A few days ago, I discussed Warren Buffett (Trades, Portfolio)’s 1990 letter to shareholders of Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial), and specifically his opinion on the junk bonds that became popular during the 1980s. He pointed out that as credit standards deteriorated, the bonds being issued were becoming increasingly risky, until they got to the point where even a problem for the underlying company led to default.
Buffett derided the "dagger thesis" - the idea that higher levels of debt would make company management more aware of potential risks, much like how a dagger positioned in the middle of the steering wheel leads to more careful driving. All the careful driving in the world will do you no good if the slightest problem on the road will lead to catastrophe.
Let us look at just how bad some of these bonds were.
"Junk" - it’s in the name
Buffett gives good examples of just how deeply-ingrained the "dagger thesis" was among junk bond issuers in the 80s. Here is one especially shocking scenario:
“One particularly egregious 'kill- 'em-at-birth' case a few years back involved the purchase of a mature television station in Tampa, bought with so much debt that the interest on it exceeded the station's gross revenues. Even if you assume that all labor, programs and services were donated rather than purchased, this capital structure required revenues to explode - or else the station was doomed to go broke.”
Incidentally, many of these bonds were sold to savings and loan associations, which contributed to the collapse of that part of the banking sector. I have talked about the savings and loan crisis previously. As Buffett points out, the taxpayer ultimately had to bail them out.
How did this happen? Who would choose to buy this? After all, the word junk is literally in the name. At the time, those promoting such low-quality instruments pointed to historical evidence that demonstrated that in the past, the higher interest rates provided by low-grade bonds provided adequate compensation for the increased risk of default.
The problem with this thinking was that junk bonds were a new type of low-grade bonds, not at all similar to the "fallen angel" bonds that we looked at in part one of this series (good bonds issued by companies who had fallen on hard times). Buffett explained how junk bonds differed from fallen angels:
“The universes were of course dissimilar in several vital respects. For openers, the manager of a fallen angel almost invariably yearned to regain investment-grade status and worked toward that goal. The junk-bond operator was usually an entirely different breed. Behaving much as a heroin user might, he devoted his energies not to finding a cure for his debt-ridden condition, but rather to finding another fix. Additionally, the fiduciary sensitivities of the executives managing the typical fallen angel were often, though not always, more finely developed than were those of the junk-bond-issuing financiopath.”
With all that being said, Buffett did not exclude the possibility of finding a bargain among the junk bonds, given that the entire asset class had gone through a profound devaluation in the early '90s. He also stated that he would never buy a new issue of a junk bond, believing that nothing good could come of such a decision.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Warren Buffett on Junk Bonds, Part 1
- What Will Break the Brexit Impasse?
- Seth Klarman: Venture Into Complexity
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