The Public Policy/Turning America into Junk
Mysak, Joe
THE PUBLIC POLICY TURNING AMERICA INTO JUNK H istory was made on February 9, 1989, when Kohlberg Kravis Roberts & Co., a leveraged buyout specialist, completed the biggest commercial deal ever,...
...All the while, the debt the companies sell in an LBO—junk bonds—has become even junkier, to the distress of thinking men in the market...
...The thinking behind this one is that a change will encourage corporations to sell more stock if they are able to deduct for dividends, instead of going into hock and selling securities whose interest payments they can deduct...
...With LBOs, you have to work your assets harder...
...Most of them are underutilizing their assets...
...Until Congress or the market speaks, the party goes on, the "restructuring of America" continues apace, the fantastic debt mounts...
...The default rate increases in lean times, of course...
...In the long-term, it's good for companies," Long told me...
...But this was the topper, an awesome marvel, the woolly mammoth of the debt-financing craze...
...Neither should corporations...
...But nothing seems foolhardy to investors who reach for yield...
...Its nearest competitor, First Boston Corp., underwrote sixteen issues totaling $3.9 billion...
...In 1979, about $1.3 billion in junk bonds was sold...
...As individuals, we can't deduct interest until we pay it...
...The fund invests heavily in zero-coupon junk bonds...
...The Treasury's long bond yielded 12.25 percent, and is now under 9 percent...
...To get this "interest rate holiday" my man at Morgan Stanley referred to, a "standard feature" of most LBOs in the past four years has been the sale of zero-coupon junk bonds and PIK ("payment in kind") preferred stock...
...In a recession, or even a minor financial downturn, the tide presumably goes out on all boats...
...It also generates handsome by Joe Mysak tax benefits, because companies deduct the interest payments they make on junk bonds...
...the prime rate was 20 percent and had been as high as 21.5 percent, and is now 10.5 percent...
...He fairly glowed...
...Perrin Long, an analyst at Lipper Analytical Services, told Investment Dealers Digest earlier this year that merger and acquisition work at brokerage houses "has been the godsend of the industry in 1988...
...The market Joe Mysak is managing editor of the daily Bond Buyer...
...A raft of reforms is being considered...
...Lipper Analytical Services tracks seventy-seven high-yield junk bond funds, and the top performer for last year was Executive Investors High-Yield Fund, which had a whopping total return of 21.6 percent...
...The idea behind the leveraged buyout, and its concomitant staggering amount of debt, is a simple one...
...The lower the rating, the higher the yield on those bonds has to be...
...So do bankruptcies...
...Drexel, in its High Yield Review, recently wrote of any legislation that might be the result of the Do something about it backlash, "Although we don't believe legislators want to prevent minorities, women, or union employees from raising capital, enacting restrictions on high-yield financings would accomplish this since investment grade firms are not typically owned or managed by such individuals...
...Because they go into so much debt, their companies' bond rating dips below investment grade—Baa at Moody's Investors Services and BBB at Standard & Poor's—and becomes speculative...
...The figure climbed to $12.9 billion in 1984 and nearly $30 billion in 1988, about one-quarter of all corporate debt issued, and the third consecutive year it approached that lofty figure...
...What we think of $25 billion is not the same as what the principals at KKR think of it...
...Inc.'s High Performance monthly magazine, junk bonds were priced to yield approximately 405 basis points, or over four points, above what comparable US...
...For them, the $25 billion amounts to $2 billion in actual equity, the cash they put up, and layers and layers and layers of loans—!`leverage" in the parlance of the business, with a good deal of it consisting of high-yield, or "junk," bonds, many of which would not require payments of any kind, principal or interest, for years...
...Smart, sharp entrepreneurs (and this can include current management), wisdom has it, can take over bloated, uncompetitive corporate giants, sell various assets (including any unrelated businesses those giants may have acquired over the years), and retain the core business, which they can proceed to run with greater efficiency...
...But to judge just how good times have been since the junk-bond boom has taken off, just take a look at the numbers: since 1981, unemployment has gone from 7 percent to just above 5 percent...
...Drexel Burnham Lambert is, of course, the top firm in the field, home of Michael Milken, notorious as the Junk Bond King...
...Hence junk bonds...
...That's not founded in fact," the investor replied defensively...
...PIK securities pay investors in additional securities, in an effort to put off the day of reckoning...
...Lawyers, leveraged buyout specialists, junk-bond dealers, and investment bankers walk away with bags of loot after their fees are calculated, leaving the more cynical observers to wonder whether these people care more about the deals, or just getting the deals done...
...Probably about 60 percent to 70 percent of pretax earnings are coming from M&A at most firms," instead of from more traditional activities like underwriting, trading, and sales...
...the bondholders, who previously held securities of what they thought was a blue-chip company, watch glumly as prices plunge on their holdings (when the RJR Nabisco buyout was announced, holders of the company's $5 billion in outstanding debt lost about $150 per $1,000 in securities they held...
...Investors in zero-coupon bonds buy them at a deep discount and receive no interest payments for five years or more...
...I think that, whether we realize it or not, the country has capitalized itself as if prosperity were going to be permanent...
...Somewhere, deep down, we like to plan for winter...
...Industries that have been riding the boom, and selling the junkier junk bonds, would seem to have built their dreams on particularly fragile foundations...
...Such stuff once would have interested only the old fellows dozing in front of the fire at the Down Town Association, a club slightly north of Wall Street, or the boys bending an elbow at Harry's...
