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For instance, when managers believe
the value of the firm (as measured by
the market) is too low, they have an
incentive to buyout the firm's existing
stockholders.
This may involve temporary borrowing to purchase outstanding shares of the firm. Examined
in this light, the optimal capital structure approach is too restrictive in scope
and should be thought of as an optimal
ownership problem.
If the nation's legislators are really
concerned with the growth of corporate
debt, they should act by reducing the
size of the tax shield available to firms.
Indeed, tax reform may be the only effective means of controlling the growth
of all forms of debt in our economy.
When the potential gains from leverage
are removed, managers will respond by
changing the way they finance their
operations, and the substitution
of debt
for equity will slow or cease.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

Material may be reprinted provided that the
source is credited. Please send copies of reprinted
materials to the editor.

Summary & Conclusions
Junk bonds have attracted public attention because of the rapid growth in
their use, because of their association
with mergers and takeovers, and
because some observers have felt that
the Federal Reserve System is using
the margin requirements
of Regulation
G to restrict their use.
In spite of their recent notoriety,
however, low-rated bonds do have a legitimate role in the marketplace
and in
the financial structure of firms that
make use of them. Many of the performance characteristics
of junk bonds are
well-understood
by those who participate in the market. However, since
many low-rated bonds are so new, their
future performance cannot be accurately predicted, so there is need for
caution in their use.

At this point, it is too difficult to determine whether or not the growing use
of low-rated bonds in debt-based financing is harmful to our economy. The optimal capital structure of the non-financial corporation depends on so many
variables that simple rules about capitalization that have served reasonably
well to date may no longer be valid.
In the absence of a serious downturn
in the performance of junk bonds, however, it is reasonable to assume that the
use of these instruments
will increase
and that the subsequent growth in debtbased financing will cause a further
shift in the quality of corporate debt.

BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385

Address Correction
Requested:
Please send
corrected mailing label to the Federal Reserve
Bank of Cleveland, Research Department,
P.O. Box 6387, Cleveland, OH 44101.

February 1, 1986

Federal Reserve Bank of Cleveland

ISSN 0428-1276

ECONOMIC
COMMENTARY
Over the past few years, the financial
public has developed a fascination with
the growth in the market for so-called
junk bonds. In this Economic Commentary we would like to shed some light
on the role of these instruments
by
providing a working definition of the
term "junk bonds," by discussing their
place in the financial world, and by
examining a few of the issues surrounding concern over the growth of
corporate debt.
The public's interest in junk bonds
was recently fueled by the controversy
surrounding
the Federal Reserve
Board's reinterpretation
of Regulation
G, by which the debt securities of a
shell corporation, constructed
solely as
a thinly capitalized vehicle to facilitate
a takeover of the stock of another firm,
would now be subject to existing margin requirements.
The Federal Reserve Board requires
that loans collateralized
by margin
stock, used to purchase and carry securities, not exceed 50 percent of the market
value of the securing stock. Many have
interpreted the Board's recent decision
as a step to limit the use of low-grade
debt instruments.
The Federal Reserve
Board of Governors has countered this
charge, however, by stating that the
intention was only to clarify the
enforcement of existing regulations.

Jerome S. Fons is an economist at the Federal
Reserve Ba nk of Cleveland. The views stated herein
are those of the author and not necessarily those of
the Federal Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve System.

The phrase "junk bonds" was first
coined to describe outstanding
bonds
issued by so-called "fallen angels."
These were firms with initially strong
financial histories that were facing
severe financial problems and suffering
from poor credit ratings. Today, the
term "junk bonds" is applied to all
speculative-grade
debt, regardless of
the issuing firm's financial condition.
Speculative-grade
bonds are issues
with ratings below BBB- (from Standard & Poor's) or Baa3 (from Moody's).
Over the past few years, these ratings
have frequently been assigned to the
debt of new firms that do not have an
established performance
record. Previously, these firms may have been
denied access to capital markets
because of the market's distaste for
speculative-grade
debt. The emergence
of markets for these bonds has provided a viable financing alternative
for
small or new firms that traditionally
had to rely on commercial bank loans.
Since the average investor has
neither the access to information nor
the expertise necessary to effectively
evaluate an issuing firm, the bondrating agencies provide an important
service. Ideally, the assigned rating
gives the investor a single measure of
the default probability of the rated
bond. However, the value of the
assigned rating may decline as financial conditions change with the passage
of time. It has been observed, for example, that knowledgeable
investors often
incorporate new information about the
issuing firm into the price of the bond

