Junk Bonds Begin to Live Down to Their Name : Finance: Once a popular way for weak companies to raise cash, the market has fallen into disrepute.

They were credited with helping American businesses stay competitive. They helped fuel the takeover mania of the 1980s. But now, at the end of a decade in which they transformed the financial landscape, junk bonds have fallen on hard times, and the market is in chaos.

Traditional buyers of the bonds have dropped out in droves for both economic and political reasons. Mutual fund investors are clamoring to bail out too. Meanwhile, big bond issuers have run into big financial problems.

All of this has spurred an unparalleled slump in the market for the high-risk, high-yield debt. A number of issues sell for just pennies on the dollar--if they can be sold at all. And the chaos may not be over.

“It’s like a sinking ship,” said Michael Kimble, who manages a junk bond fund for Chase Investors, a unit of Chase Manhattan Corp. in New York. “Everyone is running to get on a higher level of the boat, but each level gets smaller, and eventually the whole boat is going to go down. Everyone is going to get hit.”

Nothing has contributed to the market debacle more dramatically than the escalating pace of bad news coming out of junk bond issuers such as Campeau Corp., Integrated Resources and affiliates of the leveraged buyout giant Kohlberg Kravis Roberts & Co.

The defaults and threatened defaults started somewhat innocuously in the summer of 1988, when Revco D. S. Inc., a New York-based drugstore chain, filed for Chapter 11 bankruptcy protection after failing to make payments on $700 million in junk bond debt. Revco was one of the first big leveraged buyouts to go sour.

A year later, Southmark Corp., a big real estate company headquartered in Dallas, filed Chapter 11. Then Integrated Resources, a diversified financial company with operations in real estate and insurance, stopped paying on $864 million in loans while trying to restructure its debt with creditors.

Meanwhile, KKR allowed one of its companies, Seaman Furniture, to default on some interest payments. And KKR announced last month that another of its affiliates, Hillsborough Holdings, has filed for bankruptcy after failing to renegotiate $624 million in junk bond debt.

But more upsetting to the market was the news at Campeau Corp. The Canadian parent of Federated Department Stores and Allied Stores first indicated that its debt load was overwhelming last September. Then, two weeks ago, the company announced that Allied and Federated may seek Chapter 11 bankruptcy protection.

Campeau “illustrated what happens when even a very good company gets over-leveraged,” said James R. Caywood, president of Caywood/Christian Capital Management in San Diego.

Allied and Federated “have done everything they said they would do and then some,” he added. Sales rose after Campeau’s buyout, as did profit margins. And the chains operate some of the premier department stores in the Northeast, such as Bloomingdale’s, Jordan Marsh, Bon Marche and Stern’s, he said. “But when you have an over-leveraged company and pressure from the banks, this is what happens.”

Although the junk bond market is risky by nature, many people didn’t recognize the risks until recently, industry experts said.

Partly, this stems from junk bonds having had modest default rates in the past for a variety of reasons. For example, several issuers raised enough in their bond offerings to make up to two years worth of interest payments. And others issued bonds that didn’t require cash payments to be made for years, said Marko Budgyk, president of Houlihan, Lokey, Howard & Zukin Investment Management Inc. in Los Angeles.

Other reasons for the slow recognition of the risks of junk actually go back to the current market’s beginnings, when a youthful Drexel Burnham Lambert bond trader named Michael Milken began preaching the gospel of high-yield debt.

Before Milken, the only so-called junk bonds in the market were those that had been issued by big, healthy companies that had fallen on hard times. The bonds issued by these “fallen angels” were then worth cents on the dollar and generally were shunned by mainstream investors.

But Milken maintained that the high interest rates paid on these securities more than compensated investors for the risks. Moreover, he encouraged a wide variety of smaller companies to begin issuing this high-yield debt, which was the inception of today’s junk bond market.

A number of small business owners credited Milken’s bond machine with helping spur growth in their arena--the fastest-growing segment of the economy. And that, they said, was good for job growth, U.S. economic competitiveness and the nation as a whole.

Later, of course, when junk bonds became a popular way to finance hostile takeovers, many workers felt differently. They were being squeezed out of their jobs in junk-financed deals.

Still, the public market for this debt was taking off, with $204 billion being financed in just over a decade, from virtually nothing before. A large part of the acceptance of junk bonds stemmed from the fact that while investors were getting double-digit returns, only a small percentage of the bonds defaulted. And those that ran into trouble were typically the smaller, less-known issues.

