Crash Hasn’t Shaken Drexel’s Faith in the Value of ‘Junk Bonds’
Drexel Burnham Lambert, the New York investment house with the high-profile presence in Beverly Hills, has squabbled with Wall Street colleagues for years over the merits of “junk bonds.”
So it should not surprise anyone that Drexel executives contradict the prevailing view among analysts and money managers that the future for the high-yield, high-risk investments is clouded by the stock market crash and fears of a recession.
Drexel has placed $1 billion worth of junk bonds since the crash on Oct. 19, and its figures indicate that junk bonds have rebounded faster than the stock market. Drexel’s top corporate finance executive in Beverly Hills said he expects to complete two dozen additional private and public transactions by year-end--one-third the number completed in the past 10 1/2 months.
“We have made money all year on junk bonds, and we continue to make money on junk bonds,” said John H. Kissick, Drexel’s executive vice president for corporate finance in Beverly Hills, the command center for its 300-person junk bond operation. “We still have a significant backlog of business that we anticipate closing before year’s end.”
What may come as a surprise is that Kissick’s optimism was echoed by Robert D. Long, director of high-yield research at First Boston, the New York investment bank that is a distant second to Drexel in junk bond deals.
A good indicator of the health of the market is the fact that bonds issued earlier this year by Harcourt Brace Jovanovich, the publishing and amusement park company, are trading higher than the issue price after dropping well off immediately following the crash, Long said.
“Deals are still being done,” he added. “People are more cautious because of the potential of a recession, but the junk bond market has returned to its pre-Oct. 19 levels.”
Investor caution has forced many junk bond sellers to increase the yields they pay buyers since the crash. That means the bonds will be more expensive for companies to issue and pay off, a factor that Kissick acknowledged is likely to translate into a decline in the number of new issues.
“I can’t believe Drexel thinks it can get two dozen deals done in this market,” said Andrew C. Riley, a money manager with the regional brokerage of Conning & Co. in Hartford, Conn., and a close observer of junk bonds. “Nobody can say the junk bond market hasn’t dropped too much for that to happen.”
In the days after the crash, the market for junk bonds did plummet, and at least one Drexel client, ARC International of Toronto, canceled plans to finance an acquisition with $20 million in new junk bonds. Two public financings handled by Drexel had to promise yields in excess of 16%, a level that raised concerns among some analysts about the economic soundness of the offerings.
Last week, Dallas-based Southland Corp., which owns the 7-Eleven convenience store chain, postponed a $1.5-billion junk bond offering and stoked fears about the future of the market.
While Drexel was not involved in the Southland transaction, its position as undisputed leader in junk bonds means that any downturn would be a big negative for Drexel’s bottom line.
“It has got to affect them pretty badly,” said Brenda Davis McCoy, an analyst who specializes in financial service firms for the Paine Webber investment firm in New York. “They are the No. 1 underwriter of junk bonds. There is only a handful of market makers, so when prices decline, the risk to these firms can be greater.”
Some experts believe that even a minor recession could cause the junk bond market to dry up as investors flock to U.S. Treasury bills, which tend to pay greater interest rates in a weak economy.
“Clearly, the attraction of junk bonds is lessened by fears of an economic downturn,” said James S. Chanos, manager of a private pool of capital in New York and an expert in leveraged buyouts. “At some point, if there is even a slight recession, you just are not going to see any new issuances of junk bonds.”
Many companies depending on revenue growth to pay off junk bonds could be affected by a spending cutback in a recession. Other companies relying on the sale of assets to meet junk bond obligations have seen the value of those assets drop dramatically in the stock collapse.
Historically, only about 1.5% of all junk bond issues have involved defaults. But many experts said that figure is no longer realistic because there are more junk bonds in the market than ever, which increases the potential for default.
“The proliferation of junk bonds is unprecedented, and that group of bonds really scares me because they have never been through a recession,” said Joel S. Isaacson, manager of personal financial planning at the New York accounting firm of Weber Lipshie. “These companies are leveraged to the hilt and there will be some fallout.”
A Sharper Decline
There are some indications that investors are already wary. James Grant, publisher of Grant’s Interest Rate Observer, a Wall Street newsletter, maintains an index of 13 companies associated with Drexel’s junk bonds. It is compiled for him by Riley, the Hartford money manager.
Between Aug. 26, the day after the market’s peak, and Nov. 18, the Standard & Poor’s index of 500 stocks was down 27% and the “Drexel index” was off 40%. A similar index of 30 companies with high levels of corporate debt showed them to be off 31% for the same period, which is slightly more than the S&P; 500.
Drexel’s statistics paint a brighter picture.
Kissick said an index of 110 companies with the largest outstanding junk bonds shows that the bond price has increased 2.6% since the crash, while the stock market remains about 25% lower. The junk bond market has been sluggish in 1987, and one reason for the recent improvement is strong demand by institutional investors attracted by the high yields.
Still Industry Leader
Even if the junk bond market collapsed under the weight of a recession or investor fears of one, it would not have the effect on Drexel that it once would have.
Because Drexel is a closely held, private company, its earnings and revenue mix are not public. Analysts estimated that Drexel once depended on junk bonds for as much as 40% of its annual profit, which has been among Wall Street’s highest in the past three years.
Drexel executives said the proportion of profit gleaned from junk bonds has diminished in recent years as the firm has expanded and diversified. Since 1981, Drexel has almost tripled its number of employees to 10,500--only 6% to 8% of whom are connected even indirectly to the junk bond business, according to Kissick.
In a 21-month period from Jan. 1, 1986, until Sept. 30, 1987, junk bonds accounted for only three of every 10 financing issues by the corporate finance department. And Kissick said the contribution of junk bonds to the company’s bottom line is “significantly less than 40%, possibly less than 20%.”
Yet Drexel remains the industry leader in junk bonds, earning a 45% share of the market in 1986 and capturing 43.2% of the market so far in 1987, according to statistics compiled by IDD Information Services in New York.
“Historically, the market share of the leader in any sector goes up in tough markets and we expect that to happen now,” Kissick said.
