If ‘Junk’ Bonds Fail, You’ll Clean the Mess
Why are we hearing so much these days about so-called junk bonds, and why are they one of the fastest-growing types of investment?
Simple. Junk bonds are paying 12% to 16% interest at a time when long-term Treasury bonds are paying 7.7% and the highest-grade corporate bonds less than a point over that. Add the fact that banks and investment bankers make higher fees in junk bond deals than they do in other forms of financing, and that junk bond issuers can make enormous killings, and it’s easy to understand why junk is booming--an estimated $30 billion in new issues this year. At $100 billion in issues, junk bonds already total more than 20% of all corporate bonds outstanding.
But nobody pays or receives such interest without risk, and there could well be a price down the road for the rapid growth of junk bond financing today. And though you may come no closer to high-risk, high-yield bonds than an old battered bank passbook, you could be called upon to pay that price if the great minds of finance outsmart themselves once again.
High Risk of Default
The bonds are called junk to begin with for the same reason that they pay high interest--because the rating agencies perceive a high risk of default and, thus, refuse to rate the bonds, or rate them at less than investment grade--below BBB for Standard & Poor’s or below Baa for Moody’s Investors Service.
Such low-rated bonds used to scare people, but not any more. The lure of 4 to 7 percentage points in added interest, coupled with studies by investment bankers claiming that historically the risk in junk bonds has been overstated, have attracted a broad public to high-yield mutual funds.
But insurance companies and pension fund money managers are the major investors, professionals who are looking for performance with which to impress clients and who say they understand the risk. “With proper analysis and monitoring, you can get rewards that are worth the risk,” says one institutional investor. What he means is that there is safety in numbers; if you buy 10 of such issues and one fails, you will make enough on the rest to more than compensate.
Help of Commercial Banks
Rather than deal in generalities, however, let’s examine a specific issue, the $405 million in junk bonds issued last month by JSC/MS Holdings Inc. when it purchased Container Corp. of America, the packaging company, from Mobil Corp., the oil company. JSC stands for Jefferson Smurfit Corp., an Alton, Ill.-based paper company that has been growing rapidly by acquisition. MS stands for Morgan Stanley Leveraged Equity Fund--a group set up by investors and Morgan Stanley to take flyers in leveraged buyout deals.
Together, Jefferson Smurfit and Morgan Stanley put up about $20 million of their own money. Yet they were able, with the help of commercial banks and two issues of junk bonds, to pay Mobil $1.1 billion for Container Corp.--or CCA as they now call it. Mobil got a good price, but JSC/MS didn’t do badly either. If CCA can pay all the debt it has taken on in its own acquisition, then JSC and MS will have acquired full equity ownership of $1.7 billion worth of paper-making assets for $20 million.
But the debt is enormous: $655 million from the banks, $180 million at 12.375% in one bond issue and $225 million at 16.75% in another. The interest payments total $130 million a year and would seem a real challenge for CCA, which in 1985 had cash flow (income plus depreciation and timber depletion) of $159 million.
But like Mexico before it, CCA isn’t going to pay its interest immediately. No interest on the 16.75% issue is to be paid until 1991, by which time Jefferson Smurfit, which is going to manage CCA under contract, reckons that it will have increased the company’s productivity and cash flow. The Smurfit firm is paying itself handsomely to do that--an annual management fee of $7 million, plus an incentive that could boost the fee to $13 million if Smurfit achieves certain cost savings.
Fees are important in these deals. CCA starts out paying $26 million in fees to banks and investment banks--which goes far to explain why the bankers would lend $655 million to such a tight proposition. In addition, Morgan Stanley takes down another $10.5 million for financial advice.
OK, it’s clear that the junk market is a honey pot for financiers and bankers.
But what, you say, would happen if Container Corp. had a losing year, as it last had in 1983, and couldn’t make its debt payments? What if the economy went sour and a lot of junk-financed companies had trouble meeting debt payments? Simple. If CCA and a few more like it went bankrupt, owing billions of dollars to commercial banks, it would be the Hunt brothers all over again.
In other words, the U.S. government would be called upon to save the banks and to save the speculators who call themselves institutional investors. Which means that Uncle Sam once again would want your taxes to bail out the great minds of finance.
Unstable? Not at all. You’re good for the money, aren’t you?
