(FORTUNE Magazine) – JUNK IS IN TROUBLE. The big questions now are ''How bad?'' and, even more important, ''Why?'' Peddlers of high-yield bonds argue that the current malaise is merely temporary. The market is suffering just one more bout of indigestion, they say, having swallowed too much debt from the RJR-Nabisco takeover and feeling heartburn from suddenly illiquid borrowers -- Campeau, Integrated Resources, Resorts International, and the like. A more complete diagnosis suggests the problems go much deeper. New money isn't flowing into the market as it once did, while the line of would-be borrowers gets longer every day. Says a major buyer of junk bonds: ''For the next couple of years I wouldn't expect to see any growth in the market at all.'' Borrowers who have tried to finance deals elsewhere -- notably the group that wants to buy United Airlines parent UAL Corp. -- have also run into unexpected flak. If investors stay on the sidelines, prices of high-yield bonds will remain depressed, borrowers will face bracingly stiff interest rates, and many big deals -- acquisitions, buyouts -- will be done at prices far lower than anyone would have expected a year ago. That is, if the deals get done at all. What happened? A lot, and the explanation goes beyond the hiccups of the temporary-indigestion theory, to the role of Michael Milken in the junk bond market and the part played by savings and loan associations, heretofore among the biggest investors in junk. Only by sorting out such elements can one get an accurate sense of the market's long-term prospects. The signs of trouble in junkdom abound. For much of 1989, buyers of high- yield securities, fretting about possible recession and the defaults it might bring, demanded staggering premiums from borrowers. The spread between the rate on Treasuries and that on the average high-yield bond widened to five or six percentage points this spring -- as wide as it has ever been -- and it stayed there. Despite the high coupons, holders of the bonds have suffered miserably. The total return on junk bonds -- the interest they pay plus the change in the price they trade at -- slumped into negative numbers in the third quarter. When Campeau Corp., one of the largest borrowers in the market, teetered at the brink of disaster in mid-September, prices faltered and buyers ran for cover. In the face of such perturbations, many investors long wistfully for the stability that Michael Milken brought to the junk market. In particular, they miss Milken's uncanny ability to patch up a troubled junk bond issuer before its problems reached a critical stage. Through his firm, Drexel Burnham ! Lambert, Milken would arrange swaps of securities -- trading, say, preferred shares for an outstanding issue of high-yield bonds -- that kept bondholders and the issuing company at relative peace. He bought time for the borrowers to fix what ailed them. Without Milken, the market seems to lurch from one crisis to another. No one else can get borrower and lender to accept restructurings until the borrower is on the edge of bankruptcy. In a flap with major implications for junk, Integrated Resources, a big issuer of commercial paper, couldn't raise enough money from other sources to keep creditors at bay. ''Mike never would have allowed that to happen,'' says a manager of a large portfolio. Resorts International nearly buried itself under too much debt. Another big junk borrower, Robert Campeau, had to put his company's Bloomingdale's subsidiary up for sale after its reported cash-flow problems prompted suppliers to stop delivering merchandise to his stores. EVEN SEAMAN Furniture Co., a relatively small retailer acquired by buyout king Kohlberg Kravis Roberts, nearly sank before it could be restructured. KKR wrangled with the banks and junk bond holders until the company was near collapse. Says Morton Seaman, founder and chief executive: ''My family thought we had sold the business. I was cleaning out my desk, when at the twelfth hour, with the company almost in Chapter 11, we decided to stay.'' Morton and his brother Carl put up $7 million, which proved critical to resolving a stand-off between KKR and the banks. All this brinkmanship unnerves investors. While Drexel still accounts for some 42% of the new high-yield bonds issued, its junk bond team, missing Milken and key lieutenants, can't replicate his feel for the market. Says Jim Caywood, a partner in Caywood-Christian Capital Management of La Jolla, California, a firm that manages high-yield portfolios: ''You used to be able to call up Drexel and find out what was going on at a small company that had issued bonds a couple of years before. Mike kept track of that. Now you call up and nobody is up to date on the company.'' Missing as well is the special network of buyers that Milken built. Columbia Savings, a big S&L, and First Executive Corp., an insurance company, both long in the Milken orbit, are no longer buying. Also out of the market are several investment partnerships now under criminal investigation and a few managers at mutual funds suspected of taking some of the warrants that Drexel sold with its new issues and putting them into their personal accounts. With that network disassembled, Drexel can't sell some of the junk it once could. ''Mike had the ability to use his network to finish a tough deal,'' says Caywood. ''If a deal got to the point where there was only $10 million or $50 million left to sell, Mike would find a buyer. Drexel just can't sell deals the way it used to.'' With Milken