The University recently invested $5 million of its $573.9 million endowment fund in high-yield bonds, better known as junk bonds.
While the investment makes up only 1 percent of the fund’s value, it points to the unquestioned integrity of U.S. businesses; just a decade ago, investors would have been better off putting their savings into New Kids On the Block memorabilia than into junk bonds.
Other universities — including Notre Dame, Southern California, Stanford and Pepperdine — have ventured into junk bonds. Even some insurance companies known for extremely conservative investments have joined in.
Companies, states, schools and cities issue bonds when they need to raise money to make a large expansion, for example. Investors buy the bonds and collect a fixed rate of interest on their investment. A bond’s risk depends on the ability of a company or city to pay back investors when the bonds come due.
Junk bonds, which are usually issued by smaller, newer companies or by established firms whose fortunes have soured, are called “junk” because the businesses are more likely to default on their bonds. In a default, investors lose everything. To lure investors to these risky investments, junk bonds offer relatively high returns.
“The high-yield bond market isn’t for anyone who can’t stand to lose all the investment,” said John Kuny, a broker with Minneapolis-based Dougherty Summit Securities.
A company’s bonds can become junk bonds when bad news like a lawsuit descends on a company, Kuny said. “RJR Nabisco is a good example,” Kuny explained. “After their (tobacco) lawsuits, their bonds became rated double-B,” a bond rating above junk bond territory but well below the high ratings to which a company is accustomed. Ratings range from triple-A, which are the safest, to D, which are the riskiest.
Although all investments carry some risk factor, junk bonds raise eyebrows on account of their racy, scandal-tainted reputation.
Upon the mention of junk bonds, Michael Milken and Charles Keating, Jr., come to mind. The two fallen financiers’ junk bond failures demolished the savings of thousands of Americans in the late 1980s.
Keating alone dragged down 23,000 investors and $285 million when Lincoln Savings and Loan went belly-up in 1989. The investors, largely Southern California residents, thought they were buying safe, insured investments, which were actually junk bonds that soon became worthless.
Meanwhile, Milken ran the bond-trading department Drexel Burnham Lambert, a now defunct banking firm. Beginning in 1984, he used junk bonds to raise huge amounts of capital to fund hostile takeovers, acquisitions and leverage buy outs. For this he was credited with fueling the merger mania of the 1980s.
Unfortunately for Milken, he was also later credited with numerous illegal financial dealings, charged with securities fraud, fined $600 million and sentenced to 10 years in prison.
In 1989, a year after Milken left the scene, the junk bond market promptly collapsed.
Today, junk bonds are gaining in popularity because the strong U.S. economy has put so many businesses in good financial standing, significantly lowering the risk — and return — of all bonds.
A bond index managed by Salomon Smith Barney, a major investment firm, recorded a negative 0.6 percent return for bonds rated triple-A in the first quarter of 1999.
Junk bonds have fared a little better with a return of 1.5 percent during the same period. This reassuring return, coupled with a relatively low chance of default, makes junk bonds a decent investment — in moderation.
“A 1 percent investment is a pretty insignificant part of a portfolio,” said Richard Nelson, a finance professor and former senior vice president with ReliaStar Investment Research. He added that any diversification improves a portfolio, and “given the strength of the economy, it is fairly easy to see how some investors would think that the chance of high-yield bond default is lower.”