...has blossomed from one where such securities were sold mainly to finance small and untried companies, to one where junk bonds are routinely sold to finance the largest and most prestigious companies' leveraged buyouts...
...In 1988, half of the twenty-four defaults—the largest number in recent history—that occurred took place in companies specializing in energy, financial services, and leisure products...
...Nobody last year really thought that RJR Nabisco was worth $25 billion, but when you're dealing with funny money, numbers tend to lose their meaning...
...Now the news magazines write about it, and even the kid in the cornfield knows the lexicon and can tell you about arbs, and junk bond kings, and management buyouts...
...Treasury securities yield (about 13 percent to 14 percent at this writing...
...It's a good idea," said Lipper's Perrin Long...
...Do something about it...
...Thomas Jefferson, no stranger to debt, once sagely advised, "Never spend money before you have it...
...Or they can resell everything in pieces, on the theory that the sum of the parts will bring more than the whole...
...And so what Barron's has termed "the buyout bubble" goes on, with companies piling on more and more debt, their balance sheets resembling nothing so much as a bankrupt's, their managements optimistically predicting more growth and higher and higher prices for the unproductive assets they plan to sell off...
...This is, of 28 THE AMERICAN SPECTATOR APRIL 1989 course, assuming the company is still around in five years, or ten years, to pay...
...As the bids mounted last fall, if one listened carefully, one could hear a fretful murmuring from burned bondholders, concerned lawyers, the old fellows dozing in front of the fire, the boys at Harry's, miscellaneous editorialists, the kid in the cornfield, and even members of Congress: This is absurd Do something about it...
...Congress and the Treasury are now looking at ways to do something about it...
...One naturally wonders about the buyers of such securities...
...Drexel underwrote seventy-three issues totaling $11.52 billion last year, a 41 percent share of the market...
...In 1988, according to Morgan Stanley & Co...
...Or consider broadcasting, homebuilding, or health services...
...In order to proceed with this plan, however, those sharpies first have to buy out a majority of the stockholders...
...Morgan Stanley put together eleven deals worth $3.7 billion...
...After all, when you're talking $25 billion, you're talking about money, money that buys things...
...Chief among them is a move by the Treasury Department to limit the amount of interest payments companies can deduct, based on a formula measuring a company's equity and debt...
...they need "an interest rate holiday for a few years," said a banker at Morgan Stanley, the third-ranked underwriter of junk bonds last year...
...Something there is in the American character that still likes the old virtues of hard work and thrift, andbridles at the very thought of debt, let alone such massive, almost unconscionable loads of debt...
...The past ten years have seen what more than a few analysts are calling the junking of America...
...I think that our infatuation with debt constitutes a kind of mass delusion, and that our grandchildren will regard the leverage boom with the same bug-eyed incredulity with which we read about tulip bulbs...
...The LBO has, as one writer put it, "a disciplining effect" on executives...
...When their zero-coupon bond matures, they receive the principal, or face value, of the bond...
...There are questions of a truly mammoth breach of duty" to the bondholders, economist Benjamin Stein noted at the time in Barron's...
...And so far, investors in junk bonds have been safe...
...THE PUBLIC POLICY TURNING AMERICA INTO JUNK H istory was made on February 9, 1989, when Kohlberg Kravis Roberts & Co., a leveraged buyout specialist, completed the biggest commercial deal ever, the $25 billion acquisition of RJR Nabisco Inc...
...And to do this, they put up a small amount of cash and go heavily into debt for the rest...
...This would get rid of the excess which has taken over the market," said Theodore J. Forstmann, a partner at Forstmann Little & Co., a leading LBO specialty firm which works with its own cash on buyouts, and does not rely on junk bonds...
...All glory is fleeting...
...Leveraged buyouts, we are told, are the way to energize sluggish American companies...
...O ne of the latest ideas on how to rein in the excesses of the junk bond market, however, is to eliminate the junkier junk that has been the mainstay of the market during the past four years, by not allowing companies to take regular deductions for interest payments when in fact they defer such payments, as is the case with zero-coupon and PIK securities...
...retailing or savings and loans—none seem very likely to be "growth" industries during a financial downturn, especially if they are toddling along supporting a load of high-yield debt...
...Companies are still able to deduct "interest" on these securities as if they have paid it annually...
...The existing stockholders receive an unexpected bonanza as their shares triple and quadruple in price...
...Just take a look at the numbers...
...According to High Performance, the average default rate on high-yield bonds during the past ten very healthy years is 2.08 percent...
...In our own day, James Grant, the proprietor of Grant's Interest Rate Observer, recently offered a sober analysis of our mania for "leverage": "I think there is too much debt and too much complacency about debt," he told the Management Investment Institute last fall...
...The situation appalls...
...I think that wealth is being pledged even faster than it is being created...
...I mentioned one investment banker who had told me that there seems to be an equity-like risk, without the same reward...
...I asked one bond investor, who spends a lot of time working for an organization that is supposed to look out for bondholders' rights, why people or institutions buy junk bonds...
...The companies have to "wait for cash flow to grow" in order to repay their debt...
...Is it reasonable to assume that energy, financial services, or leisure products will make a comeback during that time, because owners wish it were so...
...Another notion making the rounds would eliminate the current double taxation of dividends—corporations are taxed on profits, but can take no deduction for paying out dividends, which stockholders then also pay interest on...
Vol. 22 • April 1989 • No. 4