and his network largely gone, the most troubling question facing the junk bond market is where the cash will come from to buy new securities. As early as last spring, credit was being rationed: Only the strongest borrowers could move their securities, often by issuing bonds that give new lenders seniority over the old. Weaker borrowers -- small companies or those with credit problems -- are being forced out entirely. Ramada, for example, had to defer a restructuring because it could not bring to market the $400 million junk issue the transaction required. Says Peter Carches, head of the high-yield securities operation at Morgan Stanley: ''If the deal is good, people will buy the bonds. But you can't get buyers to accept marginal business. There is a $10 billion calendar out there, but I doubt more than $6 billion will ever come to market.'' A MAJOR REASON for the thinness of the market, though most junk bond traders don't like to admit it, is the S&Ls' fast exit. When Congress passed its bailout bill for the S&L industry, it mandated that the institutions no longer invest in junk. Current holdings must be liquidated within five years. Traders expected an orderly exit, but the S&Ls appear to be rushing for the door. In the second quarter alone, they jettisoned nearly $2 billion of the $14 billion in junk they held. That might not look like a crippling blow to a market with $200 billion in debt outstanding, but look more closely. In the first nine months of 1989, about $20 billion of new junk bond issues were sold. Some $4 billion of that went into RJR paper, an offering so liquid and by a company so well-known that it ended up in the hands of many investors not accustomed to buying high-yield bonds. A surprisingly large slug of the money to buy the remaining $16 billion in junk came from corporations that were calling in or redeeming bonds. For the first nine months of 1989, total redemptions ran to just under $9 billion. This means that only about $7 billion of new money has actually flowed into the market so far this year -- or about $2.3 billion a quarter. , That figure puts the sales of junk bonds by S&Ls in a different perspective: In the fourth quarter of 1988, S&Ls were buyers, injecting $2 billion of new money into the market. In the first quarter of this year they sold, dumping about $700 million of bonds, and in the second quarter their sales nearly tripled, sopping up almost $2 billion of cash that might otherwise have gone to newly issued securities. This represents a big swing. THE MARKET may not yet appreciate how much the sales by S&Ls damp hopes for a recovery. Over the past few weeks, opinion has solidified among S&L executives -- and among the institutions' accountants -- that under the still somewhat ambiguous new rules laid down by Congress, S&Ls holding junk bonds should carry the securities at market value, not at their purchase price. This means that any losses on those bonds will tumble right to the income statement this quarter or next, which will in turn remove one of the few deterrents to wholesale dumping -- traders had expected S&Ls to hold on to bonds rather than recognize those losses. If this seems counter to much of what you've heard about the S&Ls and their junk holdings, you're not alone. The language in the S&L bailout bill is so murky that it appears to offer thrifts the chance to stay in the high-yield market. At least, it permits them to set up separate subsidiaries to hold and trade high-yield bonds. The trouble is that these subsidiaries must have their own capital base, separate from that of the thrift, and they can't raise money with federally insured deposits. That being the case, most S&Ls can't raise capital cheap enough to profitably finance a junk portfolio. Among S&Ls with the largest junk bond holdings, only one, Imperial Savings Association of San Diego, has faced up to reality so far. In late September the institution announced that it will be writing its portfolio of junk to market in the third quarter, which at current prices would mean a loss of about $80 million on $1.2 billion of junk bonds. An even bigger loss could be reported by Columbia Savings of Beverly Hills, which has a junk bond portfolio of $3.9 billion. Owners of junk would not miss the S&Ls so much if the rest of the market were growing. But it isn't. Nervous about credit problems, small investors stopped putting cash into junk-bond mutual funds in July, and money has been trickling out steadily since. Though fund managers say they weren't hit by huge redemptions after the mid-September sell-off, they are keeping cash reserves higher than normal in case more investors decide to bolt. Gone as well are some of the most sophisticated holders of high-yield paper. Many insurance companies have moved to the high-quality end of the high-yield market. Other former buyers now sitting on the sideline include First Executive of Los Angeles, the life insurance company that has bet most heavily on high-yield securities over the years. Its junk bond portfolio represents more than 40% of its total investments, in percentage terms the largest holding in the industry by far. But some two years ago, First Executive began to cut its exposure. Once a net buyer of $1 billion or more of junk bonds a year, in the first six months of 1989, its junk holdings decreased by over $300 million. The circumstances surrounding First Executive's departure illustrate the forces buffeting buyers these days. The insurer has faced tough regulatory criticism for the past few years