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For Junk Bonds, Stain of the Past Is Long Forgotten

March 01, 1998|TOM PETRUNO

When Michael Milken stood before a federal judge in April, 1990 and pleaded guilty to securities law violations, more than just his career appeared to be dying.

The "junk" bond market Milken had molded into a powerful financial force in the 1980s--a major capital-raising vehicle for legitimate companies and some not-so-legitimate chief executives and corporate raiders--was in the process of violent collapse.

Milken had in the 1980s convinced a large number of investors that high-yield, high-risk bonds weren't junk at all, but gold. While some of the deals would of course go bust, Milken insisted that the overall returns on the bonds would be so good that the effect of the bad bonds would be almost irrelevant.

But with junk-issuing companies' default rates soaring in 1990--which had as much to do with misguided federal regulations and the onset of recession as with Milken's demise as the junk market's chess master--high-yield bonds came to look like Wall Street's Big Lie.

Last week, Milken's name returned to the headlines, once again connected with allegations of wrongdoing. This time, he agreed to pay the government $47 million to settle charges that he advised companies involved in two large investment deals in the mid-'90s, even after the Securities and Exchange Commission had banned him from the business.

Clearly, the government never liked Milken or his bonds, and the hostility may be perpetual. But the marketplace's assessment of Milken's idea--if not its assessment of the man himself--has been quite different: Instead of fading away after its 1990 crash, the junk sector--officially, bonds deemed less than "investment grade" in quality--went on to become the single most successful segment of the U.S. bond market in this decade.

Last year, in fact, set a record for junk-bond issuance, as more than $142 billion worth of the securities were sold to investors. And issuance this year is running far ahead of last year's pace, with $22 billion sold since Jan. 1, versus $12 billion in the first two months of 1997, according to Securities Data Co.

Individual investors have made junk-bond mutual funds their favorite bond fund category, other than municipal bond funds: Junk funds' assets now total $94 billion, up from $21 billion in 1990. (In the same period, assets of funds that invest in long-term U.S. government bonds have actually fallen, from $45 billion to $33 billion.)


Perhaps most striking is the default experience of junk-bond investors in the 1990s compared with the 1980s. Data from the Bond Investors Assn. in Miami Lakes, Fla., show just how tough it has been to pick a true loser in the junk sector this decade:

* The junk default rate--that is, the percentage of each year's crop of newly issued bonds that eventually miss an interest or principal payment--has yet to exceed 20% in the 1990s, and has been 11% or less since 1992.

* By contrast, roughly half of the 1,037 junk bond issues sold between 1980 and 1985 eventually went into default.

The numbers suggest that many of the early-1980s deals underwritten by Milken through his now-defunct investment banking firm, Drexel Burnham Lambert, weren't nearly as sound as Milken expected them to be.

Indeed, as Milken and Drexel exited the scene in 1990, many of the junk-issuing companies they supported quickly ran aground as well--names like Charter Medical, U.S. Playing Card and Swan Brewery, for example.

By early 1991, the whole notion of high-risk companies raising capital by selling high-yield bonds was widely discredited. And the idea of using such bonds to finance takeovers and leveraged buyouts--the schemes Milken may (unfairly) be best remembered for--became virtually unspeakable.

The government sent Milken to prison on charges that basically amounted to market manipulation, and it was true that, at his peak, he exercised enormous control over who issued junk bonds, and who bought them.

Without Milken, the junk market initially appeared lost. But its collapse in 1990 was worsened by the global recession triggered by Iraq's invasion of Kuwait (as corporate earnings fell, so too did companies' ability to pay their debts), and by the government's ill-advised decision in the summer of 1989 to order savings and loans to dump their junk-bond holdings, a move ostensibly aimed at lowering the risk in S&L investment portfolios.

As sellers flooded the junk market with securities, the face value of many of the bonds fell 30% to 50% or more in 1990.

It was, however, a fantastic buying opportunity for the brave: As the economy rebounded in 1991, so too did investors' assessment of many of the junk bonds that had been trashed in 1990. Merrill Lynch's index of junk bonds posted a spectacular total return (interest earnings plus principal gain) of 35% in 1991.

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