An instrument of high yield debt issued by a corporation or governmental agency is commonly known as a Junk bond. The term is considered slightly pejorative and is often referred to by the euphemisms high yield bond and non-investment grade bonds.
In modern economies, debt is bought and sold in the form of bonds traded in organized markets. The price of a bond is determined by numerous factors, including the interest rate, the term, and the degree of risk associated with the underlying assets. The risk of a bond is determined by one of serveral credit rating agencies such as Standard and Poors and is expressed by a rating such as 'AAA' (where 'A' is better than 'B' and 'AA' is better than 'A').
For a bond to be considered 'Junk' it must have a rating lower than a certain level. This lower rating implies a higher yield, making junk bonds attractive investment vehicles for certain types of financial portfolios and strategies. Many pension funds and other investors, however, are prohibited in their by-laws from investing in bonds which have ratings below a particular level.
Unlike investment grade bonds, the value of junk bonds is affected by the possibility of default. For example, in a recession interest rates tend to drop, this tends to increase the value of investment grade bonds, however a recession increases the possibility of default in junk bonds.
Junk bonds were popularized in the 1980s by Michael Milken as a financing mechanism primarily for mergers and acquisitions. In a leveraged buyout or LBO an acquirer would issue junk bonds to pay for a corporate acquisition and then use the cash flow of the target company to pay off the debt over time. This strategy was widely used in the '80s, with both success and dramatic failure. A very well-known LBO was the purchase of Nabisco by Kohlberg, Kravis, and Roberts as chronicled in the book Barbarians at the Gate. A person who had insider knowledge as to whether a merger was about to succeed or fail could illegally use this knowledge to make a large amount of money through insider trader, a practice which ultimately caused people such as Michael Milken and Ivan Boesky to end up in jail.
Proponents of LBO's claimed that they caused companies to make more efficient use of their resources. Opponents claimed that they tended to destroy value and cause great economic hardship through the economic disruptions they caused.
Many LBOs resulted in corporate bankruptcy, such as the one for Federated Department Stores. This occurred when the acquirer miscalculated the potential value of the buyout. Furthermore, companies adopted a number of financial techniques, such as the poison bill which protected them against hostile takeovers. These measures caused the use of LBO's as a financing tool declined during the 1990s. However, junk bonds are still used to finance capital intensive industries such as telecommunications.