rapid American Corp., Occidental Petroleum, MCI Communications, and Coastal Corp. For the first time since it began its junk-fueled growth in 1971, Columbia last year established a loss reserve of $3.5 million for its corporate securities holdings. (The association noted in its annual report, however, that "there was no specific material credit deterioration identified" in the portfolio.)
Such investments by thrifts, which theoretically exist to finance the housing industry, disturb regulators partially because associations like Columbia have used the high yields available in the market to grow dramatically--to $4 billion last year from $400 million in 1981, in Columbia's case.
Insofar as their deposits are federally insured, of course, the S&L;'s are playing the junk-bond market with the Treasury's money. Federal regulators fear the combination of protection from loss and a higher-risk investment portfolio.
"We consider rapid growth and high leverage to be a problem," says Eric I. Hemel, director of the office of policy and economic research of the Federal Home Loan Bank Board. But he adds that the academic default-rate studies are theoretically comforting. "On safety and soundness grounds, we don't have the evidence that these pose any real threat."
Other professionals in the thrift industry argue that junk bonds are not significantly different from commercial loans, which S&L;'s are currently permitted to make. Some make the argument that thrifts can't fare much worse in the junk-bond market than they have in any other investments.
"There are no substantial losses in the junk-bond world that would compare to the losses in direct lending on real estate, where they're reputed to have the expertise," says Richard Pratt, the former chairman of the Home Loan Bank Board.
HOW JUNK BONDS HAVE MULTIPLIED Junk bonds are defined here as those rated below investment grade by the two major rating agencies JUNK BONDS' GROWING PRESENCE As a percent of new publicly offered corporate debt Source: Salomon Bros. DREXEL BURNHAM LAMBERT'S TOP TEN JUNK-BOND ISSUES New York-based Drexel Burnham Lambert is by far the largest issuer of junk bonds, with 69% of the market. The figures below include zero-coupon bonds at cash value.
When issued Metromedia Broadcasting Co. $1.3 billion 11/29/84 Occidental Petroleum 1.2 billion 10/23/84 MCI Communications 1 billion 7/29/83 Occidental Petroleum 700 million 4/17/84 Coastal Corp. 600 million 8/9/84 Mesa Petroleum 500 million 7/19/84 Wickes Cos. 475 million 4/24/85 MCI Communications 400 million 3/11/83 ACF Industries 395 million 12/14/84 MGM UA Entertainment 351 million 4/14/83
Source: Drexel Burnham Lambert