A few days ago, I wrote a brief introduction to junk bonds, which are debt instruments that rose to prominence in the 1980s thanks to the remarkable salesmanship of Michael Milken. Simply put, junk is low grade debt that offers a high yield, and Milken’s great pitch was to convince money managers that the higher yields more than compensated for the higher risk of default.
But who were these money managers? Who was actually buying junk? You may think that the only people willing to take a shot on low grade debt would be high risk gamblers, perhaps proprietary trading firms or other institutions of that nature. As it turned out, Milken’s pitch had far broader appeal.
Who would buy this?
Seth Klarman (Trades, Portfolio) identifies a number of groups that were particularly enamoured of junk bonds. The first were the high yield bond mutual funds. These days, we associate high yield with high risk, but back in the 1980s, it was expected that an investor should be able to make double digits just by owning U.S. Treasuries.
Qhen rates started to go down, investors had to look for those yields elsewhere. This made the high yield bond mutual funds prime buyers for junk bonds. Exacerbating the problem was the fact that the more money flowed into these funds, the further they had to reach for yield. This is analogous to when a dividend bearing stock’s yield falls as its price rises (because you are getting fewer dividends per dollar spent on buying the shares). Since high yield funds were judged on their ability to deliver high yields, this created a strong incentive for managers to buy increasingly more risky bonds.
The second group of buyers were the thrifts. A thrift, or a "savings and loan association," is a financial institution that exists primarily for the purpose of taking savers' deposits and providing mortgages. In the United Kingdom, they are known as building societies. They have traditionally been more heavily regulated than banks, but in return receive federal deposit insurance. They were what you would call "mom and pop" institutions, making sensible loans for families to buy houses, and were not supposed to take on much risk.
This all changed in the 1980s when restrictions on what thrifts could invest in were relaxed. This combustible mixture of free reign and federal guarantee led to a number of thrifts becoming huge players in the junk bond market. Small institutions that really had no business dealing in low-grade debt became massively overexposed, and this was a major contributing factor to the savings and loan crisis that ran from the mid-1980s to the mid-1990s.
The final group were the insurance companies. Although not all such companies participated in the junk bond bonanza, enough of them did for regulators to seize a number of leading insurers, and it only took a small number of firms to get involved with junk bonds for their competitors to follow suit.
Conclusion
The common theme that runs through all of these stories is that these buyers were compelled to reach for higher yield by forces outside their own control. To be sure, a lot of it was probably greed, but there was immense pressure on these institutions to buy what the junk bond salesmen were selling, and not to ask too many questions. This was yet another example of a broken incentive structure, where professional money managers mindlessly followed the herd due to the ways in which their performace is assessed, which directly ties into their ability to keep their jobs.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Black Monday 1987: Why Investors Should Be Wary of Automated Selling Strategies
- Seth Klarman: Why It Is So Hard to Have a Long-Term Perspective
- Howard Marks; The Federal Reserve Shouldn't Encourage Bad Behavior
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