Junk Bonds

and Public Policy
by Jerome S. Fons

well before its rating is actually
adjusted by companies such as Moody's
and Standard & Poor's.
Since much emphasis is placed on
ratings, however, business and financial economists have closely examined
the factors that determine the rating,
as well as the subsequent
performance
of the bonds.
By and large, agencies that rate bonds
admit that there is no precise formula
for determining
which rating a bond
receives, although studies have shown
that certain patterns can be established
between the different ratings and various aspects of the rated firms.'
Factors that appear to figure prominently in the rating process are
accounting ratios, including debt to
equity; measures of past performance,
including variability of earnings; and
many so-called qualitative features,
such as the evaluator's
disposition
towards management,
and the general
outlook for a particular industry.
Although they may vary from issue
to issue, the chosen provisions under
which bonds are issued (such as call
terms, dividend restrictions,
or subordination) seek to enhance an issue's
attractiveness
by providing protection
against abuses that could endanger the
bondholder. Management,
for example,
may be restricted from entering into a
merger that might dilute the bondholder's claim, or from using the proceeds from a bond sale to payoff shareholders in a liquidation move.

1. For an excellent survey of this literature, see
Robert S. Kaplan and Grabriel Urwitz, "Statistical Models of Bond Ratings: A Methodological
Inquiry," Journal of Business, vol. 52, no. 2 (April,
1979), pp. 231·61.

Companies usually pay to have their
bonds rated. This indicates that being
rated is generally beneficial, although
some companies choose not to undergo
the process. Their bonds, being nonrated, are usually considered speculative grade.
A high bond rating may be important
to the issuing firm because it can reduce financing costs due to the lower
yield required by bondholders. One reason a lower yield is required is because
there are many more potential holders
of high-rated securities-since
federally
chartered banks and others with fiduciary responsibilities
are prohibited from
holding speculative-grade
instruments.
The expected gains from obtaining a
rating are weighed against the cost of
the rating process. In general, the more
potential holders there are, the greater
the benefits of obtaining a rating.

Low-Rated Bond Characteristics
Low-rated (or junk) bonds are commonly described as speculative because
the financial characteristics
of the issuing firm are thought to increase the
risk of default. Things are not quite
that simple, however.
Economists have kept track of the
performance of corporate bonds for
many years. Part of the difficulty in
establishing
a relationship
between the
likelihood of default and an issue's rating stems from the fact that, by the
time an issue defaults, it usually descends in rating until it reaches the rating D (for Default). In testimony to the
effectiveness of the ratings agencies,
not one corporate bond originally
issued with the highest rating (AAA) in
the past 10 years has defaulted.

On the other hand, bonds originally
rated single-B have had the worst default record in recent times. If we look
at the performance of issues rated
single-B during 1982 (the trough of the
worst postwar recession), we find that
roughly 4 percent (in terms of par value)
defaulted. One measure of average annual default rates for all grades, covering 1971 through 1984, has a mean value
of 0.12 percent." Since even defaulting
bonds continue to trade at positive
prices, these figures do not represent
the percentage of original investment
lost by holders of these bonds.
Based on prices prevailing one month
after a default, a study by researchers
Edward Altman and Scott Nammacher
found that defaulting bonds continue to
trade, on average, at 41 percent of par
value. Since low-rated bonds have traded
at yields more than five percentage
points above comparable-maturity
Treasury issues, many feel that holders
of well-diversified
portfolios of junk
bonds are more than compensated
for
losses that result from defaults.
Bonds issued to facilitate (or to prevent) mergers can be given a speculative grade. The additional debt tends to
cause a deterioration
in the firm's debtto-equity ratio, at times to the point of
reducing its ability to service the additional debt. Often, however, the newly
capitalized firm will divest itself of
some of its operations, thereby allowing
it to shed part of its debt burden.
Whether or not traditional rating techniques can be applied to merger-related
debt has yet to be determined. The lack
of a clear track record for these issues
contributes
to their riskiness. Mergerrelated debt financing has proliferated
in an economic environment
that, for
the most part, has been characterized
by falling interest rates and low inflation. It may not be rational, however, to
expect that the performance of corporate bonds over the next business cycle
will be anything like that of the past.
In addition, there are those who
believe that a large majority of firms
with assets exceeding $25 million
would be given ratings that are below
investment grade if they were to apply
to Moody's or to Standard & Poor's.

