A Case Study on "Junk Bonds"- Part 1

Hey guys, This post is a bit more connected to the finance, "bond valuation" and "value investing". Recently I am engaged in analysis on JUNK BONDS and its viability. So i am going to post my findings and analysis on the blog so that more people get an overall idea of the concepts.

So let's get started.

Junk bonds was misunderstood as those bonds which have undervalued or they are treated as hidden gems in 1990s. This concept is first introduced by W. Braddock and popularized by “Michael Milken” and thus, the era of 1980s saw the unprecedented growth of junk bonds, often used to finance in mergers and acquisitions ( Often in leveraged buyout (L.B.O.)).
Junk Bonds can be categorized into two types of bonds according to the nature how they behave in financial markets. First one is Fallen Angels i.e. those bonds which actually provides potential good yield or had a status of investment grade bond but deteriorated in credit quality due to some financial distress, making them unattractive by risk-averse investors. E.g. General Motors bond was given a junk bond status when it declared bankruptcy. Second one is Rising Stars i.e. these bonds have termed as junk not because of degradation in financial performance but because they are new to the bond market or still establishing a decent track record or they are not of sufficient size to earn an investment grade status from a credit rating agency.  

Milken has a theory about “fallen angels” that they are undervalued and credit rating are allotted wrongly to them. He used uncharted territory of valuation to push the valuation of the fallen angels, ignoring basic fundamentals of valuation. But when the bubble breaks out, the whole market crashed. It was revealed that Milken was involved with many financial crimes and subsequently punished. Fallen angels or junk bonds are often illiquid in spite of trading in the market. For this, Milken placed a belief on the investors that they are liquid by trading heavy amounts of junk bonds back and forth among his fellow disciples, making an illusive liquid junk bond market. For an investor, he must recognize value hidden in his investment. Junk bonds from initial point shows that the financials are not enough strong or truly weak to expect a return in future or defaults in coupons in future (in 1990s, when bubble broke out, there were some bonds called as NFCs i.e. No first coupons), yet people bought it following the market consensus. Rather interpreting the bonds in a simple manner, Milken theory believed that the junk bonds are capable of earning more yield than investment grade bonds, not by its high coupon rates but by its low price. He concluded that the return/yield earned from “low price” will surpass the capital losses incurred from the defaults in coupon or principal payments. Obviously, the “low price” is due to the radical behavior of the investor against junk grade bonds due to low credit ratings (low demand leads to low prices).

…To be continued

Note: This whole analysis is based on the content published in the book "Margin of safety" by Seth A. Klarman. I have developed my own views after reading the book and the same is posted here. I expressely agree that this is not my work and concepts and views are the work of my silent mentor and great value investor, Klarman. It may be possible that certain texts are totally copied from the book to maintain the relevance of the concept.

Note : You can find similar more posts on my personal blog- 

Credits :
1. Book "Margin of Safety".
2. Wikipedia
3. Image from Investopedia

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