and has been dogged by reports that the ties of its chief executive, Fred Carr, to Michael Milken have been a subject of a series of federal investigations. In addition, First Executive's portfolio of high-yield bonds has suffered like everyone else's. First Executive contends the losses and the regulatory pressure aren't as important to its buying decisions as the riskiness of new junk bond issues. Says Merle Horst, the chief financial officer: ''We believe the high-yield deals that we have seen the past couple of years have not been as attractive as in the past. There isn't as much equity behind them; they aren't as well thought out.'' A year ago the complaints of bond buyers didn't bother issuers: Almost anything sold. But now it's a buyers' market. Investors are demanding more equity from issuers, and tighter legal protections in the event of problems. Indeed, it's not too much to say that the problems in the junk market are causing a sea change in the world of deals. Many transactions that might have once been snared by junk bond-backed buyers now go to purchasers who can raise capital in other ways. Alfred Checchi, the former Marriott executive who bought NWA, owner of Northwest Airlines, relied solely on bank borrowings. Executives at Holiday Corp., completing a $2.2 billion restructuring, thought about a high-yield financing but decided instead to obtain a bank letter of credit to back their bonds, which will boost the rating to at least single-A and save the company a bundle. But in the current jittery climate, even banks may not have the requisite capacity to finance deals: They failed, for example, to fund the proposed buyout by an employee group organized to acquire UAL, parent of United Airlines. Hardest hit by the skepticism of junk bond investors are transactions that involve zero-coupon, increasing-rate, or payment-in-kind (PIK) notes. Zero- coupon notes don't pay any cash interest until maturity. Increasing-rate notes start with low interest rates that gradually increase. PIKs give the issuer the option of issuing new securities instead of cash when making interest payments. These financing techniques grew popular in deals where cash-flow projections couldn't cover the interest normally paid on junk. Now that Congress is seemingly determined to eliminate the tax breaks these exotic variations entail, they are particularly tainted. Says James Stern, head of merchant banking at Shearson Lehman: ''I would certainly not bet my future on financing an LBO in this market with paper that doesn't make current interest payments in cash.'' For that matter, it seems increasingly difficult to bring any LBO to market these days. In the third quarter, according to Securities Data Co., the number of leveraged buyouts dropped 38% below the same period a year earlier, while for the year the number of deals is off 28% and the dollar value down 21%. DEALMAKERS say that a series of companies that went up for auction have either been sold for prices lower than expected or not sold at all. While investment bankers had talked of getting as much as $600 million for Ethan Allen, the furniture retailer, it finally went private for less than $350 million. The Lily Cup division of Fort Howard paper, which some analysts thought might fetch $1 billion, sold in a private transaction for $700 million or less. Harcourt Brace Jovanovich got only $1.1 billion for Sea World, despite earlier estimates it was worth $1.5 billion. An LBO group including First Boston and the Pritzker family restructured its bid for American Medical International Inc. because of the congressional assault on the tax benefits of PIK notes, which they were relying on to finance the deal. The group ended up lowering the offering price by $250 million and increasing the amount of equity it would put in. The drop in prices that LBOs command should further jangle the nerves of high-yield bondholders. Much of the debt they've been buying is designed to be | paid off as companies are broken up and sold off. If prices keep coming down, the assumptions on which those deals were based may soon look ludicrous. RJR sold its Del Monte division to a group of buyers for a decent price. But it has more to sell. The market for retailers is glutted, with Bloomingdale's, Saks, and a half dozen other chains for sale. Campeau, which is selling Bloomingdale's, expected the chain might fetch $2 billion, but in the cold reality of today's market, investment bankers think $1 billion is a better estimate. With investors leery, the competition to underwrite a shrinking number of deals is likely to grow more intense. Even as they hustle after a declining business, Drexel, Morgan Stanley, and other firms that have dominated the high-yield market are about to be met by eager newcomers. BT Securities Corp., a subsidiary of Bankers Trust, is preparing the first junk bond underwriting in 50 years by a commercial bank. Prospective junk bankers waiting in the wings include J.P. Morgan, Chase, and Citibank. From this new, more intense competition, there may even emerge improved, less junky deals. Indeed, no less an authority than Michael Milken has started exhorting underwriters to change their tactics. In recent speeches he has encouraged them to demand that would-be borrowers put up more equity. Milken also suggested that his brethren seek ways to finance the growth of companies without overburdening them with debt. The message seems clear: no temporary case of indigestion this. In the long haul, junk ain't gonna be what it used to be.