Using this reasoning, one might expect
that, if the loans on the balance sheets
of commercial banks were rated by one
of the rating agencies, the average
commercial bank portfolio would be
given a speculative grade.' Consequently, the term "junk bonds" may
have connotations
that may not
appropriately
describe the true strength
of the issuing firm.
The list of institutions
and individuals willing to hold low-rated bonds
appears to be growing with the passage
of each year in which there are few
defaults on these bonds. Studies undertaken by investment
banks, as well as
by academics, suggest that a diversified
portfolio of low-rated bonds contains
advantages that may offset some of the
default risk. It has been observed that
low-rated bonds behave more like
equity issues than do their high-grade
counterparts.
Low-rated bond prices
tend to respond to new information
about the issuing firm or industry. As a
result, the returns on low-rated bonds
selected from different industries tend
to offset one another, resulting in a less
volatile overall portfolio return.
Studies of the performance of portfolios of low-rated bonds indicate that
their returns are in fact less risky in
the sense that the return variance is
lower than other fixed income investment portfolios.' A recent study concludes that, as long as one does not
concentrate
his holdings in a particular
industry, as few as 10 different issues
constitutes
a well-diversified
portfolio.'
Of course, mutual funds that specialize
in low-grade bonds provide an even
greater potential for diversification.
The growth in the market for lowrated corporate debt has been caused
by two major factors: new issues and
downgradings.
In terms of dollars
raised, roughly 25 percent of all publicly
offered debt (excluding mortgage-backed
bonds) by U.S. corporations
in 1984 was
either non-rated or had a speculativegrade rating. Although this figure fell
to 20.3 percent in 1985, it still stands in
stark contrast to the lack of such offerings as recently as 10 years ago.

2. We constructed a monthly time series of total
corporate default rates by summing all corporate
defaults (obtained from Edward I. Altman and
Scott A. Narnmacher. consultants. The Default
Rate Experience on High Yield Corporate Debt.
Morgan Stanley. March 1985) over the past 12
months. at each point in time. We then divided
by total corporate debt outstanding (interpolated

in monthly terms from the Board of Governors of
the Federal Reserve System's Flow of Funds statistics) 12 months prior.

Since 1979, ratings agencies have reported that downgradings
have consistently led upgradings. Standard & Poor's
downgraded 267 issues in 1985 while
upgrading only 125. Chart 1 presents a
summary of the par value of straight
corporate bonds outstanding,
by rating,
from 1982 through 1985. In 1982,8.8
percent of outstanding
corporate bonds
had speculative-grade
ratings; by 1985,
this figure had risen to 13.4 percent.
The shift in the quality of the nation's
corporate debt can generally be attributed to the accumulation
of larger
amounts of debt by the nation's corporations, as well as to increased merger
activity in recent years.
Chart 1 Par Value of Publicly Traded
Outstanding Corporate Bonds by Rating
Billions of dollars

0

1982

1983

DAAA
WAA

1

.BBB
.BB

.A

DB

.0
.Alle's

DNotrated

SOURCE: Based on Standard & Poor's Bond Gilide.
various year-end issues.

