Financial History 142 Summer 2022 - Page 26


By Martin Fridson
As Mark Twain , Josh Billings and Will Rogers never said , “ It ain ’ t what you don ’ t know that gets you into trouble . It ’ s what you know for sure that just ain ’ t so .” Much of the received history of the high yield bond market consists of just-not-so stories . Many of these canards have long since been debunked , yet they remain firmly implanted in investors ’ minds , periodically reinforced by recital in the media .
To begin with , speculative grade corporate debt ’ s critics maintain that the original — and more appropriate — term for the securities is “ junk bonds .” They characterize “ high yield ” as a euphemism dreamt up in the 1970s by the securities ’ promoters . In truth , former rating agency executive Jerome Fons found documentation that John Moody used “ high yield ” at least as early as 1919 . There is no attested application of “ junk ” to low-quality stocks and bonds prior to the 1920s .
Another popular misconception is that prior to about 1977 , the universe of bonds rated lower than Baa by Moody ’ s or BBB by Standard & Poor ’ s consisted entirely of “ fallen angels ,” i . e ., bonds issued with investment grade ratings but subsequently downgraded . The standard narrative assigns total credit for the supposedly brand-new idea of “ original issue ” high yield bonds , rated below-investment grade from the outset , to the Drexel Burnham Lambert department headed by Michael Milken .
In reality , Securities Data Company tabulated 19 new issues with at least one non-investment grade rating during 1970 – 1975 . These were conventionally structured offerings for such mainstream companies as B . F . Goodrich , Metro-Goldwyn-Mayer and Tenneco . Issuance accelerated in 1976 , when nine non-investment grade bonds were floated . The modern high yield primary market truly got underway in 1977 , when annual volume reached $ 1 billion for the first time . This is all aside from the fact that 17.8 % of all 1900 – 1943 corporate bond offerings had non-investment grade composite ratings , according to the National Bureau of Economic Research ( NBER ). ( Note that for most of that period , the regulatory distinction between public and private securities did not exist .)
Drexel underwrote none of the 1970 – 1976 non-investment grade bonds and did not pioneer the more innovative variety that characterized issuance in the modern high yield market ’ s early years . That honor goes to Blyth Eastman Dillon , which squired a City Investing units deal on December 6 , 1976 . Drexel soon became the high yield market ’ s leading firm , however , urged on by CEO Fred Joseph and powered by Milken ’ s organizational wizardry . ( Milken , by the way , made no claim to have invented anything .)
According to the standard narrative , the investment banks conceived out of nowhere the idea of original-issue high yield bonds and set out to create the demand . It is more accurate to say that the Wall Street firms capitalized on innovation by investment companies . Mutual funds specializing in bonds first appeared in 1969 . In the first few years , fallen angels mostly sufficed to accommodate capital inflows to funds that vied to offer the highest yields by buying non-investment grade paper . The author ’ s 1993 line-byline examination of Standard & Poor ’ s Bond Guide back issues established , however , that between 1974 and 1976 , the face amount of outstanding non-convertible , non-defaulted corporate debt rated BB or less shrank by 42 % through a combination of redemptions , defaults and upgrading . This supply contraction provided Wall Street the opportunity to fill the gap with original-issue high yield bonds .
Drexel portrayed this activity not merely as a business , but as a mission . Thanks to its invention of non-investment grade public bond issuance , the story went , young , entrepreneurial companies that were previously excluded from the capital markets could now obtain funding and spur American innovation . Supposedly , this “ democratization of capital ” was especially welcomed by minority-group entrepreneurs who , until then , had been thwarted by financial discrimination .
The reality constituted less of a paean to start-up ventures . The median age of the companies that issued public high yield bonds during the 1977 – 1978 takeoff phase was 24 years . Two issuers had been in business for more than 70 years when they came to the high yield market . Neither had the 1977 – 1978 issuers previously been deprived of capital . On average , in the two years prior to issuing public bonds they tapped the equity and private debt markets for an amount equivalent to 104.1 % of their high yield financing .
What induced those long-established companies to switch to the public debt market , often paying higher interest rates than they could obtain from their traditional private placement buyers ? As some of them freely admitted , it was the absence of strong covenant restrictions on the issuers — that is , covenant protection for the investors — in the public high yield primary market .
Much of the issuance in high yield ’ s early modern era consisted of subordinated debentures . The indentures often gave issuers carte blanche for subsequent issuance of senior or secured debt . Such issuance reduced the subordinated holders ’ expected percentage recovery of principal in the event of default , producing an immediate , negative price impact on the “ sub debs .”
When leveraged buyouts became the rage in the mid-1980s , many private companies entered the ranks of public high yield issuers . They were required to disclose financial data in their offering circulars , but in some cases , bondholders discovered shortly afterwards that the issuer was providing no SEC Form 10-Qs to update its financial information . The investors were left in the dark , thanks to a regulatory exemption from the ongoing filing requirement for companies with less than a minimum number of public securities holders .
High yield critics also pointed to the lack of meaningful restrictions on early
24 FINANCIAL HISTORY | Summer 2022 | www . MoAF . org