property, such as heavy equipment or airplanes. Typically, the collateral backing these
bonds is more easily marketed than the real property backing mortgage bonds. As
Chapter 12 The Bond Market
291
with mortgage bonds, the presence of collateral reduces the risk of the bonds and
so lowers their interest rates.
Unsecured Bonds
Debentures are long-term unsecured bonds that are backed only
by the general creditworthiness of the issuer. No specific collateral is pledged to repay
the debt. In the event of default, the bondholders must go to court to seize assets.
Collateral that has been pledged to other debtors is not available to the holders of
debentures. Debentures usually have an attached contract that spells out the terms
of the bond and the responsibilities of management. The contract attached to the
debenture is called an indenture. (Be careful not to confuse the terms debenture
and indenture.) Debentures have lower priority than secured bonds if the firm
defaults. As a result, they will have a higher interest rate than otherwise compara-
ble secured bonds.
Subordinated debentures are similar to debentures except that they have a
lower priority claim. This means that in the event of a default, subordinated deben-
ture holders are paid only after nonsubordinated bondholders have been paid in
full. As a result, subordinated debenture holders are at greater risk of loss.
Variable-rate bonds (which may be secured or unsecured) are a financial inno-
vation spurred by increased interest-rate variability in the 1980s and 1990s. The inter-
est rate on these securities is tied to another market interest rate, such as the rate
on Treasury bonds, and is adjusted periodically. The interest rate on the bonds will
change over time as market rates change.
Junk Bonds
Recall from Chapter 5 that all bonds are rated by various companies accord-
ing to their default risk. These companies study the issuer’s financial characteristics and
make a judgment about the issuer’s possibility of default. A bond with a rating of
AAA has the highest grade possible. Bonds at or above Moody’s Baa or Standard and
Poor’s BBB rating are considered to be of investment grade. Those rated below this level
are usually considered speculative (see Table 12.2). Speculative-grade bonds are often
called junk bonds. Before the late 1970s, primary issues of speculative-grade securi-
ties were very rare; almost all new bond issues consisted of investment-grade bonds.
When companies ran into financial difficulties, their bond ratings would fall. Holders
of these downgraded bonds found that they were difficult to sell because no well-
developed secondary market existed. It is easy to understand why investors would be
leery of these securities, as they were usually unsecured.
In 1977, Michael Milken, at the investment banking firm of Drexel Burnham
Lambert, recognized that there were many investors who would be willing to take
on greater risk if they were compensated with greater returns. First, however, Milken
had to address two problems that hindered the market for low-grade bonds. The first
was that they suffered from poor liquidity. Whereas underwriters of investment-grade
bonds continued to make a market after the bonds were issued, no such market
maker existed for junk bonds. Drexel agreed to assume this role as market maker
for junk bonds. That assured that a secondary market existed, an important con-
sideration for investors, who seldom want to hold the bonds to maturity.
The second problem with the junk bond market was that there was a very real
chance that the issuing firms would default on their bond payments. By compari-
son, the default risk on investment-grade securities was negligible. To reduce the
probability of losses, Milken acted much as a commercial bank for junk bond issuers.
He would renegotiate the firm’s debt or advance additional funds if needed to pre-
vent the firm from defaulting. Milken’s efforts substantially reduced the default risk,
and the demand for junk bonds soared.
