Junk bonds are bonds that are sold for a specific purpose with the expectation that those who purchase the bonds will be repaid (with interest) when that purpose is achieved. Often these bonds are offered in order to raise funds to purchase a company, break it up, and then sell the pieces. It is expected (hoped) that the value of the pieces sold will far exceed the purchase cost, thus leaving ample funds available to repay investors.
They are termed junk because, unlike normal bonds, which are backed by some form of assets, these bonds have nothing behind them except the belief that the proposed transaction will take place and will result in a profit. If the deal falls through, holders of these bonds may get some portion of their investment returned but they will not make the big profit they had envisioned.
Perhaps the most vigorous proponent of the junk bond business was Michael Milken. He was convicted of fraud several years ago, but that is a different matter. He had great skill in estimating the value of the assets owned by a company. If the market value (price per share times number of shares outstanding) was less than the value of the assets, he would assemble investors to provide the funds for a takeover. He made a great deal of money, both for himself and for his associates, in doing so. As an example of just how profitable it could be, he once hired a young broker from an investment bank. The broker at that time had an annual salary of $42,000, with the expectation of an annual bonus of about half that, so a little better than $60,000 for a year. After working for Milken for six months, Milken himself came into the young man’s office, and handed him an envelope with a check for a six month bonus. It was for three million dollars.
Another investor who has been known to use junk bonds is Kirk Kerkorian. He once assembled a team of investors to provide funding for a hostile takeover of Chrysler Corporation. Their bid was thwarted by Chrysler’s board of directors, but he had a great plan. Years earlier, Chrysler had some big trouble with their labor union. It cost them a great deal of money and the board of directors decided they would not let that happen again. They stockpiled cash so if a labor dispute arose, they would have enough funds to ride it out. They had several billion dollars in cash available. Kerkorian’s idea was to borrow, through junk bonds, the funds to buy Chrysler, and then pay the investors out the money Chrysler had in the bank. He was planning, in effect, to buy Chrysler with its own money. Investing in junk bonds is not for the faint-hearted and it would be really stupid to use the grocery money to buy them. The returns can be astonishing, but you may lose your entire investment.