June 2, 2014

NOTHING WRONG WITH RISK, AS LONG AS IT ISN'T HIDDEN FROM INVESTORS:

Junk Bonds Are Back! : And actually, they never really went away. (Zachary Karabell, 6/02/14, Slate)

We've lost track of what these bonds actually were and are: Instruments that allow riskier ventures to be funded. Historically, risk didn't necessarily mean financial risk. The rise of modern Las Vegas was facilitated by junk bonds because traditional banks wouldn't lend to an industry considered to be (for good reason) the playground of the mafia. There aren't many more surefire business ventures than owning a casino in the right location. But they just couldn't get funding.

Today, with so many banks chary of risk and forced by a new regulatory framework to be more diligent than they were in the early 2000s, the only way more speculative, untested, and creative companies can finance themselves is by turning not to banks, but to the marketplace. When these companies raise debt, they are first graded by a ratings agency such as S&P, Moody's, or Fitch, which assigns the debt a rating based on an analysis of the company's debt, metrics, and its chances of meeting its obligations under a variety of scenarios. Companies that are seen as riskier get a lower grade, and then lower ranks are considered "junk."

It might come as a surprise that companies rated "junk" include the likes of Sprint, T-Mobile, and Chrysler. They're rated junk because they all require massive amounts of spending and take on high levels of debt. These are hardly sketchy companies.

In a world where the cost of capital is cheap and perhaps getting cheaper, however, the primary risk is not that rates will spike and a business won't be able to meet its debt payments. The primary risk is that the business itself will fold. And on that score, most companies that successfully raise debt in public markets have passed enough scrutiny that they can repay their debts. There is very little equivalent in the bond market of the almost non-existent lending standards that existed in the mortgage markets in the early 2000s. Firms whose bonds are rated junk, therefore, may be riskier than GE or U.S. Treasuries, but they are likely to be much less risky than the market thinks.
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Posted by at June 2, 2014 9:25 PM
  
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