Contrary to the promises of underwriters, junk bonds were a poor investment. They offered too little return for their substantial risk. To meet contractual interest and principal obligations, the number of things that needed to go right for issuers was high while the margin for error was low. Although the potential return was several hundred basis points annually in excess of U.S. Treasury securities, the risk involved the possible loss of one's entire investment.
Motivated by self-interest and greed, respectively, underwriters and buyers of junk bonds rationalized their actions. They accepted claims of a low default rate, and they used cash flow, as measured by EBITDA, as the principal determinant of underlying value. They even argued that a well-diversified portfolio of junk bonds was safe.
As this market collapsed in 1990, junk bonds were transformed into the financial equivalent of roach motels; investors could get in, but they couldn't get out. Bullish assumptions were replaced by bearish ones. Investor focus shifted from what might go right to what could go wrong, and prices plummeted.
Why should the history of the junk-bond market in the 1980s interest investors today? If you personally avoided investing in newly issued junk bonds, what difference should it make to you if other investors lost money? The answer is that junk bonds had a pernicious effect on other sectors of the financial markets and on the behavior of most financial-market participants. The overpricing of junk bonds allowed many takeovers to take place at inflated valuations. The excess profits enjoyed by the shareholders of the acquired companies were about equal to the losses eventually experienced by the buyers of this junk. Cash received by equity investors from junk-bond-financed acquisitions returned to the stock market, bidding up the prices of shares in still independent companies. The market prices of securities involved in arbitrage transactions, exchange offers, and corporate reorganizations were all influenced by the excessive valuations made possible by the junk-bond market. As a result, even those who avoided owning junk bonds found it difficult to escape their influence completely. We may confidently expect that there will be new investment fads in the future. They too will expand beyond the rational limitations of the innovation. As surely as this will happen, it is equally certain that no bells will toll to announce the excess. Investors who study the junk-bond debacle may be able to identify these new fads for what they are and avoid them. And as we shall see in the chapters that follow, avoiding losses is the most important prerequisite to investment success.
Ref: Margin of Safety by Seth Klarman