Junk Bonds in Investment Banking

Investment bankers help their clients raise money by selling equity as well as bond securities on the securities markets. Investors know that equity securities are risky by their very design. However, when investors think about debt, they often think about secure investments, which are almost certain to pay a fixed rate of return. Debt is usually secured with collateral, and hence it is considered to be investment grade. However, there are certain types of debt, which are not considered to be investment grade. In investment banking parlance, these types of bonds are called “junk bonds.” In this article, we will explain what “junk bonds” are and how the investment banking community has turned these types of bonds into major sources of revenue.

What are Junk Bonds?

There are credit rating agencies that study the investment profile of various bonds issued. Before the bonds are issued, it is compulsory for credit rating agencies to grade these bonds so that investors are aware of their inherent riskiness. Rating agencies classify bonds into three categories.

1. The first category bonds, which have enough collateral and cash flow to make good on their obligations with certainty. These are called investment-grade bonds.

2. The second category is bonds that have already defaulted. This means that they are already in liquidation or restructuring.

3. There is a third category of bonds that have weak financials and hence cannot be considered investment grade. On the other hand, they haven’t already started defaulting. Hence, they cannot be considered in that grade, as well. Junk bonds are bonds of companies that do not have strong financial credentials to back up the loan that they are taking by issuing the bonds. This does not mean that the company or its underlying business is bad. This simply means that the company is overleveraged. Many reputed companies issue junk bonds when they undertake leveraged buyouts.

There are many investors who have made a lot of money investing in junk bonds. This is because junk bonds provide yields that are much higher as compared to regular bonds.

Statistics about Junk Bonds

The term junk bonds can be somewhat misleading. It makes one believe that the bonds are worthless. This is not the truth. There are some facts about junk bonds that debunk this myth.

• Less than 10% default: Despite the riskiness that is associated with junk bonds, it is important to realize that very few of them actually default. Studies have shown that less than 15% of the junk bonds actually default. More than 85% of the junk bonds paid back their loans as per the cash flow schedule, which was decided when the bond was issued. The problem is that the values of these bonds fluctuate wildly in the secondary market whenever the economy faces any disruption. Hence, liquidating these bonds at a fair price may be problematic.

• Salvage Value: The 15% junk bonds which failed to pay back their loans were also not a complete loss for the investors. This is because, firstly, they didn’t default immediately. Most of these bonds make more than half of their coupon payments before default. Then, there is a salvage value associated with these bonds as well. Hence, even if a default occurs, investors regain most of their money.

Why Do Investment Bankers Make Money With Junk Bonds?

Investment bankers are actively involved in the issuing of junk bonds. Over the years, issues and sales of junk bonds have accounted for a significant portion of the income generated by investment bankers. The reasons for the same are as follows:

• High Commissions: When companies issue investment-grade bonds, they can sell to a lot of potential buyers. Pension funds, mutual funds, and many other such institutions buy these investment-grade bonds. However, since these institutions invest public money, they are not allowed to buy securities that are below investment grade. This greatly reduces the number of possible buyers. Hence, selling junk bonds is quite difficult, and the investment banker needs to have an extensive network in order to be able to accomplish such a sale. Only investment bankers that are well connected with hedge funds and other investors who make risky investments can sell such securities. This is the reason they often charge high commissions to do so.

• High Underwriting Fee: Just like other securities issues, the issue of junk bonds also has to be underwritten by someone. This means that the investment banker will have to take responsibility to sell all the bonds. Depending upon the contract, if they are unable to do so, they might have to hold on to the bonds themselves. This means more risk for the investment banks. Hence, in order to mitigate the risks, investment bankers charge a high underwriting fee, which improves their bottom line!

• High Spreads: Many times, investment banks provide market maker services in these junk bonds. This means that they are always willing to execute a buy or sell trade in order to provide liquidity in the secondary market. They buy at a lower price and sell at a higher price. The difference between the two prices is called the bid-ask spread. In the case of junk bonds, investment banks often have very large spreads in order to compensate them for the risk they are undertaking. This becomes another source of money for investment banks.

The bottom line is that despite their inherent riskiness and speculative nature, junk bonds are major sources of revenue for investment banks all over the world.