Corporate Debt Growth
The growth of all forms of debt is of
great concern to the nation's legislators
and financial regulators. Many feel that
the rapid growth of debt may eventually restrict the ability of households,

3. The comparison between publicly traded
bonds and commercial bank loans should be
approached with caution. In most cases. the
bank's lending officer is in closer contact with
the borrower's management and is therefore
privy to information that even rating agencies
might lack. The avenues of recourse. in the event
of a default. are greater as well.

government,
and businesses to pay
what they owe in the event of an economic downturn. The notion that there
is an optimal ratio of debt to equity (or
debt-service expense to income) is largely based on these concerns. In order to
put these matters into their proper
perspective, economists have developed
theories to help explain why households and businesses might want to
accumulate debt. In particular, economists have paid considerable attention
to the idea of how firms should structure their net worth and long-term debt
for the best results.
Among the first to provide a rigorous
treatment of this issue were economists
Franco Modigliani and Merton Miller in
1958.6 They demonstrated
that, in an
idealized world without taxes or bankruptcies, the choice of financing is
irrelevant to the valuation of the firm.
As long as the fundamental
characteristics of the firm's cash flows are not
altered, it makes no difference whether
debt or equity financing is used.
Subsequent extensions of Modigliani's
and Miller's work highlight the importance of the deductibility
of interest
expense for tax purposes and of the socalled deadweight losses that result from
bankruptcy.
The ability of the firm to
deduct interest expense when determining its tax bill implies that there is a
"tax shield" that increases the value of
the firm without affecting the distribution of the cash flows, although the
contribution
of the shield is reduced in
the presence of personal income taxes.
The fact that there are usually thirdparty costs involved when a firm
declares bankruptcy
has also been
shown to inhibit the ability of a firm to
increase its value through additional
bond-related debt. These (explicit and
implicit) costs take the form of liquidation losses and legal/settlement
fees
that a bankrupt firm faces. As more
debt is issued, the probability of default
rises, as do the expected costs of bankruptcy. The optimal capital structure is
reached when the firm's debt level
equates the marginal expected costs of
possible bankruptcy
to the marginal
gains from the firm's tax shield.

In the context of the Modigliani/Miller
viewpoint, there are a number of factors that could be linked to a shift in
the preference of managers for higher
debt levels which, in turn, has contributed to growth in the use of speculativegrade bonds. The changing political
and economic environment
in the United
States may have fostered a belief that
the costs of bankruptcy
have been
reduced. This belief may be grounded
in the development of our nation's
financial system. Today's financial
manager has at his disposal many
instruments
to reduce the firm's exposure to unanticipated
changes in the
economic environment.'
The development of markets for risk management
could invalidate long-held rules of
proper financial conduct.
Other factors, such as a growing
economy, may contribute to the feeling
that the expected costs of bankruptcy
should be revised downwards.
If this is
the case, then the substitution
of debt
for equity by the nation's corporations
constitutes
the most logical behavior.
Until events arise to change this view,
the present trend of growth in the use
of low-rated bonds may continue until a
new balance of debt-to-equity is reached.
Finally, the notion of agency costs
illustrates the complexities of determining the optimal capital structure of
the firm. One can view the modern
corporation as a set of contracts
between stockholders,
bondholders,
managers, suppliers, customers, unions
and others. The problem of choosing
debt-versus-equity
financing must be
considered in light of possible conflicts
of interest among these groups. Corporate decisions can adversely affect one
group while positively affecting
another. Each has his own set of claims
on certain aspects of the firm.

4. See Marshall E. Blume and Donald B. Keirn.
"Risk and Return Characteristics of Lower-Grade
Bonds." Rodney L. White Center for Financial
Research. The Wharton School. Philadelphia. PA.
University of Pennsylvania. 1984.

6. See Franco Modigliani and Merton H. Miller.
"The Cost of Capital. Corporation Finance. and
the Theory of Investment." American Economic
Review. vol. 48. no. 3. (June 1958). pp. 261-97.

5. See Richard Bookstaber and David Jacob.
"The Diversification Potential of High Yield
Bonds." High Performance, Morgan Stanley
Credit Research. December I. 1985. pp. 8-11.

