CFA Institute

Investing in Junk Bonds: Inside the High Yield Debt Market by Edward Altman; ScottNammacherReview by: Martin S. FridsonFinancial Analysts Journal, Vol. 42, No. 6 (Nov. - Dec., 1986), p. 79Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4478988 .

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Book Revie ws Robert I. Cummin, Lloyd Investments, Inc., Editor

INVESTING IN JUNK BONDS: In- side the High Yield Debt Market. By Edward Altman and Scott Nam- macher. John Wiley & Sons, Inc., 272 Pages, 1986, $24.25.

Reviewed by Martin S. Fridson Principal, Manager of Credit Research Morgan Stanley & Co. Incorporated

As a bond specialist, one of the books I have most enjoyed recommending over the years is W. Somerset Maugham's The Razor's Edge. Maugham's protagonist rides through the 1929 stock market crash quietly clipping his bond coupons, remaining serene enough to become an expert in Hindu philosophy. Meanwhile, his best friend's father, a stockbroker caught up in the speculative euphoria of the late 1920s, goes broke attempt- ing to bail out his clients, eventually dying from the strain. Nowhere have I found a more eloquent statement of the relative merits of fixed income se- curities.

Unfortunately, Maugham's novel is becoming dated, at least in its financial aspects, for bonds are no longer the low-risk, modest-return securities they were in the '20s and for several decades thereafter. As Edward Alt- man and Scott Nammacher point out in Investing in Junk Bonds. Inside the High Yield Debt Market, CCC-rated cor- porate bonds (considered "predomi- nantly speculative" by Standard & Poor's) produced an astounding 75 per cent total return in 1982, primarily as a result of volatile interest rates. The authors also document that volatility cuts both ways-even "riskless" long- term United States Treasury bonds generated negative returns in 1978, 1979 and 1980. (This is before consid- ering the impact of inflation on real returns in those years.)

One consequence of the resulting disenchantment with high-quality bonds, according to Altman and Nam-

macher, is the emergence since the late 1970s of a vast market for specula- tive-grade (i.e., below Triple-B) corpo- rate issues. As defined by the authors, who are respectively a professor of finance at New York University and a member of Pepsico's treasury depart- ment, this sector mushroomed from under $8 billion in 1978 to over $50 billion by the middle of 1985. Growing participation by institutional investors in what was formerly an obscure cor- ner of the securities market has creat- ed a need for a systematic study of the risks and rewards of high yield debt.

Investing in Junk Bonds is the first book to satisfy this need and will prob- ably remain the chief investment offi- cer's definitive source for years to come. In it the reader can find reliable information on such essentials as re- turn and volatility comparisons be- tween high and low-grade bonds, a profile of the typical speculative-grade issuer, and historical default rates. To cite just one example of the book's practical benefits, the small invest- ment adviser who lacks personal ex- pertise in speculative-grade bonds will find a guide to high-yield mutual funds. In selecting a fund for clients, the investment advisor can compare 40 funds on the basis of their 1978-85 performance and on the extent of their diversification. (The authors strongly recommend that nonprofessional in- vestors participate in the high-yield market only through mutual funds, which have a greater ability to spread risk.) Large institutions, too, will dis- cover a wealth of useful data, includ- ing a breakdown of the low-rated uni- verse between "fallen angels" (i.e., issues that originally had investment- grade ratings) and bonds that came to market with ratings below Triple-B. Even when the discussion does not address vital topics, it is provocative, as when the authors attempt to ana- lyze the factors that determine the underwriters' spreads on new issues.

Altman and Nammacher's book is also must reading for those concerned

with the various controversies sur- rounding high-yield bonds. One of the most widely publicized of these is the role of low-rated debt in mega- mergers. The authors' findings indi- cate that, contrary to the impression created by the media, not all mergers are funded with junk bonds, nor are all junk bonds issued to finance hostile takeovers.

Another controversy concerns the degree of risk to investors (and in some observers' minds, to the finan- cial system) posed by speculative- grade bonds. No one can dispute that the securities are risky; the question is whether prevailing yield premiums over higher-quality securities ade- quately compensate for the risk. With- out knowing what future default rates will be, the investor can strive for nothing more than an informed judg- ment on this matter, but Investing in Junk Bonds provides several important clues. For one thing, by detailing the extent of institutional participation in high-yield bonds, the authors refute the notion that the high-yield market consists solely of overlevered specula- tors lending to one another and certain to go down together at some point. They also show that investors can limit their risk, and potentially raise their returns, by using quantitative credit analysis techniques such as the Zeta scores developed by Altman.

The authors have by and large made their book accessible to the layman, explaining even the most elementary aspects of bond ratings, for example, and incorporating a brief treatise on duration. On the other hand, a few rather sophisticated terms, such as the "Durbin-Watson test for autocorrela- tion," are not defined.

Investing in junk Bonds will prove indispensable to anyone hoping to un- derstand, analyze, invest in or borrow in the high-yield market. Given this market's dramatic expansion, I sus- pect that this book may displace Maugham's as my top reading recom- mendation.

FINANCIAL ANALYSTS JOURNAL / NOVEMBER-DECEMBER 1986 O 79

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