It's winter in Silicon Valley, which usually means one thing: when it rains, it pours. This year, that's more true than ever, because just when investors and entrepreneurs thought the worst of the 2000 correction was over, more bad news is arriving from an old, notorious friend -- junk bonds. A series of high-tech industry announcements (and nonannouncements) shows that the junk bond market is at least temporarily moribund. In October, details emerged of Morgan Stanley (NYSE : MWD)'s junk bond ("high-yield," to aesthetes) department getting hammered by investments in, among others, ICG Communications (Nasdaq : ICGXQ), an ISP whose stock once traded in the high $30s but now is available for about the price of a first-class postage stamp. (The debacle reportedly hastened the retirement or reassignment of several prominent Morgan Stanley junk bond investors.)

The stocks of other telecom operators, including Viatel (Nasdaq : VYTL), Covad Communications (Nasdaq : COVD), and GST Telecommunications (OTC: GSTXQ), got similarly pounded. But when privately held network infrastructure provider Linc.net announced that it couldn't find any takers for its $175 million junk bond sale, it became official: the junk bond rout was on. Combined with stock market volatility, the still mostly shuttered IPO window, and a newly selective private investment community, capital is now more expensive than ever.

The implications are potentially enormous. More costly capital means entire sectors -- like telecom -- could have development efforts slowed or even crippled, resulting in failed companies and a mergers-and-acquisitions shakeout. Cash-intensive online retailers like Amazon.com (Nasdaq : AMZN) -- which has used junk bonds to finance several inventory warehouses -- and Webvan (Nasdaq : WBVN) -- which evidently has failed to secure junk bond financing for its planned distribution centers -- could see expansion plans hindered. And innovation could suffer as promising technologies, too young to show a sustainable business model, fail to find development funding.

WHEN JUNK WAS FASHIONABLE

As technology blossomed in the mid- to late '90s, junk bonds became a fashionable financing option, especially among telecom companies that needed lots of cash to build out their networks. For example, telecom providers Level 3 (Nasdaq : LVLT) and Global Crossing (Nasdaq : GBLX) raised at least $5 billion and $3.5 billion, respectively, from their IPOs, revolving credit, and junk bond financings. Junk was in vogue as investors underwrote cheap debt for rapidly growing companies whose promise seemed endless. But when the market cooled and the bills came due, junk was sneered at and whispered about like an embarrassing relative.

That happened last fall when the proportion of junk bonds trading at distressed prices -- yielding 10 percent or more over U.S. Treasury bonds -- reached the highest level since 1990, right before the current economic boom started.

Rick Miller, managing director of global research for investment bank UBS Warburg, says a confluence of factors contributed to junk's sudden demise, including repeated interest rate hikes by the Fed in 1999 and 2000, a strong treasury bond market, and the stock market's negative reaction to its own tremendous growth. All these have resulted in the increased default rate for junk, from about 1 percent in the mid-1990s to about 4 percent through the first half of 2000.

Mr. Miller's colleague Aryeh Bourkoff, senior telecom analyst at UBS Warburg, says telecom companies' massive equipment expenditures have outpaced their ability to reap income from the gear. "Building networks and buying switching equipment is extremely costly, but it also depreciates quickly, so these companies made heavy capital expenditures that are already in depreciation, and now they can't raise more funds to support their debt," he says.

But Mr. Miller cautions those who would wag a scolding finger. "It's easy to look back and say how silly these investments were, but at the time they seemed plausible," he says. "In many cases, investors were compensated well and would probably do it again. Now they're paying for the sins of the boom. But if we're in a slowdown, I wouldn't want to be in paper or steel, either."

QUICK CAPITAL

What is the lure of junk funding? In a word, price. With expensive venture and strategic funding already in place and a continued, usually urgent, need to raise development financing, companies in cash-intensive sectors like telecom must do what, in theory, enables them to build most quickly. "These companies need capital and they can't access the equity markets yet (or again)," says Molly Toll-Reed, an analyst with Standard & Poor's ratings service. "But leveraging yourself in the tech industry is riskier than in other industries because earnings and cash flow can be less predictable."

The problem for telcos, in particular, is the more they spend now, the more they need to spend later to keep up with other companies building competitive networks, to sustain existing projects until consumer demand arrives, or to scale up when demand increases.

Junk bond investors must deal with the ripple effect caused by a spectacular failure like ICG, according to Robert Waldman, managing director of telecommunications for Salomon Smith Barney. "If you buy a bond at par, and everything works out so it's up two to five points over time, plus the yield, but then you have one ICG that's trading for 20 cents on the dollar, you need a whole lot of good ones to make up for that one bad one," he says. Because bonds are essentially IOUs issued by these companies, consistently high network construction costs combined with perpetually imminent demand -- the broadband services and applications boom always seems to be just around the corner -- means these very pricey chits become difficult to repay.