7. Examples of these are interest rate swaps.
options. and futures contracts.

Companies usually pay to have their
bonds rated. This indicates that being
rated is generally beneficial, although
some companies choose not to undergo
the process. Their bonds, being nonrated, are usually considered speculative grade.
A high bond rating may be important
to the issuing firm because it can reduce financing costs due to the lower
yield required by bondholders. One reason a lower yield is required is because
there are many more potential holders
of high-rated securities-since
federally
chartered banks and others with fiduciary responsibilities
are prohibited from
holding speculative-grade
instruments.
The expected gains from obtaining a
rating are weighed against the cost of
the rating process. In general, the more
potential holders there are, the greater
the benefits of obtaining a rating.

Low-Rated Bond Characteristics
Low-rated (or junk) bonds are commonly described as speculative because
the financial characteristics
of the issuing firm are thought to increase the
risk of default. Things are not quite
that simple, however.
Economists have kept track of the
performance of corporate bonds for
many years. Part of the difficulty in
establishing
a relationship
between the
likelihood of default and an issue's rating stems from the fact that, by the
time an issue defaults, it usually descends in rating until it reaches the rating D (for Default). In testimony to the
effectiveness of the ratings agencies,
not one corporate bond originally
issued with the highest rating (AAA) in
the past 10 years has defaulted.

On the other hand, bonds originally
rated single-B have had the worst default record in recent times. If we look
at the performance of issues rated
single-B during 1982 (the trough of the
worst postwar recession), we find that
roughly 4 percent (in terms of par value)
defaulted. One measure of average annual default rates for all grades, covering 1971 through 1984, has a mean value
of 0.12 percent." Since even defaulting
bonds continue to trade at positive
prices, these figures do not represent
the percentage of original investment
lost by holders of these bonds.
Based on prices prevailing one month
after a default, a study by researchers
Edward Altman and Scott Nammacher
found that defaulting bonds continue to
trade, on average, at 41 percent of par
value. Since low-rated bonds have traded
at yields more than five percentage
points above comparable-maturity
Treasury issues, many feel that holders
of well-diversified
portfolios of junk
bonds are more than compensated
for
losses that result from defaults.
Bonds issued to facilitate (or to prevent) mergers can be given a speculative grade. The additional debt tends to
cause a deterioration
in the firm's debtto-equity ratio, at times to the point of
reducing its ability to service the additional debt. Often, however, the newly
capitalized firm will divest itself of
some of its operations, thereby allowing
it to shed part of its debt burden.
Whether or not traditional rating techniques can be applied to merger-related
debt has yet to be determined. The lack
of a clear track record for these issues
contributes
to their riskiness. Mergerrelated debt financing has proliferated
in an economic environment
that, for
the most part, has been characterized
by falling interest rates and low inflation. It may not be rational, however, to
expect that the performance of corporate bonds over the next business cycle
will be anything like that of the past.
In addition, there are those who
believe that a large majority of firms
with assets exceeding $25 million
would be given ratings that are below
investment grade if they were to apply
to Moody's or to Standard & Poor's.

Using this reasoning, one might expect
that, if the loans on the balance sheets
of commercial banks were rated by one
of the rating agencies, the average
commercial bank portfolio would be
given a speculative grade.' Consequently, the term "junk bonds" may
have connotations
that may not
appropriately
describe the true strength
of the issuing firm.
The list of institutions
and individuals willing to hold low-rated bonds
appears to be growing with the passage
of each year in which there are few
defaults on these bonds. Studies undertaken by investment
banks, as well as
by academics, suggest that a diversified
portfolio of low-rated bonds contains
advantages that may offset some of the
default risk. It has been observed that
low-rated bonds behave more like
equity issues than do their high-grade
counterparts.
Low-rated bond prices
tend to respond to new information
about the issuing firm or industry. As a
result, the returns on low-rated bonds
selected from different industries tend
to offset one another, resulting in a less
volatile overall portfolio return.
Studies of the performance of portfolios of low-rated bonds indicate that
their returns are in fact less risky in
the sense that the return variance is
lower than other fixed income investment portfolios.' A recent study concludes that, as long as one does not
concentrate
his holdings in a particular
industry, as few as 10 different issues
constitutes
a well-diversified
portfolio.'
Of course, mutual funds that specialize
in low-grade bonds provide an even
greater potential for diversification.
The growth in the market for lowrated corporate debt has been caused
by two major factors: new issues and
downgradings.
In terms of dollars
raised, roughly 25 percent of all publicly
offered debt (excluding mortgage-backed
bonds) by U.S. corporations
in 1984 was
either non-rated or had a speculativegrade rating. Although this figure fell
to 20.3 percent in 1985, it still stands in
stark contrast to the lack of such offerings as recently as 10 years ago.

