The junk-bond market, to be sure, has been around for many years. It began attracting investor interest -- and picked up its less-than-flattering nickname -- back in the early 1970s, when nearly all of the lower-rated bonds in the market belonged to weak, or extremely leveraged, companies, such as Penn Central, LTV, and Bangor punta. But what began almost exclusively as a secondary market made up of aging corporate bonds that had been issued years before, has recently been transformed into a vastly different market. Starting in 1977, "the market began buying new debt issues of emerging companies that hadn't proven themselves to the rating agencies," notes Frederick H. Joseph, who heads Drexel Burnham's corporate finance department. It has become another avenue for smaller companies -- public and private alike -- to expansion capital.
Far from falling into the category of "junk," at least some of the companies with bond ratings of B or lower, asserts Joseph, are "the companies of the future." In keeping with this philosophy, his Wall Street firm has spent much of its time and resources over the past several years underwriting deals for growing companies. Drexel has sold public debt issues as small as $10 million. But as a practical matter, Joseph says, issues should be at least $12 million, to provide investors with confidence that there will be a secondary market if they decide to sell. To meet debt service costs on a $12-million deal, Joseph notes, a company should have aftertax earnings of about $2 million -- or at least be generating sufficient cash to support repayment. The companies issuing low-grade bonds don't always seem to be the most worthy credits. But that isn't the way Drexel views it. In the course of accepting a new client, Joseph says, "our main benchmarks aren't the company's current financial ratios but what we think about its long-term prognosis for success."
It is not surprising that the earliest low-rated bond issues to be sold in the market were for younger public companies with appetites for growth capital that went beyond their abilities to retain earnings. Among the companies that raised money this way were MCI Communications, a telecommunications company; Comdisco, a computer marketing and leasing company; and Golden Nugget, a hotel and gambling concern. Standard & Poor's and Moody's had -- and still have -- real doubts about the ability of companies rated B or lower to meet principal and interest payments on long-term debt. But Drexel, in its eagerness to create a lucrative new niche on Wall Street, was willing to look deeper.
A rating agency, Joseph contends, might give a company a rating of B or less for any number of reasons, including low reported earnings, a high debt-to-equity ratio, or even the fact that the business is small. Yet relying on these criteria alone, he says, may cause an investor to overlook the company's other key strengths, such as its impressive cash flow, market position, or record of stability and growth. Getting a handle on the less obvious credit characteristics of a business -- including the qualty of management -- can take weeks or months. "That's usually a lot longer than Moody's and S&P can justify," Joseph says. "We learned to rely on our own credit analysis." In the process, the firm's expanding team of analysts and traders were learning a lot about what institutional investors would be willing to buy (see sidebar at right). Says Joseph: "There was no reason why there couldn't be high-yield bonds for private companies."
The first smaller private company to issue long-term bonds to the public was North American Watch Corp., a New York City-based importer and distributor of Swiss-made watches, which was November, 198395 on INC.'s list of the 100 fastest-growing public companies in 1983. In May of 1979, the company raised $14 million at a fixed rate of 13 1/8%, compared with a prime rate of about 12% at the time. The $26-million business was looking for a way to refinance some of its floating-rate bank loans at a lower cost. Since virtually all of its assets were tied up in inventory and receivables, Drexel structured the 15-year deal as senior, rather than subordinated, debt -- both to provide the company with a lower interest rate and to make it less risky for investors. Although the bonds carried a speculative B-rating from Standard & Poor's, Drexel found willing buyers. "The company got long-term capital to augment its retained earnings," notes Stephen D. Weinroth, a managing director at Drexel who worked on the transaction. "And its principal payments don't start until the seventh year."
The successful North American Watch deal proved the basic hypothesis that public bonds can be sold for private companies. But on subsequent debt issues, investors have shown a willingness to settle for less senior credit status in exchange for higher yields. In one such deal in January 1981, American Sign & Indicator Corp. of Spokane, Wash., sold $25 million of 20-year bonds on a subordinated basis. The $46-million company, which leases time and temperature displays to banks, paid a fixed rate of 15%, compared with the 13% to 14% then being charged to top-rated companies. But even at that rate, says president Luke Williams, "we were better off than at the rate we were paying on our bank loans. They were up as high as 22%."
Buyers of junk bonds, however, aren't always attracted simply by interest rates on straight debt issues. During hard times in the market, companies eager to raise money are often forced to provide sweeteners that give investors participation that goes beyond the fixed rate. Among the features companies have offered have been a percentage of profits -- as Hovnanian furnished -- and warrants to buy stock.
