Now let's say a few words about facts surrounding junk bonds.
Well first of all, what is a junk bond?
So I'll put like junk bonds (facts).
Well by definition, a junk bond is the one that
is rated below investment grade bond.
So the fact that this is risky,
this is sort of a qualitative description or it may be not rated at
all because rating agencies what their job
is it's they just put labels on this bond is investment grade,
this bond is investment grade,
this bond is on the verge,
and this bond is junk.
Why are they doing so?
Because their recommendations and their ratings are key in decisions that they're made by
some large financial institutions
whose guidelines allow them to invest only in let's say investment grade bonds.
That goes for pension funds,
that goes for some other huge funds.
So, we are talking about
very large financial institutions and they always refer to the quality of this debt.
Now, so we can say that this is
a bond without
investment grade rating.
Well to give you an idea if we take these ratings,
the threshold that sort of below are junk,
above, this is investment grade.
So for Moody's, it normally is BA and for S&P it's BBB,
so all ratings that are below that are thought to be junk.
Now, here we come
to the idea of what historically the junk was.
First of all, historically these are so-called fallen angels.
Again, we mentioned that before.
Let me briefly remind you that the problem of the bond is it's long maturity.
When the bond is issued, the corporate bond,
then it has maturity of up to 30 years.
A lot can happen to a company over this long period of time.
It's more than the life of a generation and therefore let's
say when the company issues bonds or borrows money from the public,
it may be doing perfectly but then 10 years on,
15 years on, the company may lose part of it's brilliant advantage or whatever.
And as a result,
the company starts doing much more poorly and the people who hold
these bonds they face a much vaguer perspective of their redemption.
So that is a process by which formally investment grade
nice bonds over the passage of time can become junk.
And that was the only way to produce these junk bonds for the vast majority
of time before the issue of first bonds that were junk when issued.
This first issue happened in 1977.
And ever since for about 15 years,
the junk bond market had been growing very fast in the 80s, somewhat explosively.
So, this is the historical idea.
And now there are some, like I said the 1980s,
this is sort of explosive growth of new issues.
Well immediately we have a question,
what happened during this period of time that fueled that explosive growth?
Well let's take a look at
the economic setup of that time.
Again, I'm not saying it's a repetition but we talked about in our capital markets course
when we mentioned the S&L crisis,
we said that the 80s was a very special period of time.
Let's recall something. First of all,
before there was high inflation.
Well, when inflation is high there are at least two important things
that contribute to this growth of the borrowing market.
Well first of all, you need more money because if inflation is high then
in nominal terms for financing projects we have to borrow more and more money.
And at the same time there is growing investors demand for that because people would
like to have really high yields to protect themselves against inflation.
So here we can see more money
needed and then there
is also investor demand.
So, roughly speaking, people were
ready for investing in something risky that would promise high yields to them.
High yields could go as high as to whatever 15 percent coupons and maybe
yield to maturities are up to
sometimes 200 percent just of the order of [inaudible] huge, huge numbers.
This is comparing to these days that's just unbelievable.
But that was not it because there was some kind of the environment in which people
were prepared to run faster because it seemed to be many more opportunities around.
So that was the time of deregulation on a massive scale, increased competition.
So people were sort of willing to engage in something that was new.
And on top of that,
we can also say that the thing that is sort of linked to that,
there was growth in external financing in general.
Now to that we have to add that at that time we did not have the global capital market.
It all happened later,
as late as many 20 years from that moment in time.
But the first seeds of that they were planted at that time people started to
look after some schemes to raise money not only nationally but also internationally.
That was the time when some new financial instruments were invented.
So that was the overall idea.
And against this background you can see that
some people were quite willing to invest in high-yield bonds.
So that's exactly what was happening.
And now, the final set of things about the facts here is,
were these junk bonds really junk if you will?
Because the idea is such let's say clearly they are
worse in quality than investment grade but how much worse?
Because when people say I am an investor and
someone says you can invest in investment grade,
this is one yield to maturity,
and this is junk.
And they can say well wait a minute,
if this is junk I require
a high premium to that because God knows what happens to this bond.
And then the market was studied.
It was studied first on the basis of these fallen angels.
And later when the new issue started to be
implemented and then people started to study this
and what they noticed was that investors in general were
requiring too much of a premium in terms of yield for that.
Just to give you an idea,
the mortality rates, so basically the rates of default,
happened to be lower than they had been predicted by
these premia and I'll mention just one thing,
that the historical spread over investment grades was found to be about two percent.
But the promised spread when
issuing was about 4.6 percent.
So to some extent we can say that
we're not talking about free lunch because these investors,
they indeed were taking risk but they required too much of a premium for that.
To a significant extent the growth from this market that is normally associated with
the famous company Drexel Burnham Lambert that
is long done and then the people like Michael Milken.
So they sort of identified this potential in this market when
they saw that if the people are willing to require that high a premium,
then by showing them that actually the risk is not so
great you can attract many more people
to invest in these bonds and that's exactly what happened.
Now here we can see that the overall idea
of a junk bond is specifically with this classic name,
it sort of gives you an idea that this is something bad or something too much risky.
Well, it is not so but it is
important to really balance this out to see to what extent it's risky,
to what extent it's not,
and when there were a lot of people who were
pushing the sales of these new issues by saying you know this is
a free lunch story that created maybe not a huge but still a bubble-like situation.
Now, when we start talking about bubbles you can see that this is more of the area
of legends or myths rather than the area of facts.
And in next episode,
we will say a few words about myths and legends that surround junk bond.