Back to "Junk"
The end of "high yield" bonds
When I started working in the investment banking business back in the early 1980s, Michael Milken and his cronies at Drexel Burnham Lambert (Drexel) were just beginning to underwrite non-investment grade bonds to finance hostile takeovers. These securities generally yielded over 10% (12-15% was not uncommon) but were viewed by the issuers as attractive sources of risk capital in a high interest rate environment and with the stock market just beginning to come out of a decade-long bear market. Keep in mind that the issuers of these bonds had very low credit quality with very little in the way of cash, cash flow or equity to back the bonds they were issuing. Hence the term “junk”.
Junk bonds became big business for Drexel and Milken and his team made a lot of money for the firm and for themselves, that is until Milken and then the firm were indicted for securities fraud in 1989. Many people think the indictment was unjust, but the criminal charges put both Milken and Drexel out of business. Milken ultimately paid a personal fine of $600mm and was sentenced to ten years in prison, of which he served two. (He was later granted clemency by President Trump, some of whose companies were themselves big junk bond issuers.) Milken’s cohorts largely survived the demise of Drexel and many went on to work at other more established Wall Street firms or in some cases to found their own very successful firms. You probably know some of the names but may not have known where these folks got their start: Leon Black (Apollo), Ken Moelis (Moelis & Co.), Stephen Feinberg (Cerberus), and Richard Handler (Leucadia National). All are Drexel alums, and all are much richer for the experience.
During the 1980s, senior executives at the more successful Wall Street firms (eg Morgan Stanley and First Boston) publicly expressed disdain for the disruptive and seemingly nefarious activities of Milken’s Beverly Hills cowboys and their clients. At the same time, however, the leading Wall Street investment banks were working hard to replicate within their own firms Drexel’s profitable junk bond activities while pulling in huge M&A advisory fees defending their establishment corporate clients from attack by Drexels’ very non-establishment group of junk-bond financed raiders. Eventually, the big Wall Street firms even went so far as to launch their own more staid versions of Drexel’s annual junk bond investor conference, which had famously become known as “The Predator’s Ball” (also the name of a fun book by Connie Bruck, reviewed here.)
At my old firm, the fixed income powerhouse Salomon Brothers, partner and chief economist Henry Kaufman (“Dr. Doom”) argued strongly against the firm getting into the junk bond business. His argument was that “bonds are securities which pay interest and repay principal”, which was not likely to be the case with many of the securities issued by Drexel’s clients. Dr. Kaufman thought of junk bonds as more like speculative equity, with a high but temporary dividend (the coupon on the bond) which would likely soon be cut (along with some of the principal). Dr Kaufman lost the internal political battle over junk bonds to CEO John Gutfreund and a cadre of much younger leaders who did not share Dr. Kaufman’s scruples about underwriting (and even bridging) junk bonds. You can read about this debate here: “Can Salomon Brothers Learn to Love Junk Bonds?”
Although Salomon Brothers went on to become a big player in the junk bond business (“go big or go home”), it did not exactly cover itself in glory along the way. You can read about some of Salomon’s amateurish attempts to buy its way into the junk bond business in conjunction with the RJR LBO in the book, Barbarians at the Gate. I am pretty sure that Dr. Kaufman was not a big fan of this deal.
Ironically, Dr. Kaufman later in his career went on to serve on the board of directors of Lehman Brothers, itself a big underwriter and trader of junk bonds and other low quality securities, particularly commercial real estate and residential mortgages. In the film Too Big to Fail, Dr. Kaufman’s voice is the last one you hear very quietly voting “yes” when the Lehman board decides to file for bankruptcy. I don’t know what was going through Dr. Kaufman’s mind at that time, but what a sad way to end an otherwise distinguished career. And to be brought to this point by Lehman’s excessive holdings of junk securities is more than a bit ironic.
At some point in the early 1990s, investment banks discovered that they could sell more of these bonds if they marketed them as “high yield” instead of “junk”. Viewed from today’s perspective, this seems more than a bit ironic with the average yield on non-investment grade corporate bonds now at 4% (and under 3% for some top-rated BB securities). I may be showing my age here, but when I see junk bonds priced at these low levels, I feel like a character from Star Trek: “Beam me up Scotty, no sign of intelligent life here”.
In what parallel financial universe are we now living? I guess the same one in which 10-year UST bonds yield 1.3% and T-bill rates have been at 0% for much of the last 12-years. Student readers, you have not yet experienced any other capital markets environment than the current one, but trust me when I say “THIS IS NOT NORMAL”. At least not to those of us who began work back in the 1980s.
The average yield on the ICE BofA HY Bond Index is now at 4%. This seems quite low to those of my generation, and it is by historical standards. But for those of you who say “4% isn’t too bad in this low interest rate environment”, keep in mind that 4% is the average contractual yield on the securities in the index, which assumes that all of the contractually promised payments of principal and interest are made in full and on time, without default. Students of finance will understand that bond yield is not the same thing as expected return, at least not for low-rated credits. It is highly unlikely that investors in a portfolio of junk bonds will receive 100% of the promised future cash flows (principal + interest) on bonds rated BB, B or CCC. (A rating of D means in default). If investors incur credit losses of just 1% per annum on their high yield bond portfolio, that contractual portfolio yield of 4% would fall by 25% to a realized yield of only 3%. And yet large institutional investors keep buying these bonds, lots of them, even at these remarkably low yields. Why is that?
For some perspective let’s turn to a true expert, Howard Marks, chairman of Oaktree Capital, one of the world’s largest distressed debt fund managers. Oaktree periodically publishes memos written by Mr. Marks on various investment topics, which are read by many investment professionals and which I recommend to you all. For purposes of today’s discussion I would like to highlight a particular memo that Mr. Marks wrote in February 2013, when the average yield on HY bonds had fallen to a recent low of 6%, down from 9.5% in September 2011 and over 20% during the 2008 financial crisis. In explaining the market pricing of HY bonds at this seemingly low yield, Mr. Marks focused on three sources of value to the investor: (1) the high credit spread over USTs (then almost 5%, now 3%); (2) the relatively short duration of HY bonds (which cushions HY bond prices against the impact of rising rates or widening spreads); and (3) the low expected loss from future defaults (probability of default x loss given default). As Mr. Marks explained in 2013, with credit spreads of close to 5%, HY bond investors could absorb even historically high default losses and still generate a return in excess of the yield on UST bonds, thus compensating investors for the higher credit risk associated with HY bonds.
Today’s post was inspired by a recent WSJ article, the headline of which reads: “Recent Junk Bond Rally Pulls Yields Below Inflation”. The headline is accurate, if we compare average bond yields (4%) to the latest CPI data from May 2021 (5%). This may or may not be a sensible way to think about the relationship between bond yields and inflation (probably not), but to me this is not the most interesting aspect of the article. What I find most interesting is that the WSJ headline writers no longer refer to non-investment grade bonds as “high yield”. The WSJ is now back to calling these securities “junk”. This seems about right to me. At average yields of 4% or less, we can’t really call these bonds “high yield”, even in today’s Alice in Wonderland world, which just keeps getting “curiouser and curiouser”.
I have no doubt that the term “high yield” bonds will come back into vogue at some future time. But for now it seems that we can once again publicly refer to these securities as “junk”, just like we did back in the 1980s. For those of you just now beginning your investment banking careers, don’t despair. As Michael Milken taught us, there is a lot of money to be made even in selling “junk”.