We are almost done with our discussion about the history of the junk bond market. In today’s article, we will focus on the role of junk bond research when it comes to the growth of the market in the fourth wave. Let’s get to it.
There were multiple studies and research on junk bonds. These studies indicate that these securities are not as risky as some may think. Investors, in particular, view junk bonds as a risky investment.
However, these junk bond research proves that they are not. In fact, they may even provide returns in excess of the risk they have.
Junk Bond Research
In 1958, W. Braddock Hickman published a study. This particular junk bond research concluded that the non-investment-grade bonds had higher returns than investment-grade bonds. This is true even after considering the default losses.
His study was set between the years of 1900 to 1943. The results of this particular junk bond research were later challenged by Fraine and Mills.
According to them, there were different factors that have affected the conclusion. The factors, including the interest rate variation, may have partisan the results of Hickman’s junk bond research.
To this day, Hickman’s pro-junk bond conclusions have been extensively mentioned. Especially in the line of the securities industries. On the other hand, the contradictions in the findings of Frain and Mills’ junk bond research hasn’t received as much attention.
Michael Milken used the findings on Hickman’s research to market high-yield bonds. And it worked very well for cautious institutional investors.
As you may remember from our previous article, we discussed that high-yield bonds were still difficult to sell until the late 1970s. This is even with Hickman’s junk bond research.
At the time, institutional investors were still reluctant. They didn’t want to add to their portfolio bonds that they treated immensely risky.
Altman and Namacher’s Junk Bond Research
However, another major research was published. This research suggested lending endorsement to the Hickman conclusions. Altman and Namacher’s junk bond research seemed to provide evidence that supports Hickman’s research.
In their study, Altman and Namacher showed proof that the delinquency rates of low-rated companies were lesser than what was believed. It demonstrated that the average delinquency rate for junk bonds was 2.1%.
This percentage was not considerably greater than the default rate on investment-grade bonds. The default rate on these types of securities was almost 0%.
Moreover, their junk bond research revealed that as the time of default approaches, the rating declines. According to their observation, 13 out of 130 were rated as investment-grade one year prior to default. That’s exactly 10%.
On the other hand, only 4 out of 130 received the same rating six months prior to default. That’s a measly 3%. It strongly implied that the bond appraisal can be utilized as a dependable sign of the possibility of default.
This popular study dominated the junk bond research field. It has always been one of the most compelling papers of study on the default risk of junk bonds.
The results of these studies strongly implied that the marketplace is inefficient. It also implied that the market produces a profit in the exuberance of the risk on these bonds.
Altman’s Default Measure
However, the results of their research were affected by Altman’s default measure. His default measure goes like this: the dollar value of bonds, divide it by the total dollar value of high-yield bonds in the market.
This default was heavily affected by the speedily development of the market. This growth was witnessed in the mid-1980s, as we discussed before. To some extent, the rapid growth masked the default rate.
Because of this, risky bonds might not manifest the risk until they have “aged.” And this only happens over the course of time Their study did not follow the bonds over their life. They did not study it excessively to see how their risk profile changed as the bonds aged.
Asquith, Mullins, and Wolff Research
On the other hand, there was a study by Asquith, Mullins, and Wolff. Their study examined the aging development of junk bonds.
They examined the junk bonds that were issued between ‘77 and ‘78 until 1986. By doing this study, they counterbalance the effect of the speedily growing junk bond market. These were the ones that affected the junk bond research of Altman and Namacher.
Asquith, Mullins, and Wolff’s study took notice of the role exchanges played in understating the true junk bond default rate. For instance, when junk bond issuers were in danger of defaulting, they would sometimes offer an exchange to bondholders. They will offer bondholders an exchange of new bonds. These new bonds might not pay interest right away. However, they might also offer a higher interest in the future.
Additionally, junk bond issuers may also offer exchanges that involve non-dividend-paying stocks. Or at least, not paying dividends at that specific time.
Oftentimes, bondholders are reluctant to accept exchanges like these. However, they do so as the alternative of default was less attractive.
Moreover, their study also considered the adverse impact that the call-in bonds had. There were lots of firms that extorted the deterioration in interest rates after the junk bonds were issued. These firms were the ones who issued junk bonds with comparatively greater interest rates.
Call Protection for Junk Bonds
A lot of junk bonds have call security for a finite duration. Now, during that same duration, the bonds may not be enforced. However, at the end of that duration, the bonds may be enforced. This is as a consequence of which the bondholders may be disadvantaged. They may be deprived at a rate of return that is far greater to other rates in the market.
According to Asquith and his co-researchers, around 23-43% of bonds issued between the years 1977 and 1982 were called by November 1st of 1988. The deterioration in interest rates that started in ‘82 caused these calls.
Moreover, their study described defaults to be any of the following:
- The issuer filed for bankruptcy
- The official proclamation of delinquency by the bond trustee
- The appointment of a Standard & Poor’s D rating
It is also considered a default of the original issue if the bonds were swapped for other bonds that eventually defaulted. This specific junk bond research showed that default rates were higher for aging issues. Many expected this outcome.
What’s Next?
We hope that this study about junk bond research has helped you understand its role in the growth of the market in the fourth wave. We’ll see you at the next one!
© Image credits to Anni Roenkae