By Glenn Yago
Junk bonds, also known less pejoratively as high-yield bonds, are bonds that are rated as “speculative” or “below investment” grade issues: below BBB for bonds rated by Moody’s and below Baa for bonds rated by Standard and Poor’s (the two main debt-rating agencies). Bond ratings measure the perceived risk that the bonds’ issuer will not make interest payments or repay the principal at maturity. The riskier a bond is, other things being equal, the lower its rating. The highest-rated nondefaulted bonds are rated AAA or Aaa, and the lowest are rated C, with defaulted bonds rated D; thus, junk bonds can be rated anywhere between Baa (BB) and D. As junk bonds are perceived to be riskier than other types of debt, they typically trade at higher yields—that is, higher rates of return—than investment-grade bonds. Over the past twenty years, this difference, or spread, between junk bonds and U.S. Treasury bonds has varied between three and nine percentage points, averaging six percentage points. The debt of 95 percent of U.S. companies with revenues over $35 million (and of 100 percent of companies with revenues less than that) is rated noninvestment grade, or junk. Today, junk bond issuers that are household names include U.S. Steel, Delta, and Dole Foods. Moreover, the use of high-yield securities for corporate financing greatly expanded after the mid-1990s in Latin America, Asia, and Europe (both in transition markets in Central and Eastern Europe and in the European Union). Many high-yield bonds issued in the United States are now placed by foreign corporations spurred by privatizations, mergers and restructurings, and new technology expansions.
The history of high-yield bonds is nearly as long as the history of public capital markets, with early issuers including General Motors, IBM, J. P. Morgan’s U.S. Steel in the first few decades of the twentieth century, and the United States of America soon after the nation’s founding in the 1780s. The public market for new-issue junk bonds gradually atrophied, and for most of the twentieth century—up to the 1970s—all new publicly issued bonds were investment grade. The only publicly traded junk bonds were ones that had once been investment grade but had become “fallen angels,” having been downgraded to junk as the financial condition of the issuer deteriorated. The interest payments on these bonds were not high, but with the bonds selling at pennies on the dollar, their yields were quite high. Companies deemed speculative grade were effectively shut out of the public capital market and had to rely on more expensive and restrictive bank loans and private placements (where bonds are sold directly to investors such as insurance companies). Interestingly, even though these private placements were riskier than the public high-yield bonds of the 1980s, they were never labeled “junk.” Indeed, the label “junk” and the decision about what level of risk it applies to, though now well established, is essentially arbitrary.
Financial conditions in the United States in the 1970s set the stage for the success of the junk-bond market. The collapse of the Bretton Woods system of fixed exchange rates (see foreign exchange) resulted in an upward spiral of inflation and interest rates. By the mid-1970s, three decades of interest rate stability came to an abrupt end, and short-term borrowing costs doubled in less than two years. At the same time, two oil shocks and a recession sent stock prices into a two-year slide that reduced the market value of U.S. firms by more than 40 percent. Banks curtailed lending to all but the largest and highest-rated companies, and as yields in the open market rose above government-set interest-rate ceilings on bank deposits, funds flowed out of the banking system into money market accounts. As this “credit crunch” spread, only the most creditworthy borrowers could receive credit, and, paradoxically, the most innovative companies—those with the highest returns on capital and the fastest rates of growth—had the least access to capital. From these circumstances, the contemporary high-yield securities market emerged.
If other debt is “junior” to junk bonds—that is, if junk-bond owners can be paid ahead of other debtors—then, in the event of a default, other debtors will be hurt. But these other debtors can protect themselves with debt covenants (see bonds) that give them certain rights when junk bonds are issued in a recapitalization or merger transaction.
The market for new-issue junk bonds dramatically reopened for business in 1977 when Bear Stearns and Company underwrote the first new-issue junk bond in decades. Soon thereafter, Drexel Burnham brought the debt of seven below-investment-grade companies to market. By 1983 more than one-third of all corporate bond issues were noninvestment grade. Today, the junk-bond market, by most definitions, exceeds half a trillion dollars.
This explosive growth had several causes. High-yield bonds were extremely attractive for borrowers, as they had lower interest rates and greater liquidity than private placements, and they imposed fewer restrictions on the actions of the borrowers (restrictive covenants) than either loans or private placements. The value of high-yield bonds to investors, moreover, was strengthened by the research of W. Braddock Hickman, Thomas R. Atkinson, Orin K. Burrell, and others, who discovered that below-investment-grade debt earned a higher risk-adjusted rate of return than investment-grade bonds. In other words, the interest rate that premium junk bonds offered more than compensated investors for the added risk of default. Michael Milken trumpeted these insights to both his investor customers and entrepreneurs seeking growth capital, with stunning success. The companies Milken financed with these bonds created millions of new jobs between the 1970s and 1990s.