2. We constructed a monthly time series of total
corporate default rates by summing all corporate
defaults (obtained from Edward I. Altman and
Scott A. Narnmacher. consultants. The Default
Rate Experience on High Yield Corporate Debt.
Morgan Stanley. March 1985) over the past 12
months. at each point in time. We then divided
by total corporate debt outstanding (interpolated

in monthly terms from the Board of Governors of
the Federal Reserve System's Flow of Funds statistics) 12 months prior.

Since 1979, ratings agencies have reported that downgradings
have consistently led upgradings. Standard & Poor's
downgraded 267 issues in 1985 while
upgrading only 125. Chart 1 presents a
summary of the par value of straight
corporate bonds outstanding,
by rating,
from 1982 through 1985. In 1982,8.8
percent of outstanding
corporate bonds
had speculative-grade
ratings; by 1985,
this figure had risen to 13.4 percent.
The shift in the quality of the nation's
corporate debt can generally be attributed to the accumulation
of larger
amounts of debt by the nation's corporations, as well as to increased merger
activity in recent years.
Chart 1 Par Value of Publicly Traded
Outstanding Corporate Bonds by Rating
Billions of dollars

0

1982

1983

DAAA
WAA

1

.BBB
.BB

.A

DB

.0
.Alle's

DNotrated

SOURCE: Based on Standard & Poor's Bond Gilide.
various year-end issues.

Corporate Debt Growth
The growth of all forms of debt is of
great concern to the nation's legislators
and financial regulators. Many feel that
the rapid growth of debt may eventually restrict the ability of households,

3. The comparison between publicly traded
bonds and commercial bank loans should be
approached with caution. In most cases. the
bank's lending officer is in closer contact with
the borrower's management and is therefore
privy to information that even rating agencies
might lack. The avenues of recourse. in the event
of a default. are greater as well.

government,
and businesses to pay
what they owe in the event of an economic downturn. The notion that there
is an optimal ratio of debt to equity (or
debt-service expense to income) is largely based on these concerns. In order to
put these matters into their proper
perspective, economists have developed
theories to help explain why households and businesses might want to
accumulate debt. In particular, economists have paid considerable attention
to the idea of how firms should structure their net worth and long-term debt
for the best results.
Among the first to provide a rigorous
treatment of this issue were economists
Franco Modigliani and Merton Miller in
1958.6 They demonstrated
that, in an
idealized world without taxes or bankruptcies, the choice of financing is
irrelevant to the valuation of the firm.
As long as the fundamental
characteristics of the firm's cash flows are not
altered, it makes no difference whether
debt or equity financing is used.
Subsequent extensions of Modigliani's
and Miller's work highlight the importance of the deductibility
of interest
expense for tax purposes and of the socalled deadweight losses that result from
bankruptcy.
The ability of the firm to
deduct interest expense when determining its tax bill implies that there is a
"tax shield" that increases the value of
the firm without affecting the distribution of the cash flows, although the
contribution
of the shield is reduced in
the presence of personal income taxes.
The fact that there are usually thirdparty costs involved when a firm
declares bankruptcy
has also been
shown to inhibit the ability of a firm to
increase its value through additional
bond-related debt. These (explicit and
implicit) costs take the form of liquidation losses and legal/settlement
fees
that a bankrupt firm faces. As more
debt is issued, the probability of default
rises, as do the expected costs of bankruptcy. The optimal capital structure is
reached when the firm's debt level
equates the marginal expected costs of
possible bankruptcy
to the marginal
gains from the firm's tax shield.

