There are still gold nuggets in junk
Drexel was first into junk bonds; now there’s a gold rush – how much is worth competing for?
Very little is standard in the junk bond market. Issues range from billions to a humble $25 million. The issuers vary from such household names as Beatrice Foods and Safeway stores to obscure start-ups whose stocks trade at premiums of 10 or 11 times book value. In the secondary market junk bond prices are, at best, subjective. Apart from the big restructuring deals, few dealers bother to make prices in other houses’’ deals. Most junk deals are single-house without syndicates or underwriters.
The absence of standards reflects the merchandise the market trades in. In the junk bond market nothing can be taken on trust. Each issue, even one for the same borrower, is distinct and trades differently. The only route to successful involvement in junk is through analysis. "Anybody who says this market is a mathematical market – one where you play the percentages – is a fool, declared the managing director in charge of one junk operation.
Yet this market continues to attract some of the most respectable firms on Wall Street.
No wonder. Whereas investment grade corporate bonds provided lead managers with fees of between ⅜ and ½% (rising to a maximum of ⅞% on a long-term deal), junk bond deals generally pay underwriting and selling commissions of 3%.
Junk bonds accounted for over 20% of the funds raised by corporate bonds in the US last year.
According to the Securities Data Company new issue volume in the corporate bond market was a record $161 billion. Issues with "below investment grade ratings" – junk, in other words – came to $33 billion. Technically, junk bonds carry a rating of less than Standard & Poor’s BBB.
Last year’s output was a record for the junk bond market. The year before it did not reach $17 billion. Few investors and traders agree about the exact size of the market. Most reckon there’s between $120 and $130 billion of junk issues outstanding. Some argue that the true figure should be $10 to $15 billion higher to take account of the large number of preferred stock issues. Like junk they have no security in the event of liquidation.
Despite the record volume, last year was a harrowing one for the junk market. It took some of its biggest knocks since the spate of railway bond defaults in the 1970s. In July, one of the market’s biggest issuers, the steel company LTV, filed for protection from its creditors. And in November, Ivan Boesky, the disgraced arbitrageur, acknowledged that he had used inside information to make money.
"We are sorry we ever had Boesky for client," said Fred Joseph, the chief executive of Drexel Burnham Lambert, the company that brought the market out of the despair of the 1970s.
Envious Wall Street rivals were quick to point out that Drexel’s position as the top junk bond house, handling nearly 50% of all the public issues, owed a great deal to the boom in hostile takeovers.
Drexel’s normal procedure has been first to secure commitments from bond buyers and then to write to the takeover bidder that it is "highly confident" of pulling together the financing if the bid succeeds.
Drexel’s junk bond operation in Beverley Hills, headed by Michael Milken, has been much criticised. Drexel has admitted that Milken has been subpoenaed to give evidence, either to the Securities and Exchange Commission or to a Federal grand jury in Manhattan – the firm refused to tell Euromoney which. It has, however, expressed complete confidence in Milken. A Drexel spokesman has admitted that the SEC investigation has hurt.
Besides, Drexel suffered other blows. The Beverly Hills operation had its first major defection when Eugene Wong, who like Milken was a senior vice president, left to take over Pru-Bache’s junk bond division.
Rivals claim that this is only the first crack in Drexel’s hold on the junk market. "Borrowers are not going to go on relying on just Drexel with all the uncertainty about," said one.
One of Drexel’s traditional clients, the LBO house, Kohlberg Kravis Roberts, said it would use bank credit to finance a bid for the paper maker Owen Illinois.
This looks like diversification away from junk bonds, rather than a rejection of Drexel; KKR did not turn to one of the Wall Street firms trying to break Drexel’s hold on the junk bond market.
All the special bracket firms, with the exception of Goldman Sachs, which has limited itself to restructuring deals, have made a determined effort to push in.
Drexel’s difficulties did more than provide an opening for Morgan Stanley, Merrill Lynch, Shearson Lehman, Salomon and First Boston. They hit a market that was already reeling from LTV’s default in the summer.
The easiest way to judge the strength of the market is to compare the spread of a junk bond index over Treasuries. The strength of the Treasury rally throughout most of 1986 kept the spread wide. When it looked like closing in late spring and early summer, LTV knocked it out again. In the month of the LTV default, the spread, as measured by the Merrill Lynch index of 110 bonds, jumped 40 basis points. The following month it moved out almost as much, but it then moved down until Boesky confessed, when it moved out another 20 basis points.