Even in this troubled period, high-yield financing can be available to the right company (see "No way out"). Last fall, optical equipment maker Cyras raised about $150 million in a convertible debt offering. Cyras's chief financial officer Shekhar Mandal says the company -- too mature and near an IPO to seek venture funding but still needing research and development money -- sought the convertible offering to garner cash that should last until 2002. (Cyras had been expected to file its S-1 last fall before its CEO abruptly resigned. See "The big switch," October 30.) "We wanted to get the money lined up, to have everything perfect, before we did an IPO, so we wouldn't be forced into it, and we did the convertible round to get the best valuation for the company and minimize dilution," Mr. Mandal says. However, the company ended up not following the IPO route: on December 19th, Ciena (Nasdaq : CIEN) announced it was acquiring Cyras in a stock deal worth $2.6 billion.

Still, Cyras is an exception to the new rule, because cheap financing is simply unavailable, and according to Lehman Brothers analyst Ravi Suria, the outlook for telcos is especially bleak. In a November report, he said it's unlikely that the "high-yield players" can rely on the debt markets any more and would likely need "substantial infusions of equity."

This is equally true for companies like Webvan and Amazon.com, two retailers that have had considerable trouble selling bonds. Amazon's well-documented troubles culminated in October with another report from Mr. Suria that strongly cautioned investors about the company's cash flow and credit problems -- spelling trouble for investors when Amazon's bonds come due.

And Webvan announced in July 1999 that it had contracted engineering firm Bechtel to build up to 26 distribution centers nationwide for about $1 billion -- much of which, the company said, would be funded with junk bonds. Today, the Webvan plan doesn't even merit a mention on Bechtel's Web site. A Bechtel spokesperson was uncertain about how many distribution centers have actually been built and said the Webvan agreement was nonbinding -- and, evidently, on hold. (According to press releases, Webvan has opened only a few distribution centers since the Bechtel announcement; Webvan officials didn't respond to inquiries seeking comment.)

LOOKING FOR EQUITY

Even already-funded companies are finding it difficult to raise more capital. When Realnames, a company trying to establish a "keyword" system to replace dot-com addresses, went divining for its fifth funding round last summer, CEO Keith Teare was stunned by the ordeal. Having previously amassed well over $120 million and a strategic partnership with Microsoft (Nasdaq : MSFT), he thought the endeavor wouldn't be much more than a formality. "It was really, really hard. We had as many or more nos than yeses," he says. "One VC told me he feels like a kid in a candy store because there are so many deals he can afford that he couldn't before."

RealNames was able to land the $50 million it sought with a reasonable valuation, but Mr. Teare says the trend toward big investments for low valuations has put entrepreneurs in a weak position, one that ultimately could discourage innovation. "These days, investors are so focused on exit strategies that it may be difficult for promising, but unproven, technologies to get what they need to get off the ground," Mr. Teare says.

Less fortunate companies now are in a funding no-man's-land where they've built too much to turn back but don't have enough to continue forward. Skeptical telecom analysts think many telcos probably never had much promise and were just trying to cash in on a gold rush. Mr. Waldman says few telcos have "tested, battle-scarred managers" who have run large networks. "Telecom is difficult, full of complex systems that must be monitored and scaled," he says. "Some people can do it on a smaller scale, but to build larger networks, they'll have to go hat in hand for strategic or private equity."

This situation leaves telecom poised for a vigorous shakeout, with very large public companies gobbling up smaller ones that run out of cash. Mr. Miller says those most likely to weather the storm will be seasoned issues, companies that don't require continual access to market capital and can demonstrate real asset value. But, he adds, as crippled as junk bonds are right now, they eventually will come back. "Investors will just have to be wiser the next time around," he says, "and make sure that the companies they invest in have better management teams, good asset valuation, and a strategic importance to the rest of their sector."

There will be many casualties before that occurs. "I'm not sure what will bring the market back, but maybe good returns from midlevel companies like Level 3 and Nextel might help," says Christopher Anker, managing director for Miller Tabak Roberts Securities. "Until then, many high-tech investors will learn a lot about the bankruptcy process." In short, any company that thought it saw a break in the storm might want to keep that raincoat on a while longer.

Additional reporting by Peter D. Henig and Peter Rojas. Write to luc.hatlestad@redherring.com.

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