Jitters in the Junkyard

Their name may not seem to fit the gilded 1980s, but junk bonds have proved to be the hottest and most controversial financial instruments of the era. These low-grade, high-interest bonds have enabled corporate raiders to raise billions of dollars for ventures that have reshaped American business. Yet most investors have had persistent reservations about the safety of the securities. One concern is that too much of the underwriting and trading in junk bonds has been handled by just one firm, Drexel Burnham Lambert (last name pronounced Lamb-bear), which controls 50% of the market. If that go-go firm were to get into trouble, many certificates could become more difficult to sell and would decline substantially in value.

Those long-suppressed anxieties surfaced last week as the insider-trading probe began to focus on Drexel and several of its top officials. Resale prices for many of the $120 billion in outstanding junk bonds slumped sharply, and investors wondered if the world of high-yield, high-risk finance was crumbling.

For decades the term junk bonds referred primarily to the downgraded securities of companies that had run into financial trouble. Standard & Poor's, the investment-research firm, classifies junk bonds as those rating lower than BBB on a scale of AAA to D. Few prudent investors wanted to touch such securities until the 1970s, when a young Drexel investment banker named Michael Milken began touting them as a good deal. He contended that their high yields, typically 3% to 5% above those of U.S. Treasury bonds, were extremely attractive, since junk bonds had historically gone into default only slightly oftener than more reputable securities.

Milken began underwriting new junk bonds in the late 1970s, using them primarily as a financing tool for companies that were too small or unproven to issue investment-grade bonds. In early 1984 Milken began using the bonds to finance takeover bids. Until then virtually the only way to raise money for a corporate raid was to borrow the cash from banks, which often attached too many strings. Milken was able to raise the billions necessary for a mega-deal by assembling a network of high-rolling investors whom he could call upon to buy junk bonds, or to promise to do so, at a moment's notice. Among them: insurance companies and savings and loan associations looking for a high- paying place to put their money. Before long, Milken's bustling office in Beverly Hills became the financial fueling stop for takeover artists on their way to a raid. Milken helped Carl Icahn take over TWA, backed T. Boone Pickens' run at Gulf and supported Ted Turner's successful bid for MGM/UA, among many other deals.

The amount of cash that Drexel has raised through junk bonds has zoomed from $839 million in 1981 to $13 billion so far this year. Fees from those securities helped catapult Drexel from a second-tier investment house, ranked eleventh in 1978, to one of the three or four most powerful firms on Wall Street. Drexel's 1986 revenues will reach an estimated $6 billion, up from $4 billion last year. Milken has prospered even more stunningly. By far the most highly compensated Drexel employee, Milken, now 40, has amassed a fortune, estimated at more than $500 million. Yet Drexel's empire could fall apart rapidly if it is found that Milken or other employees systematically leaked inside information about their takeover financings.

If Drexel encounters legal problems, the gap left in the junk-bond market might be partly filled by such rivals as Merrill Lynch and Morgan Stanley. Drexel's success has made it the most resented and envied player on Wall Street, and competitors will be eager to haul away a piece of its golden junk pile.