Are Tesla’s bonds junk? Yes.
What are junk bonds? Also known as high-yield bonds, it’s debt that is rated below investment grade by the rating agencies.
Why buy them? They behave like equity or shares, higher the risk hence higher the return.
A must-know is who propelled them into being. It’s Michael Milken.
In the early 1970s, Milken made two observations. First, many large and seemingly reliable companies borrowed money from banks at low rates of interest. Their creditworthiness had but one way to go: down. Why be in the business of lending money to them? It is a trade with a tiny upside, a huge downside. Many companies that had once been models of corporate vitality subsequently went bust. There is no such thing as a riskless loan.
Second, two sorts of companies could not persuade risk-averse commercial bankers and money managers to lend them so much as the time of day: small new companies, and large old companies with problems.
Milken plugged the hole in the system. He ignored large, Fortune 100 companies in favour of ones with no credit standing. To compensate the lender for the higher risk, their junk bonds bear a higher rate of interest, sometimes 4–6 per cent higher than the bonds of the blue-chip companies. They also tend to pay the lender a fat fee if the borrower makes enough money to repay his loans prematurely. So, when the company loses money its junk sinks, in anticipation of default. Move more like equity than old-fashioned corporate bonds.
Debt ownership in a shaky enterprise means control, for when a company fails to meet its interest payments, a bondholder can foreclose and liquidate the company. Milken was building a business rather than making an endless series of trades. Milken offered these borrowers access to lenders. The lenders, along with Milken, made money. The gist of Milken’s pitch to them was this: build a huge portfolio of junk bonds and it does not matter if a few turn out to be lemons — the higher pay-off on the winners should more than offset the losses on the losers.
Milken sent out a populist message to institutional investors “Join us. Invest in the future of America, the small-growth companies that make us great.” It’s impossible to say how much money Milken converted to his cause. From virtually zero in the 1970s, new junk bond issuance grew to 839 million dollars in 1981, 8.5 billion dollars in 1985, and 12 billion dollars in 1987. Between 1980 and 1987, 53 billion dollars worth of junk bonds came to market. That is only a fraction of the market, however, because it neglects the billions of dollars worth of new, manmade, fallen angels (large companies with problems). Milken devised a way to transform the bonds of the most stable companies to junk: leveraged corporate takeovers.
Michael Milken, by 1985, was faced with more money than places to put it. He could not find enough worthy small-growth companies and old fallen angels to absorb the cash. He and his colleagues fell upon the solution: they’d use junk bonds to finance raids on undervalued corporations by simply pledging the assets of the corporations as collateral to the junk bond buyers (the mechanics are identical to the purchase of a house when the property is pledged against a mortgage). A takeover of a large corporation could generate billions of dollars worth of junk bonds, for not only would new junk be issued, but the increased leverage transformed the outstanding bonds of a former blue-chip corporation to junk. To raid corporations, however, Milken needed a few hitmen.
These hitmen were mainly men of modest experience in business but had a great deal of interest in becoming rich. Milken funded the dreams of every corporate raider of note: Ronald Perelman, Boone Pickens, Carl Icahn, Marvin Davis, Irwin Jacobs, Sir James Goldsmith, Nelson Peltz, Samuel Heyman, Saul Steinberg and Asher Edelman. Most sold junk bonds through Drexel to raise money to storm such hitherto unassailable fortresses as Revlon, Phillips Petroleum, Unocal, TWA, Disney, AFC, Crown Zellerbach, National Can and Union Carbide.
When Milken stumbled upon the idea, no one imagined that corporations could be undervalued. The raiders were the stone dropped into the still pond, they sent ripples shooting across the surface of corporate America. The process they began took on a life of its own. There was, in other words, plenty of work to go around. Mergers and acquisitions departments, investment bankers, advisers, public company managers swung into action. The money to be made from defending and attacking large companies made everything look like a pauper’s game. For Milken had made the biggest trade of the era. That trade was, of course, the buying and selling of corporate America.
(If you haven’t figured already, Milken’s well-kept secret was his privy to raw inside corporate data. As of this writing, he is a formerly convicted felon for insider trading)