In the context of the Modigliani/Miller
viewpoint, there are a number of factors that could be linked to a shift in
the preference of managers for higher
debt levels which, in turn, has contributed to growth in the use of speculativegrade bonds. The changing political
and economic environment
in the United
States may have fostered a belief that
the costs of bankruptcy
have been
reduced. This belief may be grounded
in the development of our nation's
financial system. Today's financial
manager has at his disposal many
instruments
to reduce the firm's exposure to unanticipated
changes in the
economic environment.'
The development of markets for risk management
could invalidate long-held rules of
proper financial conduct.
Other factors, such as a growing
economy, may contribute to the feeling
that the expected costs of bankruptcy
should be revised downwards.
If this is
the case, then the substitution
of debt
for equity by the nation's corporations
constitutes
the most logical behavior.
Until events arise to change this view,
the present trend of growth in the use
of low-rated bonds may continue until a
new balance of debt-to-equity is reached.
Finally, the notion of agency costs
illustrates the complexities of determining the optimal capital structure of
the firm. One can view the modern
corporation as a set of contracts
between stockholders,
bondholders,
managers, suppliers, customers, unions
and others. The problem of choosing
debt-versus-equity
financing must be
considered in light of possible conflicts
of interest among these groups. Corporate decisions can adversely affect one
group while positively affecting
another. Each has his own set of claims
on certain aspects of the firm.

4. See Marshall E. Blume and Donald B. Keirn.
"Risk and Return Characteristics of Lower-Grade
Bonds." Rodney L. White Center for Financial
Research. The Wharton School. Philadelphia. PA.
University of Pennsylvania. 1984.

6. See Franco Modigliani and Merton H. Miller.
"The Cost of Capital. Corporation Finance. and
the Theory of Investment." American Economic
Review. vol. 48. no. 3. (June 1958). pp. 261-97.

5. See Richard Bookstaber and David Jacob.
"The Diversification Potential of High Yield
Bonds." High Performance, Morgan Stanley
Credit Research. December I. 1985. pp. 8-11.

7. Examples of these are interest rate swaps.
options. and futures contracts.

For instance, when managers believe
the value of the firm (as measured by
the market) is too low, they have an
incentive to buyout the firm's existing
stockholders.
This may involve temporary borrowing to purchase outstanding shares of the firm. Examined
in this light, the optimal capital structure approach is too restrictive in scope
and should be thought of as an optimal
ownership problem.
If the nation's legislators are really
concerned with the growth of corporate
debt, they should act by reducing the
size of the tax shield available to firms.
Indeed, tax reform may be the only effective means of controlling the growth
of all forms of debt in our economy.
When the potential gains from leverage
are removed, managers will respond by
changing the way they finance their
operations, and the substitution
of debt
for equity will slow or cease.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

Material may be reprinted provided that the
source is credited. Please send copies of reprinted
materials to the editor.

Summary & Conclusions
Junk bonds have attracted public attention because of the rapid growth in
their use, because of their association
with mergers and takeovers, and
because some observers have felt that
the Federal Reserve System is using
the margin requirements
of Regulation
G to restrict their use.
In spite of their recent notoriety,
however, low-rated bonds do have a legitimate role in the marketplace
and in
the financial structure of firms that
make use of them. Many of the performance characteristics
of junk bonds are
well-understood
by those who participate in the market. However, since
many low-rated bonds are so new, their
future performance cannot be accurately predicted, so there is need for
caution in their use.

At this point, it is too difficult to determine whether or not the growing use
of low-rated bonds in debt-based financing is harmful to our economy. The optimal capital structure of the non-financial corporation depends on so many
variables that simple rules about capitalization that have served reasonably
well to date may no longer be valid.
In the absence of a serious downturn
in the performance of junk bonds, however, it is reasonable to assume that the
use of these instruments
will increase
and that the subsequent growth in debtbased financing will cause a further
shift in the quality of corporate debt.

