In this chapter, Klarman examines the junk bond market in depth to illustrate how Wall Street can create investment fads, only to leave investors much poorer when the tide goes out.
In the early to mid-1980’s, Wall Street firms pushed junk bond
s on investors, touting the positive historical results of high-yield debt. However, Klarman notes major differences between the debts of fallen angels versus newly issued bonds from fragile companies.
Since debt from fallen angels trades at a discount to par, downside risk
is reduced. At the same time, the potential for capital appreciation is large. Newly issued debt from margin
al companies does not share in these characteristics, but that didn’t stop Wall Street from pushing this form of debt, nor did it stop investors from ponying up and falling victim to these issues.
The number and size
of junk bond issues grew, despite the fact that this asset class
was untested by an economic downturn, which should have made investors cautious. Investors were happy to gobble up zero coupon bond
s (where the interest accrues to the issuer but is not paid out until the bond comes due) despite the clear risks! It took the downturn of the early nineties to wipe out those who were too eager to pay for assets that were risky.
One way investors were prodded into purchasing such securities
measures based on EBITDA. Rather than considering cash flow
, companies were valued using this accounting measure which doesn’t include depreciation
expenses. Klarman argues that a company paying its debts from EBITDA is slow
ly liquidating itself (as it can’t make capital expenditures) and leaving itself susceptible to a credit crunch.
Klarman warns that such fads will undoubtedly occur in the future, and those who are able to avoid them will do well.