The spread at the end of the year of 530 basis points over Treasuries is historically high. Part of that is due to the fact that last year all the better US markets outperformed their inferiors; the Dow Jones Industrial Average beat the Nasdaq indexes; Treasuries outperformed every other sort of bond. The junk market was hit by this flight to quality.
The prospects for the market this year look good. The US economy, leading economists say, will grow feebly; but interest rates will not rise. This is crucial, as the biggest issues of junk last year were to finance leveraged buy-outs, acquisitions or recapitalisations. A rise in interest rates might upset these big issuers’ cash flow projections. High interest rates would cause problems because corporations that issued junk bonds as part of a financing also have hefty floating-rate secured bank debts. These come before junk in the queue of creditors at the cash flow window.
At the end of the year there was even a flight to quality in the junk market. The big, better-quality LBO deals began to trade at tighter spreads to Treasuries. “Investors were prepared to give up some yield for some security," said Kidder, Peabody’s managing director in charge of high yield, Guy Minetti. "We turned over an awful lot of Beatrice Foods in December." Already the gap between similar credits – whose bonds have different liquidities – is closing. "Investors are again looking to pick up yield," said Minetti. They’ve had to look in the secondary market because there have been so few deals in the primary market. That should change as some of the bridge financing deals, such as First Boston’s for Campeau’s takeover of Allied stores, come to be refinanced in the junk market.
Investor interest, as measured by the flow of money into the mutual funds, has recovered from a slight setback after Boesky’s confession. This is partly due to the changes in the US tax code. Equity investing which relies on capital gains is not so attractive as it used to be.
One of the biggest mutual investors in junk is Putnam Fund Managers. Felix Smith, who has been following the junk market for over 10 years and running Putnam’s high-yield funds for nine, reported that despite the record level of defaults last year, money is still flooding into his funds. "We’re taking in between $500,000 and $1 million a day," he said. Putnam took the unusual step of capping (turning away potential investors) its first junk bond fund in April 1986. The fund then stood at $2.1 billion. Putnam then set up another fund, which had grown to $210 million by the end of the year.
Small funds are nimbler than big ones. Big funds tend, inevitably, to resemble the markets they are supposed to be outperforming. In junk, the problem becomes more acute because the market is so heavily biased towards troubled industries such as energy and communications.
"Because it had to keep on investing, the first Putnam would, if it had gone on, have ended up looking like the market. It would have become less diversified as it bought more and more energy and communications companies issues," said one analyst.
The flow of money to junk bond mutual funds is crucial to the survival of the market. Experienced junk marketeers reckon that mutual funds and insurance companies hold two-thirds of the market. The remaining third is shared between pension funds, thrifts, foreigners, individuals and trading inventories.
The insurance companies are more inscrutable. Few are heavy investors in junk, but the increasing popularity of Guaranteed Investment Contracts (GICs), which often depend on high yielding junk issues to make the numbers equal the promises, should keep them interested. Insurance companies, along with Savings and Loan Associations, are the most susceptible to regulatory curbs on junk investing. Indeed, just before Christmas the New York State Superintendent of Insurance recommended that the insurance companies he’s responsible for should not invest more than 15% of their assets in junk. Only two small companies have anything approaching that.
Although most of the major junk bond underwriters remain convinced that the market is going to be dominated, on both sides, by the US, that has not stopped them proselytising internationally, especially in Japan, which, according to one house, has already taken $1 billion in junk bonds. It estimates this could grow to $5 billion within a year or two. Milken recently spent a fortnight in Japan. Salomon Brothers held junk bond conferences in Osaka and Tokyo at the end of last year and claim that they generated substantial interest. “It’s logical to assume that when the US Treasury bond market yields relatively little compared with Japanese bonds, Japanese investors will start to look at high yielding assets," said Salomon’s managing director, Warren Foss.
Asset swaps involving junk bonds, which Salomon forecasts will grow this year, should help the Japanese into the market. But it’s unlikely that LBO junk will be swapped, because it’s too long-term. "Who will take a 14-year credit risk?" said Kidder, Peabody’s Minetti.
The most likely sources of asset swaps for junk issuers are private five-year deals. These may suit the Japanese. In Europe, they have been contented consumers of fixed-rate bonds which have been swapped into floating-rate assets. Junk bonds certainly have large enough spreads over the potential benchmarks of Libor or Treasuries to facilitate such swaps.
