Credit ratio averages for new junk bond issuers in 1986–88 declined by 27 to 69 per cent (depending upon the ratio selected) compared with 1983–85 averages. This decline in credit quality reflects that over 75 per cent of junk bond issues in 1986–88 were incurred to finance merger-related transactions at prices and capitalization ratios that entailed interest coverage ratios well below one.

The decline in credit quality was partially reflected in a decline in the percentage of new-issue junk bonds rated Ba/BB from over 40 per cent in 1982 to under 10 per cent in 1988. But this decline understates the true decline in credit quality, because credit ratios for issuers of new bonds rated B by Moody’s or Standard & Poor’s declined 30 to 50 per cent between 1983–85 and 1986–88.

A simplified LBO model provides some insight into the credit dynamics of junk bonds. Under various scenarios, the model illustrates the relations of growth and capital expenditure requirements to debt retirement and resale values. The model highlights the importance of growth to the issuer’s ability to repay junk bond principal, the crucial impact of capital expenditures on cash flows, and the potential for underestimating junk bond default rates if the time horizon does not include the period of junk bond principal repayments.