I was reading Barbarians at the Gate and I read that junk bonds were required to do large leveraged buyouts. What is a junk bond and how does it differ from a regular bond? Why is there higher risk/chance of default?
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3 Answers
A junk bond is, broadly, a bond with a non-negligible risk of default. ("Bond" ought to be defined elsewhere, but broadly it's a financial instrument you buy from a company or government, where they promise to pay you back the principal and some interest over time, on a particular schedule.)
The name "junk" is a bit exaggerated: many of them are issued by respectable and reasonably stable businesses.
junk bonds were required to do large leveraged buyouts.
This means: the company issued fairly risky, fairly high-yield debt, to buy out equity holders. They have to pay a high rate on the debt because the company's now fairly highly geared (ie has a lot of debt relative to its value) and it may have to pay out a large fraction of its earnings as interest.
What is a junk bond and how does it differ from a regular bond?
It's only a matter of degree and nomenclature. A bond that has a credit rating below a particular level (eg S&P BBB-) is called junk, or more politely "non-investment grade" or "speculative". It's possible for an existing bond to be reclassified from one side to another, or for a single issuer to have different series some of which are more risky than others. The higher the perceived risk, the more interest the bond must pay offer in order to attract lenders.
Why is there higher risk/chance of default?
Well, why would a company be considered at higher risk of failing to repay its debt? Basically it comes down to doubt about the company's future earnings being sufficient to repay its debt, which could be for example:
- The company's revenue is declining
- There is a legal or regulatory risk
- The company is highly geared and repayments consume a great deal of its earnings
From wikipedia:
In finance, a high-yield bond (non-investment-grade bond, speculative-grade bond, or junk bond) is a bond that is rated below investment grade at the time of purchase. These bonds have a higher risk of default or other adverse credit events, but typically pay higher yields than better quality bonds in order to make them attractive to investors.
In terms of your second question, you have the causality backwards. They are called junk bonds because they have a higher risk of default.
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5+1 for the reference to causality. (Although I still believe it rains because I forgot my umbrella) Sep 25, 2011 at 21:42
A "junk bond" is one that pays a high yield UP FRONT because there is a good chance that it could default. So the higher interest rate is necessary to try to compensate for the default
Junk bonds are used in leveraged buyouts (LBOs) because such deals are INHERENTLY risky. "Normal" companies may have 20%-30% debt and the rest equity, so that the company will have to lose 70%-80% of its value before the debtholders start losing money on "normal" bonds. But in an LBO, the company may have only 10%-20% equity and the rest debt. Meaning that if it loses that small equity cushion, the value of the "junk" bonds will be impaired.
