Convertible bonds, zero bonds, junk bonds, strips, and other bonds 85
4.6 Junk bonds and credit derivatives
Junk bonds is the name Wall Street has attached to credit risk-exposed, high yield-
ing, often unsecured debt graded BB or lower by independent ratings services. In the
not-too-distant past, debt instruments below investment grade were issued by the
so-called ‘fallen angels’. These were rather well-to-do companies which had fallen
into hard times:
Lost their credit qualification
Found it difficult to secure bank loans, and
Came to the capital market for financing, paying significantly higher interest than
going rate.
But their bankruptcy record was low, something in the level of 2%, as Michael
Milken found in the early 1980s in his research. Starting with the 1984 Drexel
Burnham High Yield Bond Conference in Beverly Hills, Milken launched the credo
that: ‘It is profitable to believe what others doubt.’
There were many takers and the
market for junk bonds boomed, but this tremendously changed the fallen angels
default probability for the worse.
Today, one of the definitions of junk bonds is that of risk capital masquerading as
debt financing. Non-investment grade debt instruments are bought by investors willing
to ignore substandard credit ratings in exchange for better yields. Their holders also
bet on a permeability between the BBB and BB compartments of independent rating
agencies, but without adequately considering the downside possibility.
Warren Buffett dismisses junk bonds as weeds priced as flowers.
The way The
Economist has it, it is hard to think of a surer way to lose money than buying lowly-
rated bonds by US companies at their present yields. When this chapter was written
in November 2004:
The credit spread of junk bonds was a mere 220 basis points.
This was way down from a peak of nearly 1000 basis points in March 2002, when
their default likelihood stood at 10.5% in a year.
True enough, risk-taking is inseparable from lending and investors can profit more by
taking credit risk than market risk. That is precisely what debt is, and just as precisely
what credit is. As cannot be repeated too often, every loan, even if fully secured, has
embedded in it a certain level of speculation. With the democratization of lending and
socialization of risk in the banking business (see Chapter 1) the element of speculation
was not removed; only its costs were shifted.
Junk bonds are one of the engines of this shift.
Credit derivatives are another, more modern example of risk shifting.
‘The market with credit derivatives might become FUBAR [fouled up beyond all
recognition] if there are many bankruptcies in manufacturing and merchandising,’ said
one analyst during my research, adding that ‘There is considerable speculation over if

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