The problem with junk bonds lies in getting the credit accepted. International investors react to junk bonds in the same way as they do to US corporate Eurobonds: if they recognise the name they are more likely to buy the bond. Some investment bankers even argue that international investors buy junk bonds as surrogates for stocks. "In Japan most interest is coming from equity orientated accounts," said Merrill Lynch’s managing director, Ray Minella. "Investors who are expert in consumer foods or retailing have the right knowledge to buy those companies’ high yield securities."
Several junk bond originators point out that junk bond deals could easily start coming to America from abroad. Already the market has absorbed issues from the Australian Bond Corporation. Israeli companies, notably Koor, have also floated issues in the US. But, so far, Europe has seen few of the huge leveraged buy-outs and restructurings that have powered the US junk market’s growth. Foss expects to see more of those deals happening internationally, especially in the UK.
"Merrill Lynch has traded its way into the market," said Kevin Perry, portfolio manager, endowment management. "Drexel doesn’t dominate the secondary market as much as the primary."
Domestically, the market is still dominated by Drexel. It did 46% of the new issues last year. Its nearest rival Merrill Lynch accounted for 10%. Salomon, 1985’s runner-up, and Morgan Stanley virtually shared third spot with 7.5%. Although the amount of money raised from the junk bonds all but doubled in 1986, the number of issues rose only from 190 to 225.
Last year’s market was dominated by large issues which leveraged companies. Fruehauf, Colt, National Gypsum, Safeway and Southmark all did huge deals. The previous year the market had a different emphasis. In 1985 over 22% of the money raised went to non-rated companies. They were generally start-ups, from People Express to plastic bag manufacturers. Last year that sector accounted for only 6.6% of the money raised. It even fell in dollar terms from $3.7 billion in 1985 to $2.5 billion in 1986.
Junk issues by small companies are hazardous. Markets are thin and bankruptcy can be sudden.
So far none of the large acquisition, LBO or restructuring deals have come unstuck. Large corporations, like small ones, may go bankrupt, but their declines are easier to keep track of. Take the steel company LTV, the junk bond market’s largest default yet. When LTV originally issued the bonds it is now defaulting on, it was an investment grade company. The bonds were, unlike most junk issues, secured on LTV’s assets. There is now a minor scramble for those bonds which seem to have the security of LTV’s potentially profitable aerospace division. Investors argue that, if the company is reorganized in Chapter 11, the aerospace division might be spun off. That would make the bonds either eligible for repayment or, possibly, for an equity stake in the newly capitalised company.
It is the obscure names like the paint company Mary K, brought to market by Morgan Stanley, or Bear Stearns’ disastrous and embarrassing deal for the defence contractor Wedtech, which push the junk market’s default rate up. Wedtech went into Chapter 11 before it had made the first interest payment on a $75 million junk bond it issued in August last year.
Even the rate of default in the junk market is a matter of dispute and interpretation.
Sometimes a company dodges default through a judicious exchange offer. Called, in junk jargon, 3A9s, after the section of SEC rules which allow securities to be exchanged without the issue of a prospectus, they’re the last exit before Chapter 11. Exchange offers allow companies to alter the original terms of a deal, for example by paying dividends in common stock rather than cash, or simply reducing the dividend. The small office equipment supplier Savin Corp was rescued in this way through an exchange offer organized by Drexel, which pioneered the technique. Also rescued was the US movie maker, Cannon Group.
All exchange offers are the result of negotiation. There’s no fixed percentage of the bond holders who have to agree before an exchange goes through but it’s generally over 70%. That is similar to the two-thirds who have to agree to changes in investment grade bonds.
Investors generally seem to prefer an exchange offer to an outright default. Drexel will also take investors out of bonds. "Drexel will swap you if you’re willing to lose your head as well as take a haircut," said Putnam’s Smith. But even Drexel couldn’t stop Flight Transportation defaulting a fortnight after issuing a bond in 1982.
"Drexel are one of the better firms," said one portfolio manager with over $1 billion in junk. “Their due diligence is good."
But the level of clear default – defined as the non-payment of interest and principal – does seem to have jumped in 1986. Analysts suggest it’s running at around 3 %, well above the average of 1.52% in the last 12 years. Bullish junk analysts, such as Robert Waill from LF Rothschild, compare the default rate to university admissions. "Some colleges have admission requirements, others have open enrolment," he said. "Under open enrolment you’re giving a chance to thousands of people, but your failure rate will be higher. It’s the same in high yield."
Although the start-ups are vulnerable, some of the large LBO deals might also come unstuck. "The LBO concept of owner-management in mature industries with stable cash flows and high debt is entirely new," said the head of one junk bond operation. "The big ones like Beatrice and Storer Communications should be secure, but I wonder about some of the others like Fruehauf and Revco. The risks are simply the dollar amounts these companies need to generate."