In addition to big institutional buyers such as insurance companies, a number of savings and loans began to buy junk bonds. And individual investors stepped into the market through mutual funds that invested in the high-yield debt. As of last July, T. Rowe Price, a big mutual fund company, reported that small investors had poured $1.2 billion into its high-yield fund.

But all of that changed last year.

First, Milken, the junk bond king, was indicted on 98 counts of securities fraud, insider trading and other violations. Milken has denied the charges, and the case is pending.

In the past, Milken had helped companies restructure their debt before they were forced to default. And he steadied market prices by buying the debt even when there were few other buyers. Now there is no true market maker willing to risk company assets on junk bond debt.

Additionally, some of “the biggest and the brightest” bond issuers defaulted, said John Lonski, senior economist with Moody’s Investors Service in New York. At the same time, savings and loan regulators, who had always been skittish about the risky bonds, won changes in industry rules that forced S&Ls; to sell their junk bond holdings over a five-year period. Insurance regulators in several states also tightened up, limiting the amount these companies could invest in junk bonds.

In short, the market is flooded with sellers. And although a handful of scavengers have emerged in the past several months to pick up the most undervalued issues, in no way do they make up for the loss of the big institutional players who served as the market’s ballast in past years.

To add insult to injury, economists are now predicting an economic slowdown, which would create further risks for highly leveraged firms, Lonski noted.

All of this is also frightening away individual investors. T. Rowe Price said investors have pulled $400 million out of its high-yield bond fund since July, for example. And other mutual funds report similar investor drains.

“A whole group of buyers is history and has to liquidate. You are tarred with moral opprobrium if you own a junk (bond), and you have the credit problems that started out with Campeau this summer and that are evidently continuing,” said Thomas Revy, managing director of Froley, Revy Investment Co. in Los Angeles. “It is no longer chic to be in junk bonds.”

The effect on market prices has been dramatic.

Since September, when Campeau announced its problems, prices for a wide variety of bonds have fallen precipitously. Although troubled companies, such as Federated and Allied, have been hit the hardest, even healthy junk bond issuers have found the value of their debt issues sliding.

Federated Stores’ subordinated discount debentures now sell for 4 cents on the dollar, down 87.5% from their market price four months ago. One issue from Allied Stores now sells for 9 cents on the dollar, down more than 80%. But bonds issued by R. H. Macy--a healthy firm--have also been hit.

“Macy’s 14.5% bonds were selling for $95.75 on Dec. 13. But on Dec. 21, they’re worth $85.50,” said Ana Marshall, portfolio managing assistant and trader at Caywood/Christian. “Macy’s is a quality issue.”

Overall, market prices have slipped by about 10% in just the past few months, added Ronald Vannuki, managing director of Drake Securities in Los Angeles. And if the seller is anxious, they could find they get even less for their bonds.

And bonds that are perceived as problematic cannot be sold at all, Kimble said. He would not specify which issues are currently in this predicament because “when you’ve got some of these in your portfolio, you don’t want anyone to know about it,” he said.

Meanwhile, a number of investors have begun to hunt through the ruins of the junk bond market, searching for bargains. These scavengers believe that bonds have fallen too far too fast and that the market is due for a recovery. But other industry experts disagree.

“The junk bond market has become anxious, quietly fearing more upsetting news,” Lonski said. “I would like to think that most of the damage has been done. But I don’t think we have turned the corner, and I don’t think we will until the danger of recession has passed.”

THE JUNK BOND MARKET’S BIG LOSERS

The table shows the drop in bid prices and the percent change for selected junk bonds from Sept. 1 through Dec. 20.

Approximate bid price Percent Issuer Issue Sept. 1 Dec. 20 Change Federated Dept. Stores Subordinated $32 $4 -87.5% discount debenture, due 2004 Allied Stores 11.5% senior $49 $9 -81.6% subordinated debentures, due 1997 Federated Dept. Stores 16% senior $82.50 $17 -79.4% subordinated debentures, due 2000 Southland 16.75% $75 $17.50 -76.7% subordinated debentures, due 2002 Southland Junior discount $61 $20 -67.2% subordinated debentures, due 2007 Western Union 19.25% senior $81 $35 -56.8% secured reset notes, due 1992 Memorex/Telex 13.25% senior $100 $45 -55.0% notes, due 1996 Supermarkets General Subordinated $64 $40 -40.3% discount debentures, due 2003 Wickes 11.875% $68 $45 -33.9% subordinated debentures, due 2001 Griffin Resorts 13.875% senior $67 $48 -28.4% secured reset notes, due 1998

Source: Houlihan, Lokey, Howard & Zukin Inc.