Junk bonds
Junk bonds are financial instruments issued by higher-risk companies that offer potentially high returns to investors willing to take on greater risks. Typically rated below "B," these bonds are often associated with start-ups or expanding businesses that may struggle to repay their debts unless successful. During the 1980s, as the U.S. economy improved, junk bonds gained popularity, offering double-digit interest rates that attracted individual investors and institutional players alike. Major firms like Drexel Burnham Lambert became leaders in the junk bond market, facilitating not just funding for startups but also enabling aggressive corporate takeovers by so-called "corporate raiders."
While some viewed these raiders as catalysts for efficiency, others criticized their methods, which often led to significant job losses and corporate restructuring. Anti-takeover strategies like "poison pills" were developed to protect companies from hostile acquisitions. However, by the late 1980s, the junk bond market experienced a downturn, leading to regulatory changes and a substantial reduction in their appeal. Overall, junk bonds played a complex role in the financial landscape, generating wealth for some while posing considerable risks to others.
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Junk bonds
High-risk, high-yield securities
During the 1980’s, junk bonds helped fuel the frenzy of corporate mergers and acquisitions by producing the enormous amounts of capital required for companies to purchase other companies.
Bonds are financial instruments issued by public and private entities that promise to repay the principal invested plus interest on or after a specified date. Brokers rate bonds based upon their trustworthiness, that is, the likelihood of investors actually receiving the promised return-on-investment. Bonds with assured returns are rated “A,” while riskier ones are rated “B” or even “BB.” Low-rated bonds may be issued by start-up or expanding companies, which will be unable to repay their debts unless their business ventures are successful. To convince investors to take higher risks on their bonds, such companies offer greater rates of return than those available to investors in A bonds.
As the U.S. economy improved during the 1980’s, the public looked for lucrative investment opportunities. Stockbrokers sold B bonds directly to individual investors wishing to play the market. By 1984, “junk bonds,” as B-rated offerings were labeled, were offering double-digit rates of return. Start-up companies sold junk bonds to fund their initial operations. Large firms like Dean Witter and Paine Webber began selling them, and Drexel Burnham Lambert had been brokering junk bonds since the 1970’s. By the 1980’s, Drexel was the leader in junk bonds, which had generated significant wealth for the company. Even Savings and Loans (S&Ls) bought junk bonds as investments, because federal law could be interpreted to mean their speculation was insured against loss.
New tricks were improvised: Junk bonds financed hostile takeovers over one company by another, sometimes termed a “corporate raider.” Raiders sold their own junk bonds to raise the money necessary to buy controlling shares in their target companies. Once in control, raiders divided acquired companies and sold off their various components, paying back bond holders while netting a large profit for themselves. This practice put both management and regular employees of the scavenged companies out of work. A variation on this approach was called “greenmail.” The greenmailer bought controlling interest in a company but offered to sell it back at more than its market value. If this arrangement was agreed to, everyone kept their jobs while stockholder dividends plummeted.
T. Boone Pickens and Saul Steinberg were the most famous raiders of the 1980’s. Some considered them heroes for making companies more efficient to avoid hostile takeovers; others saw them as villains for tearing businesses apart and increasing Wall Street’s debt. One anti-takeover maneuver employed by potential targets was to “swallow a poison pill”: That is, vulnerable companies would issue junk bonds paying great dividends if the company was broken up. Raiders would be required to pay those dividends out of their own pockets, preventing them from realizing profits and making the companies unattractive acquisition targets. Another strategy was to find a “white knight,” a company that would agree to a friendly merger with the target company, thereby forming a new company that was too large to raid.
In 1986, financer Ivan Boesky was accused by the Security and Exchange Commission of getting insider information about unannounced takeovers. He wore a government wire to incriminate others—especially Drexel executives—who were funneling him information and secretly buying stock for him. Boesky served two years in prison. Michel Milken, the Drexel junk bond executive, also served two years for dishonest dealings. Both left prison wealthy men, Milken a billionaire.
Impact
By 1989, the junk bond flurry was over. Congress forced S&Ls to divest themselves of junk bonds. So many were on the market, there were no buyers. Junk bonds made billions of dollars for entrepreneurs, funded some start-up companies but destroyed others, and induced companies to merge and grow larger.
Bibliography
Bruck, Connie. The Predator’s Ball. New York: Penguin Books, 1989.
Stewart, James B. Den of Thieves. New York: Simon & Schuster, 1992.