In today’s Exponential Investor…
- What are high-yield (a.k.a. junk) bonds?
- How did they transform US financial markets?
- What was the big opportunity that they provided investors?
Does the phrase “junk bond” mean anything to you?
It’s a nickname for a bond that has been rated as being below investment grade by one or more credit ratings agencies.
A low credit rating means that the agencies consider that there is a significant – perhaps high – likelihood that the issuer of the bond (usually a company) will default.
A default is a situation where the issuer is unable to make the regular interest payments (sometimes called the coupons, because old-fashioned bond certificates actually were attached to coupons which the holder would present in order to get paid) and/or the principal of the bond when it matures.
In practice, the risks of default are not just recognised by the ratings agencies. The risks are also recognised by bond market investors (who often move before the ratings agencies actually comment on the situation).
As investors sense an increased risk of default, some will sell the bond in question. Its market price falls.
Bond markets are often called “fixed income” markets. That is because, for most bonds, pretty much all the things that matter are known and fixed at the time that the bond is issued.
For our purposes, the things that matter are: the amount payable at maturity (sometimes called the face value of the bond); the date of maturity; the coupon interest rate (being a percentage of the face value); and the dates of the coupon payments (usually twice a year).
If the price goes down, the only other thing that can change is the market yield on the bond, which will go up.
Quite often, the market yield will be attractively high – both in nominal and in real (after inflation) terms. This is why a junk bond is often referred to by a more polite name – a high-yield bond.
Michael Milken and his epiphany
Many commentators consider that Michael Milken was the key figure in the development of the US high-yield bond markets in the 1980s.
Most recently, he has been a key protagonist in the development of special purpose acquisition companies (SPACs – vehicles which enable innovative and not-yet-profitable companies to get a stock market listing in a way that is much cheaper and easier than a conventional initial public offering).
In the late 1970s, though, Milken was an investment analyst focusing on bonds of “fallen angel” companies. In this context, a “fallen angel” is a company that had an investment grade rating from the credit ratings agencies when it issued its bond: however, subsequent problems meant that the company in question had fallen to below investment grade. In other words, its bonds had become junk bonds.
Milken’s key insight – or epiphany – was this: if you invested in a properly diversified portfolio of junk – or high yield – bonds, you would receive a good income with acceptably low risk.
This was because the probability of defaults was a lot lower than the certainty of the aggregate market yield from the portfolio.
Suppose that, across the entire portfolio, the market yield was 18% per annum. Now suppose that the issuers of bonds that make up 3% of the portfolio default completely – meaning that you have lost the entire investment in those bonds.
A subtraction of 3% from 18% leaves you with a return of 15% per annum. If inflation is running at around 5% (which it was in the United States for much of the 1980s and it is now in the UK) then your real – or after- inflation – return is about 10% per annum.
For many investors today, an after-inflation return of about 10% per annum, with low risk would be a very good outcome.
Junk bonds: far more to them than just a very good result for investors
The same was true in the United States in the 1980s. In part because of aggressive marketing by Milken and Drexel Burnham Lambert, the investment bank where he worked, investor demand for high-yield bonds surged.
In fact, demand grew so large that it became relatively easy for companies that were greatly indebted (and therefore risky and unable to get an investment grade rating from the ratings agencies) to issue highyield bonds.
Supply went up to meet this demand. Many of the issuers were corporate raiders. Deal-making that was partly or wholly funded through the high yield/junk bond markets contributed to the general rise in share prices in the United States at that time.
In short, the resulting junk bond boom that Milken had started became the stuff of legends. It was one of the defining features of financial markets in the United States through the 1980s.
As a profile of Milken by Forbes in May 2021 summarises:
Beginning in the late 1970s, Milken lorded over Wall Street after he discovered that fallen angel and lower grade bonds provided enough extra yield to more than compensate for their higher default rates, creating enormous investing opportunities. With that epiphany, Milken turned Drexel Burnham into a low grade bond factory, issuing debt that supported a generation of financiers from T. Boone Pickens and Henry Kravis to Carl Icahn, eager to takeover stodgy blue chip companies from RJR Nabisco to Gulf Oil and TWA. In the 1980s, it transformed Drexel from an afterthought investment bank into the epicenter of the financial universe, with Milken’s Beverly Hills based branch providing him income of more than $500 million a year.
The salient points from all this include the following:
- Milken’s epiphany resulted in people thinking about high yield bonds in a very different way.
- This was in spite of the fact that Milken (and Drexel Burnham Lambert) were outsiders from the financial services mainstream and establishment of the early 1980s.
- When people started thinking about high-yield bonds in the different way, there was a surge in both demand and supply.
- The boom was big enough to profoundly change US financial markets more generally – and not just fixed-income markets.
The really big question for UK investors in the 2020s
Now, shift your thinking forward by nearly 40 years and across the Atlantic Ocean to the UK.
At the moment, we have a situation where inflation in the UK rose from 5.1% in November to 5.4% in December – which was higher than had been expected.
The Bank of England’s Monetary Policy Committee (MPC), which aims for an inflation target of 2%, expected at its meeting in early February that inflation will rise to 7.25% in April this year. Inflation is not anticipated to get back to around 2% for another two years.
In the meantime, Bank Rate has been increased to 0.5%. Although the MPC has indicated that Bank Rate will rise further (and the MPC is doing other things to tighten monetary policy), the fact remains that the interest rates that are available from bank deposits are – and will for a long time remain – negative in real (after inflation) terms.
If you leave your money at the bank, its real value will be eroded.
If you invest in long-dated bonds, the same is true. Currently, the market yield on the 30-year UK gilt bond is just under 1.8% per annum.
The high-yield bond boom which arose from Milken’s epiphany provided investors with a way to earn a good income in real (after inflation) terms with tolerably low risk.
What will be the epiphany that provides UK investors in the 2020s with a similar opportunity?
Until next time,
Contributing Editor, Exponential Investor
PS Southbank Investment Research’s Sam Volkering has had an epiphany. If you understand that epiphany, you will have the opportunity to earn an income yield that, in real terms, could be in double digits… and with reasonably low risk.
As was the case with Michael Milken and high yields bonds in the 1980s, the opportunity comes from outside the mainstream world of traditional finance (TradFi). The opportunity may well lead to a boom in both the supply of and demand for unconventional financial products. It undoubtedly has the capacity to change global financial markets forever.
To find out more about Sam’s epiphany and the MegaYield Masterclass, click here.