Key Concepts
1. Explain how financial institutions participate in bond markets.
2. Identify the more popular types of bonds, and elaborate where necessary.
3. Provide some opinions on potential problems with using excessive financial leverage, which lead to
leveraged buyouts. Explain the role of the bond markets in facilitating corporate capital restructuring.
POINT/COUNTER-POINT:
Should Financial Institutions Invest in Junk Bonds?
POINT: Yes. Financial institutions have managers who are capable of weighing the risk against the
potential return. They can earn a significantly higher return when investing in junk bonds than the return
on Treasury bonds. Their shareholders benefit when they increase the return on the portfolio.
COUNTER-POINT: No. The financial system is based on trust in financial institutions and confidence
that the financial institutions will survive. If financial institutions take excessive risk, the entire financial
system is at risk.
WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own
opinion.
ANSWER: The answer may depend on the type of financial institution of concern. Lending institutions
are expected to provide credit to creditworthy customers, and junk bonds may be viewed as a form of
gambling. These institutions do not invest in junk bonds. Insurance companies may invest in junk bonds,
but there is some concern that the confidence in insurance companies could be shaken if there are failures
because of defaults on junk bonds held by insurance companies. Perhaps the ideal type of institutional
investor in junk bonds is a mutual fund that specializes in investing in junk bonds, since the fund’s
objective would be clearly communicated to investors, and only those investors who wanted to accept the
high risk would invest in these types of mutual funds.