Nevertheless, junk bond investors tend to prefer them. For one thing they’re more liquid. Three or four houses make good markets in deals like Storer, Colt Industries, Fruehauf and Beatrice. Investors cling to the belief that so long as the bonds are backed by piles of easily realizable assets, cash flow shouldn’t be a worry. That enabled Turner Broadcasting to forecast negative cash flow and still sell bonds to pay for its takeover of MGM. "We have our heaviest positions in companies which can sell assets and generate cash flow," said Aiden Hatton, chairman of the Trustees of Alliance Capital’s high-yield bond fund, which manages about $1 billion in junk bonds.
Other investors, such as Endowment Management, use the junk bond market to trawl for bargains. Working against a model of the US economy, the fund sector rotates, picking bonds from industries which are coming out of cyclical decline. This year has been quiet in the market. But the major houses are braced for an active time – $2.5 billion in new issues – in the next couple of months. "I think you’ll see more refinancings and more capitalisations this year," said William Forrester, Shearson Lehman’s managing director in charge of high yield. Not only is the Campeau deal in the works but there’s Kidder’s $450 million recapitalisation of Petro-Lewis for Freeport McMoran and the Holiday Inn $500 million recapitalisation.
Refinancings would be a new departure for the market. “There’s plenty of debt out there from 1981 and 1982 which acquired coupons of 15 or 16% which could be refinanced at 12%," said Guy Minetti. It hasn’t been touched before because of the general provision of five-year call protection. "We’re looking very closely at the call protection for the bonds we hold," said Putnam’s Smith.
Issuers without call options have to tender for their debt. That can prove expensive if the Union Carbide deal is anything to go by. Union Carbide brought back $2.5 billion of its debt late last year. It paid for it by selling some of its subsidiaries. The prices it paid for $2,198 million of its debt, which carried coupons from 15% down to 13¼%, ranged from $133 (for each $100-worth of bonds) to $115. "We tendered and made over $70 million," said Putnam’s Smith. Navistar, formerly International Harvester, did a similar deal, paid for by an issue of common stock, at lower premiums.
Another reason for refinancing arises when part of the senior bank debt has been paid Beatrice Foods, for example, refinanced its junk debt after 50% of the bank loans were paid. Generally, the bank takes the shorter maturity debt in an LBO and restricts the borrowers’ ability to take anything shorter.
The market has seen plenty of innovations. Zero coupons, floating-rate and convertible issues have all been done. Then there have been discount stepped notes, such as Shearson Lehman’s for Doctor Pepper. The triple-C rated bonds pay only 8% interest for the first three years of their life, then 12¾ for the remaining 12.
Innovations peculiar to the junk market include deals with registration rights. These start off as private placements – and so do not need SEC filing – but give the issuer the option to file with the SEC within a specified time. If he doesn’t, the interest rate jumps up a point.
Despite the high coupons, the junk bond market hasn’t outperformed the other fixed-interest markets in terms of total returns to investors. Treasuries Iast year brought investors a return of around 30% on their money. Junk managed about 20%. The fall in US interest rates has yet to pull up the junk market. Barring a series of large defaults, that should change this year.
Junk CP has never defaulted
Like its bigger bond brother, the junk commercial paper market is dominated by Drexel Burnham Lambert. Edward Virtue, vice president in Drexel's commercial paper department, put the size of the market at around $4.5 billion. "We've done the lion's share of it," he added.
Salomon Brothers, Drexel's main rival in the unrated market, took a more moderate tone. "There's a reasonably growing demand for unrated commercial paper from a fairly broad list of buyers," said the managing director, Warren Foss.
Some of the usual junk bond buyers buy unrated commercial paper, but the securities also appeal to more cautious investors. Few foreign investors have discovered the market, although some Japanese institutions buy it in the US. "We're exploring selling high yield commercial paper through our offices in Europe and Tokyo," said Virtue.
Issuers in the market include some well-known names. Avis, the car hire company, has a $300 million programme. International Harvester, now known as Navistar, has one of the largest programmes – $400 million arranged by Shearson Lehman Brothers.
Corporations issue unrated commercial paper for two main reasons, either because it's cheaper than a letter of credit or because they want their names in the market. Generally, unrated commercial paper pays between ½ and ⅞% over Libor. Like the market in the lowest rated commercial paper (A3/P3) this market is tidal; in December both markets were virtually dry.