The 1980s saw the junk-bond market grow from $10 billion in 1979 to $189 billion in 1989, an increase of 34 percent per year. Borrowers in new and emerging industries in the 1980s included Turner Broadcasting, MCI Communications, and McCaw Cellular (now part of Cingular Wireless). As well as financing innovation, junk bonds allowed firms and industries in distress to restructure and increased efficiency through the market for corporate control. Junk bonds financed the successful restructuring of numerous manufacturing firms, including Chrysler, and funded consolidations in a host of industries. During this period, yields averaged 14.5 percent while default rates averaged just 2.2 percent—a combination that resulted in annual total returns of some 13.7 percent, on average. This period ended by 1989, when a politically driven campaign by Rudolph Giuliani and financial competitors that had previously dominated corporate credit markets against the high-yield market resulted in a temporary market collapse and the bankruptcy of Drexel Burnham. Almost overnight, the market for newly issued junk bonds disappeared, and no significant new junk issues came to market for more than a year. Investors lost 4.4 percent in 1990, the first year of negative returns in a decade.
The market rebounded sharply in 1991 with positive total returns of a stunning 40 percent. The 1990s saw the market mature with increased emphasis by traders and investors on risk and portfolio management. Junk bonds left the controversy of the 1980s behind and became just another, albeit rather profitable, asset class. Default rates fell from their 1990 and 1991 highs (10.1 and 10.3 percent, respectively) to single digits in the 1990s, with an average rate of 2.4 percent from 1992 to 2000. From 1990 to 1999, the market returned an average of 15 percent annually. During this same period, the market grew from $181 billion to $567 billion, an average annual increase of 13 percent.
From 2000 to 2002, difficulties in the telecom industry, combined with the general downturn in U.S. economic activity, resulted in high default rates and disappointing total returns in the junk-bond market. The average default rate for this short period was 9.2 percent (more than four and a half times the average rate for the period 1992–1999), and the average annual total rate of return was 0 percent. Indeed, 2002 was a record year for defaults and bankruptcies, but the number of defaults decreased dramatically in 2003. The high-yield market recovered from this downturn as the telecom defaults became a thing of the past and the U.S. economy emerged from recession. The default rate in 2003 was 4.7 percent (down from 12.8 percent the year before), and year-to-date in 2004 was 2.41 percent. At the same time, the total rate of return for these years was 29 percent and 10.3 percent, respectively.
Despite external shocks to the market, such as the bankruptcy of Drexel Burnham, two wars in Iraq, three recessions, and the disruption of markets following the September 11, 2001, terrorist attacks, the new-issue and secondary markets recovered, issuers continued to tap the market, and institutional buyers returned. The continuing strength of the junk-bond market is based on linking the U.S. economy’s need for capital with investors’ need for high returns.
The Strange Case of Michael Milken
David R. Henderson
A discussion of the junk-bond era of the 1980s would be incomplete without at least a brief exposition of the legal case involving Michael Milken. Press accounts at the time promoted the view that Milken had committed serious crimes. Two journalists who repeatedly made these claims were Wall Street Journal reporter James Stewart and Barron’s writer Ben Stein. Stein, in fact, even claimed that Milken had run a “vast Ponzi” scheme. But there was nothing illegal about the use of junk bonds per se. Instead, Milken pled guilty to six felony counts of illegal activity, five of which had been previously understood to be simple technical violations of the law rather than actual crimes. The judge found the total economic effect of all the violations to be $318,082.
Four of the six counts involved Milken’s dealings with arbitrageur Ivan Boesky. Boesky had paid Drexel, Milken’s firm, $5.3 million, which was plausibly—as Milken claimed—simply the value that Drexel and Boesky placed on various reciprocal favors on a number of transactions. The government claimed, to the contrary, that the $5.3 million payment was the net amount Boesky owed after the gains and losses on various illegal securities transactions. But even if the government’s claim is true (and there is no evidence that it is), Milken’s “crime” was that he had not properly documented the ownership of some stock. The government never identified anyone injured by this failure to document.
The fifth count was that Milken failed to disclose an agreement with a man named David Solomon, by which Solomon would adjust some transactions prices of stocks to favor Drexel. The adjustments were small enough that they were within the bid-ask spread but large enough to keep Drexel interested in doing business with Solomon’s firm, Finsbury Group Ltd. Although Milken did fail to disclose, no one was hurt by this nondisclosure.
The sixth and final count was Milken’s having assisted Solomon in filing a false 1985 tax return. The problem with the government’s case was that the return was not false. Solomon claimed a real economic loss, something he had the legal right to do.
Why, then, did Milken plead guilty and accept a prison sentence rather than fight the charges and pay a fine for technical violations? The reason was that an aggressive and politically ambitious prosecutor, Rudolph Giuliani, the U.S. attorney for the Southern District of New York, took extreme measures to go after Milken. Giuliani let Drexel off with a reduced penalty in return for the firm’s cooperation in convicting Milken. Guiliani even invoked the Racketeer Influenced and Corrupt Organizations Act (RICO) to charge Milken with “racketeering.” When RICO was passed in 1970, it was aimed at organized crime, but Giuliani used it to get Milken.
Even Milken was probably shocked, though, when Judge Kimba Wood gave him a stiff ten-year sentence. Later, Wood reduced Milken’s sentence to two years, ostensibly because Milken had cooperated with the prosecution in other cases. Milken’s cooperation was minimal, though, as he kept insisting on telling the whole truth, even when that damaged the government’s chances in these other cases. Economist Daniel Fischel speculates that Wood had time to realize her mistake. After the initial sentencing, her colleague, Judge Louis Stanton, had stated that the tax “felony” to which Milken had pled guilty was not a felony. And Wood was aware that the Second Circuit had reversed many of Giuliani’s convictions of various people who faced charges similar to Milken’s.