Junk Bonds Once Again the Rage on Wall Street

The junk bond market, practically moribund two years ago, is poised to set all sorts of records in 1992, including the sale of more than $37 billion new below investment-grade bonds.

The revival in new offerings this year dwarfs the record $31.9-billion new-issue market in 1986, when junk bonds were the darlings of the U.S. capital market. So far this year, junk bonds have outperformed every sector of the U.S. stock and bond markets, with average returns of 14%.

“It’s been a great year,” said Robert Kricheff, head of the junk bond research group at First Boston Corp. Said Kingman Penniman, a Duff & Phelps/MCM analyst: “Even the most optimistic couldn’t have expected this recovery.”

Companies such as Owens-Illinois Inc., Safeway Stores Inc., RJR Nabisco Inc. and Coltec Inc. sold about $28 billion of junk bonds this year amid the lowest long-term interest rates in six years. Fort Howard Corp., TW Holdings Inc. and Dr Pepper/Seven-Up Cos. plan to sell at least another $15 billion.

Companies “judged to be of adequate credit quality or of making good on their IOUs have the opportunity for refinancing high-cost debt or bank loans,” said John Lonski, a Moody’s Investors Service economist. “The savings, in some cases, can be quite large. You’re going from a 15% to 16% interest rate coupon down to a coupon of 10% to 11%.”

Lonski estimates that as much as 85% of the junk bonds sold this year will refinance more expensive debt.

To be sure, the $210-billion junk bond market isn’t what it used to be. That’s because many companies aren’t getting healthier in the sluggish economy, said Joseph Bencivenga, co-head of research at Salomon Bros.

Average operating margins, defined as earnings before interest, taxes, depreciation and amortization divided by revenue, for 300 junk bond companies tracked by Salomon declined to 9.4% in June from 10.4% a year earlier, he said.

“From year to year, interest expenses for these companies are down $5 billion,” Bencivenga said. “But the underlying businesses (aren’t) getting any better.”

The anemic recovery hasn’t deterred investors, mainly mutual funds, from snapping up junk bonds, those rated below Baa3 by Moody’s Investors Service and BBB- by Standard & Poor’s, Bencivenga said. In a bid to bolster returns in a year when the yield on the 30-year Treasury bond is hovering below 7.5%, mutual funds are lapping up junk.

The gap between the yield on the average junk bond and comparable Treasury security is 5.5%, said First Boston’s Kricheff. By the end of August, junk bonds returned about 14%, 10-year Treasury notes were up about 4.76%, and the Standard & Poor’s 500 index was up about 1.27%.

The average junk bond mutual fund returned 14.8% through August, according to Lipper Analytical Services, which tracks mutual funds. Meanwhile, long-term government bond funds had average returns of 4.9%, and equity funds had a negative return of 1.4%, Lipper said.

“I think that junk bonds are an attractive alternative for every fixed-income investor,” said Carl Ericson, who manages $710 million of bonds for Colonial, the Boston mutual fund company.

One reason is that junk bond companies and their bonds are less risky than they used to be, Ericson said. In the 1980s, many companies sold bonds with exotic names such as “junior subordinated discount debentures,” or “junior pay-in-kind notes,” that didn’t pay cash interest and were the last to be paid if the issuer went bankrupt. Now most junk bond companies sell “senior notes” or “senior subordinated debentures.”

In addition, most of the junk bonds sold these days are higher rated than those sold in the 1980s. About 60% of junk bonds sold in the first half of the year were rated BB and the rest had B ratings, according to Standard & Poor’s. In the 1980s, about 80% of junk bonds had B ratings.

In August, companies sold $2.7 billion of junk bonds and retired $2.3 billion of higher-cost debt, according to First Boston. In June, sales totaled $2 billion and corporations retired $3 billion of junk bonds.

RJR Nabisco, a $32-billion leveraged buyout, pared $1 billion from its interest expense in 1991 by redeeming high-cost debt through sales of junk bonds and stocks, Treasurer Fred Zuckerman said.

RJR Nabisco reduced interest costs in this year’s first half when it bought back about $1.2 billion of bonds with interest rates of 13.5% to 15%, he said, declining to elaborate on the total interest savings so far this year. This month, RJR Nabisco sold 11-year notes with a yield of 7.68%.

Meanwhile, more companies are selling junk bonds to raise new funds instead of paying off old debt. American Re Corp. sold $450 million of bonds yesterday as part of its new $1.43-billion leveraged buyout by Kohlberg Kravis Roberts & Co.

Junk bond companies are also starting to sell more exotic securities, said Penniman of Duff & Phelps/MCM. For example, Dr Pepper/Seven-Up said it plans to raise about $375 million by selling zero-coupon bonds as part of its $1.37-billion recapitalization plan.

As junk bonds are more risky than investment-grade bonds, investment bankers can charge companies more to sell them. For example, investment banks typically charge corporations with investment-grade ratings $6.50 per $1,000 bond in commissions for a sale of 10-year debt securities.

American Re, a Princeton, N.J., reinsurance company, paid Merrill Lynch, the underwriter, $35.60 in commissions for each $1,000 bond.

So far this year, Merrill Lynch is the leading underwriter of junk bonds, with total sales of about $5.1 billion. Goldman, Sachs & Co. is next with about $4.1 billion, followed by First Boston with $3.6 billion.

That’s a turnaround from two years ago, when the junk bond market collapsed amid the fall of Drexel Burnham Lambert Inc., the biggest underwriter and trader of below investment-grade bonds. In 1990, junk bond sales totaled $1.4 billion. Last year, they reached $9.9 billion.

Salomon’s Bencivenga, who worked at Drexel as an analyst before the firm went bankrupt, said the junk bond boom may be overblown. Junk bonds could crash when the stagnant U.S. economy revives, he said.

“When you start having a recovery, interest rates generally go up, making high-yield bonds less attractive,” he said. “If mutual funds, which now account for 75% to 80% of demand, start to sell, I have one question: Who is going to buy?”

Bencivenga admitted that his view may be wrong. Since the start of the year, he revised his estimates of junk bond returns to more than 20% from 15% and his forecasts for junk bond sales from $15 billion.