Now that we know a bit more about the role of credit rating agencies in the entire bond issuance process, we can get acquainted with a particular type of bonds that became popular in the 1980s and were introduced by an investment bank called Drexel Burnham Lambert.
Ironically, that same bank collapsed in 1990 due to its illegal activities dealing with this type of securities. That’s right, I am writing about junk bonds and we are stepping into dangerous territory. Junk bonds are also known as high-yield bonds, which means that these securities pay a very high coupon and can be very profitable for lenders if things go well, but also that there is a non-negligible chance that things are not going to go well.
As you can infer by their name, junk bonds are debt securities of lower quality with respect to normal investment grade bonds. They are issued by firms that have a lower probability of repaying what was borrowed compared to traditional investment grade bonds. Most companies, governments, or government entities assessed by credit rating agencies have a positive rating. But there are also those with a rating that is lower than double B according to the S&P scale or B according to Moody’s scale.
Such borrowers are deemed more likely to default compared to others with an investment-grade credit rating. The idea of issuing junk bonds is very similar to that of providing high-interest-rate loans to individuals with low income. A significant number of such borrowers will default and will be unable to repay their loans. However, the high interest charged should compensate for that and make the operation profitable for lenders. This is very similar to non-investment grade companies, governments, or government entities in need of funds and opting for junk bond issuance.
They will have to pay a very high coupon and borrowing funds at a high interest rate makes it even more difficult to overcome financial difficulties in the long run. Nevertheless, the lack of alternatives and the urgent need of financing will result in junk bond issuances. Some investment managers believe that investors’ appetite for junk bonds is indicative of the economic cycle we are in. It is believed that if investments in junk bonds decrease, the economic cycle is about to turn and a recession is on its way.