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February 1, 1986

Federal Reserve Bank of Cleveland

ISSN 0428-1276

ECONOMIC
COMMENTARY
Over the past few years, the financial
public has developed a fascination with
the growth in the market for so-called
junk bonds. In this Economic Commentary we would like to shed some light
on the role of these instruments
by
providing a working definition of the
term "junk bonds," by discussing their
place in the financial world, and by
examining a few of the issues surrounding concern over the growth of
corporate debt.
The public's interest in junk bonds
was recently fueled by the controversy
surrounding
the Federal Reserve
Board's reinterpretation
of Regulation
G, by which the debt securities of a
shell corporation, constructed
solely as
a thinly capitalized vehicle to facilitate
a takeover of the stock of another firm,
would now be subject to existing margin requirements.
The Federal Reserve Board requires
that loans collateralized
by margin
stock, used to purchase and carry securities, not exceed 50 percent of the market
value of the securing stock. Many have
interpreted the Board's recent decision
as a step to limit the use of low-grade
debt instruments.
The Federal Reserve
Board of Governors has countered this
charge, however, by stating that the
intention was only to clarify the
enforcement of existing regulations.

Jerome S. Fons is an economist at the Federal
Reserve Ba nk of Cleveland. The views stated herein
are those of the author and not necessarily those of
the Federal Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve System.

The phrase "junk bonds" was first
coined to describe outstanding
bonds
issued by so-called "fallen angels."
These were firms with initially strong
financial histories that were facing
severe financial problems and suffering
from poor credit ratings. Today, the
term "junk bonds" is applied to all
speculative-grade
debt, regardless of
the issuing firm's financial condition.
Speculative-grade
bonds are issues
with ratings below BBB- (from Standard & Poor's) or Baa3 (from Moody's).
Over the past few years, these ratings
have frequently been assigned to the
debt of new firms that do not have an
established performance
record. Previously, these firms may have been
denied access to capital markets
because of the market's distaste for
speculative-grade
debt. The emergence
of markets for these bonds has provided a viable financing alternative
for
small or new firms that traditionally
had to rely on commercial bank loans.
Since the average investor has
neither the access to information nor
the expertise necessary to effectively
evaluate an issuing firm, the bondrating agencies provide an important
service. Ideally, the assigned rating
gives the investor a single measure of
the default probability of the rated
bond. However, the value of the
assigned rating may decline as financial conditions change with the passage
of time. It has been observed, for example, that knowledgeable
investors often
incorporate new information about the
issuing firm into the price of the bond

Junk Bonds

and Public Policy
by Jerome S. Fons

well before its rating is actually
adjusted by companies such as Moody's
and Standard & Poor's.
Since much emphasis is placed on
ratings, however, business and financial economists have closely examined
the factors that determine the rating,
as well as the subsequent
performance
of the bonds.
By and large, agencies that rate bonds
admit that there is no precise formula
for determining
which rating a bond
receives, although studies have shown
that certain patterns can be established
between the different ratings and various aspects of the rated firms.'
Factors that appear to figure prominently in the rating process are
accounting ratios, including debt to
equity; measures of past performance,
including variability of earnings; and
many so-called qualitative features,
such as the evaluator's
disposition
towards management,
and the general
outlook for a particular industry.
Although they may vary from issue
to issue, the chosen provisions under
which bonds are issued (such as call
terms, dividend restrictions,
or subordination) seek to enhance an issue's
attractiveness
by providing protection
against abuses that could endanger the
bondholder. Management,
for example,
may be restricted from entering into a
merger that might dilute the bondholder's claim, or from using the proceeds from a bond sale to payoff shareholders in a liquidation move.

1. For an excellent survey of this literature, see
Robert S. Kaplan and Grabriel Urwitz, "Statistical Models of Bond Ratings: A Methodological
Inquiry," Journal of Business, vol. 52, no. 2 (April,
1979), pp. 231·61.