Below Investment Grade Bonds & Junk Bonds
Below investment grade bonds can be divided into two types. The first types are bonds that were initially of investment grade but that were downgraded when the issuers fell on bad times. These are referred to as “fallen angels”.
The second type, “junk bonds”, are those that were already far below investment- grade at the point of issue.
In the past Warren Buffett had bought a few below-investment-grade bonds with success, but those belonged to the “fallen angels” type.
He describes the second type as a mine field, because companies with huge debts would require only a small “business pothole” to turn into a disaster.
In some cases, so much debt was issued that even highly favorable business results could not produce the funds to service it. The interest that they need to pay on their debts was even more than their gross revenue!
Buffett gives an interesting anecdote to explain the difference between a “fallen angel” and a junk bond:
“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.“
However, while he would never buy new issues of junks bonds, he finds it possible to find good investment ideas in junk bonds that were trading at huge discounts to their issue prices.
Such deals were few and far between, and at the end of the day, it still boils down to three words, “Margin of Safety”.