The Junk Bond Dilemma

Are people selling junk bonds because they might actually be junk? That’s the question we try and answer today.

The Story

Imagine you’re a distressed business owner. Your company is struggling. Your finances are in shambles and you haven’t had much luck of late. Your last hope is to borrow money from a group of prospective investors and pray that you tide over this crisis. But you won’t have many suitors looking to fund you at this hour. After all, there’s no guarantee that you’ll repay in full. Furthermore, an independent analysis will show that you are most likely to default on your obligations. That’s pretty bad news. Meaning, at this point, you’ll have no choice but to issue junk bonds.

Yes… Junk Bonds.

Despite the unappetizing name, Junk bonds aren’t exactly junk. They are just like any other bonds. First, you borrow money by issuing a promissory note i.e. the bond. And then when the payment is due, you repay the principal with some extra money on top. The key difference, however, is that with junk bonds you’re expected to cough up a lot of extra money besides the principal. For instance, last month there was some chatter about Vedanta Resources trying to borrow money (in USD) from foreign investors. Financial websites called it a “crucial test of investor appetite for Indian junk debt.”

And this commentary was based on the fact that Vedanta was willing to offer $13.25 for every $100 borrowed. So if they were borrowing a billion dollars with a promise to repay in one year, Vedanta would have had to cough up $1.13 billion at the end of it all.

Typically corporates don’t pay this kind of money. And investors don’t demand it either. But when you are talking about an Indian company with financial constraints and mountains of debt, investors seek a premium because the entity might not last for long. And in effect, these high-risk, high-reward investment options are referred to as junk bonds because there’s a fair chance they might actually turn worthless over the next few years.

Anyway, back in March when coronavirus started making national headlines, investors were fearing the worst. As one article in the Wall Street Journal noted—

“Casinos, movie theatres, bars, shopping malls and hotels are nearly empty. Some have already been forced to close. Airlines have in some cases grounded all or virtually all of their passenger flights. Numerous events have been canceled, and advertising sales are down. Just as few investors had foreseen the wave of mortgage [home loan] defaults and the mayhem they caused in the financial system a decade ago, few had considered the possibility that corporate revenue could evaporate virtually overnight. Some had stress-tested their portfolios to factor in recessions that would depress revenues and corporate profits. They didn’t envision the possibility sales would go to zero.”

And this fear was more pronounced in one specific community — the junk bond investing community. After all, if corporates did stop repaying their loans, these people would be left holding worthless paper (at least in most cases). So in a bid to de-risk, investors started selling these bonds at deep discounts. Meaning if you owned bonds after having lent $100, you were probably willing to let go of this stuff even for $90. And this persisted for a while. Until that is, governments started stepping up and offering monetary support in a bid to keep businesses alive. Soon, it was beginning to dawn on many investors that they might have overestimated the impact of the virus. Even others were beginning to think there’s value in these bonds. And before you knew it, faith in junk bonds had been restored.

But alas, last week investor sentiments turned once again and junk bonds were being sold as if there was no tomorrow. Now reports suggest that investors might have miscalculated risks last time around, not just with Covid-19, but also with presidential elections, global recovery, and corporate defaults. And while we can’t comment on the fickle nature of investor sentiments, at least we are happy that we got to talk about junk bonds this time around. We’ve really been wanting to do it for a while now.

In any case, that’s it from us.

Also don't forget to check our daily brief. In today's issue we talk about oxygen, super apps, and turnarounds. Do read the full draft here.

Share this Finshots on WhatsApp, Twitter, or LinkedIn.

Until next time…