How Junk Bonds Work

Michael Milken and the History of Junk Bonds

Junk bonds have survived a dramatic rise and fall in popularity, as well as heated controversy. Before the 1980s, few companies issued junk bonds. The only ones available were from established companies that had fallen on hard times. That changed in the late 1970s when young companies with no credit began issuing bonds that started out as "junk" in order to get off the ground. Junk bonds became a common investment tool by the early 1980s, setting the stage for the ambitious trader Michael Milken, who later became known as the "Junk Bond King."

Michael Milken speech
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Milken in 1988 before he went to prison (and before he was named one of the world's richest people in 2006)

Milken worked for the investment bank Drexel Burnham Lambert, and he recognized the incredible financial opportunities that came with the rise in junk bonds during the heady 1980s. Believing that the rewards outweighed the default probabilities, he advised bond issuers and investors to take full advantage of them, hence setting junk bonds ablaze in popularity and success.

One of Milken's more successful and controversial tactics had to do with using junk bonds to finance hostile takeovers of companies; that is, attempting to buy them against their will. With junk bonds, the acquiring company could borrow serious cash with little or no assets and use it to bid on another unwilling company, or target. Believing that a change in management would make these targets more profitable, the acquiring company would then use the target's newly acquired assets to repay the debt it incurred to fund the takeover.

Milken's Success Sours
Milken's successful financial trading career ended on a sour note when he was accused of insider trading and securities fraud. After being arrested and charged with insider trading, Ivan Boesky, one of Milken's clients, implicated him, as well as his employer, Drexel Burnham Lambert. Both Milken and the company were slapped with hefty fines, and Milken was sentenced to 10 years in prison (though he only served two). By 1990, Drexel filed for bankruptcy. Despite a lifetime ban from the securities business, Milken was named No. 382 in Forbes's 2006 list of the World's Richest People [source: Forbes]. Learn more about business fraud in ­How Cooking the Books Works.

Even without Milken and Drexel, the junk bond market later recovered, though it still hasn't hit the heights of its heyday.

This technique offended many people's ideas of fair business practices and generated a lot of animosity toward Milken. On top of that, protestors objected to the tax laws that assisted these hostile takeovers. Because the interest payments on debt are tax

deductible, companies could more easily fund their takeovers with junk bonds.

The junk bond craze came to a screeching halt by the end of the 1980s. Default rates rose significantly, and suddenly no investors were willing to buy them. Investors have since returned to these volatile securities, keeping a sharp eye on their ratings.