Lessons from the junk bonds debacles of the 1980s and their collapse in 1990

Contrary to the promises of underwriters, junk bonds were a poor investment. They offered too little return for their substantial risk. To meet contractual interest and principal obligations, the number of things that needed to go right for issuers was high while the margin for error was low. Although the potential return was several hundred basis points annually in excess of U.S. Treasury securities, the risk involved the possible loss of one's entire investment.

Motivated by self-interest and greed, respectively, underwriters and buyers of junk bonds rationalized their actions. They accepted claims of a low default rate, and they used cash flow, as measured by EBITDA, as the principal determinant of underlying value. They even argued that a well-diversified portfolio of junk bonds was safe.

As this market collapsed in 1990, junk bonds were transformed into the financial equivalent of roach motels; investors could get in, but they couldn't get out. Bullish assumptions were replaced by bearish ones. Investor focus shifted from what might go right to what could go wrong, and prices plummeted.

Why should the history of the junk-bond market in the 1980s interest investors today? If you personally avoided investing in newly issued junk bonds, what difference should it make to you if other investors lost money? The answer is that junk bonds had a pernicious effect on other sectors of the financial markets and on the behavior of most financial-market participants. The overpricing of junk bonds allowed many takeovers to take place at inflated valuations. The excess profits enjoyed by the shareholders of the acquired companies were about equal to the losses eventually experienced by the buyers of this junk. Cash received by equity investors from junk-bond-financed acquisitions returned to the stock market, bidding up the prices of shares in still independent companies. The market prices of securities involved in arbitrage transactions, exchange offers, and corporate reorganizations were all influenced by the excessive valuations made possible by the junk-bond market. As a result, even those who avoided owning junk bonds found it difficult to escape their influence completely.  We may confidently expect that there will be new investment fads in the future. They too will expand beyond the rational limitations of the innovation. As surely as this will happen, it is equally certain that no bells will toll to announce the excess. Investors who study the junk-bond debacle may be able to identify these new fads for what they are and avoid them. And as we shall see in the chapters that follow, avoiding losses is the most important prerequisite to investment success.

Ref: Margin of Safety by Seth Klarman

Collateralized Bond Obligations - a pile of junk is still junk no matter how you stack it.

Collateralized Junk-Bond Obligations

One of the last junk-bond-market innovations was the collateralized bond obligation (CBO). CBOs are diversified investment pools of junk bonds that issue their own securities with the underlying junk bonds as collateral. Several tranches of securities with different seniorities are usually created, each with risk and return characteristics that differ from those of the underlying junk bonds themselves.

What attracted underwriters as well as investors to junkbond CBOs was that the rating agencies, in a very accommodating decision, gave the senior tranche, usually about 75 percent of the total issue, an investment-grade rating. This means that an issuer could assemble a portfolio of junk bonds yielding 14 percent and sell to investors a senior tranche of securities backed by those bonds at a yield of, say, 10 percent, with proceeds equal to perhaps 75 percent of the cost of the portfolio. The issuer could then sell riskier junior tranches by offering much higher yields to investors.

The existence of CBOs was predicated on the receipt of this investment-grade credit rating on the senior tranche. Greedy institutional buyers of the senior tranche earned a handful of basis points above the yield available on other investment grade securities. As usual these yield pigs sacrificed credit quality for additional current return. The rating agencies performed studies showing that the investment-grade rating was warranted.  Predictably these studies used a historical default-rate analysis and neglected to consider the implications of either a prolonged economic downturn or a credit crunch that might virtually eliminate refinancings. Under such circumstances, a great many junk bonds would default; even the senior tranche of a CBO could experience significant capital losses. In other words, a pile of junk is still junk no matter how you stack it.