I previously wrote an article focusing on the early history of junk bonds. Now, I want to look at how the race for high yield, sparked by the invention of junk bonds, exposed a serious flaw in investor rationality. For this, I will enlist the help of Seth Klarman (Trades, Portfolio)’s 1991 book "Margin of Safety," which contains an illuminating discussion on the subject.
The great innovator
There are any number of financial innovations that quickly gained widespread popularity before investors truly understood the risks of owning them. However, Klarman believes that junk bonds were different because they caused a shift in how investors viewed the market as a whole.
Michael Milken, the inventor of junk bonds, was able to sell junk to investors by claiming that the high yield they offered more than offset the higher risk of default. He did this by pointing to historical data that demonstrated that this was indeed true. But this was only true because low-rated bonds traded at bargain basement valuations at the time. In the 1970s, no investor wanted anything to do with them, and so they were cheap. Once the junk bond market really took off, however, these low prices were no longer available, and so all that investors were left with was the higher risk of default.
However, Milken’s greatest accomplishment was convincing investors to buy newly issued junk bonds. Previously, he had specialised in the bonds of what were called "fallen angels." These were companies that used to be in good standing, but whose credit had deteriorated to below investment grade. It was the historical data from these bonds that supported Milken’s initial thesis. Unfortunately for him, the market for these bonds was pretty small - only a few billion dollars - as there were simply not that many fallen angels.
Don’t confuse an angel with junk
Once Milken and his salesmen convinced investors that existing low-grade debt was a good opportunity, it then became possible for businesses to issue new low-grade bonds that they would then sell at face value. This was a radical departure from the norm, as Klarman explains:
“Unfortunately newly issued junk bonds were not the low-risk instruments that buyers were led to believe. They have, in fact, very different risk and return characteristics from fallen angels. Specifically, newly issued junk bonds offer no margin of safety to investors. Trading around par value [100 cents on the dollar], they have very limited appreciation potential, but unlike high-grade bonds trading near par, they have substantial downside risk. A fallen angel, by contrast, trades considerably below par and thus has less downside risk than newly issued junk bonds of comparable credit quality”.
So while a bond of a struggling company selling at a 50% discount to its initial price (par value) might offer a fantastic risk/reward ratio, buying that same bond at 100 cents on the dollar is a terrible investment decision. I think this historical episode is fascinating because it shows that the basic principles of value investing, i.e. buying things for below their intrinsic value, holds up even in more esoteric asset classes. It also shows that the professionals buying these bonds without understanding their underlying structure and risk were really no smarter than retail investors buying tech stocks at price-earnings ratios of 100 at the height of the dotcom bubble. Valuation is important no matter how much capital you control.
Disclosure: The author owns no stocks mentioned.
Read more here:
- A Brief History of Junk Bonds
- What Ordinary Investors Can Learn From a 1980s Wall Street Fad
- Seth Klarman: Is Financial Innovation Good for Investors?
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