As regular Gurufocus readers might know, I’m a big believer that investors can stand to learn a lot by studying financial history. In this article, I want to look at an example of financial engineering from the 1980s: junk bonds.
What is a junk bond?
In the simplest terms, a junk bond is an income-bearing security that has a higher risk of default than most other bonds. Traditionally, bonds have been viewed as the "safe" alternative to stocks. This is because bonds are legal promises to repay borrowed money, whereas stocks just represent ownership share in a company and do not necessarily entitle shareholders to dividend payments. Bondholders have what is called seniority in the "capital stack" over shareholders. In other words, if a company files for bankruptcy, bondholders will be compensated before shareholders.
In the case of junk bonds, the companies that issue them have lower credit ratings, which implies a higher probability of default (ie. the holder of the junk bond might receive nothing, or have to take an expensive cut).
Who wants junk?
You may ask: who would want to buy such an instrument? Who wants to own "junk?" Well, to paraphrase Howard Marks (Trades, Portfolio): “there is no investment so terrible that no price is low enough.”
Investors like to be compensated for the risk that they take on, so if the price of a junk bond is low enough (and therefore the yield is high enough), the potential reward can outweigh the risk. Indeed, Marks himself invests primarily in distressed debt, which are the bonds of companies that are near bankruptcy. These bonds are actually rated even lower than junk bonds.
Investors in the 1980s were starved for yield. Interest rates on U.S. government bonds had come down, meaning that they had to go elsewhere to get the same returns. Enter Michael Milken, a trader at the investment bank Drexel Burnham Lambert and recent presidential pardonee. Milken was able to convince financial institutions that the potential rewards of buying low-rated debt far outweighed the risks of default, and over the course of the 1980s, the market for junk bonds ballooned from basically zero to almost $200 billion.
Milken’s illegal activities in this market would later land him in prison and cause the collapse of his bank, but this did not ultimately bother investors regarding his financial instruments. The junk bond genie was out of the bottle, and there was no putting it back.
Disclosure: The author owns no stocks mentioned.
Read more here:
- What Ordinary Investors Can Learn From a 1980s Wall Street Fad
- Seth Klarman: Is Financial Innovation Good for Investors?
- Why Are Big Financial Institutions Almost Always Bullish?
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