Financial History 142 Summer 2022 - Page 29

less venerable competitors ’ ability to earn higher yields on their investment portfolios by loading up on speculative grade bonds . Regulatory accounting rules made it difficult for the old-line insurers to respond by liquidating their low-coupon holdings and replacing them with higher-yielding issues .
A key battleground in the rhetorical war over high yield financing was the savings and loan crisis that began in the mid-1980s . Contrary to the impression fostered by the critics , high yield bonds played a minor role in the debacle , even though losses on speculative grade bonds did contribute to a few high-profile S & L failures . Unsound real estate investments were more central to the thrift institutions ’ travails . In 1990 , the Washington Post reported that only 200 of America ’ s roughly 3,000 S & Ls had invested in high yield bonds and that most of them placed relatively small portions of their assets in the category . One study found that during 1985 – 1989 , 95 % of S & Ls ’ total high yield investments resided in the top 50 holders ’ portfolios . To put that number in perspective , more than 1,000 S & Ls failed between 1986 and 1995 .
In between those dates , high yield bonds experienced a crisis of their own . Wall Street ’ s prodigious production of extrarisky new issues had placed the market in a vulnerable state as the US economy slid into recession . Institutional investors had been led to believe , rather implausibly , that with 55.5 % of high yield issuers rated B or below as of January 1 , 1990 , up from just 18.5 % at the beginning of 1980 , cyclical peak default rates would not surpass those of earlier years . In the event , Moody ’ s speculative-grade percentage-of-issuers default rate soared from 3.78 % in 1988 to 10.35 % in 1990 . By contrast , during 1980- 1983 , a period encompassing two recessions , the trailing-12-months default rate never exceeded 4.95 %. Reeling from this devastating blow to high yield enthusiasts ’ expectations , the high yield primary market shut down for most of 1990 .
Premier high yield underwriter Drexel Burnham Lambert was a casualty of the high yield market ’ s Great Debacle of 1989 – 1990 . The firm ’ s loyal fans portrayed its bankruptcy as the result of government persecution at the behest of envious competitors . True , Salomon Brothers CEO John Gutfreund was reported to have coarsely vowed to knee Milken ’ s nuts off , which the firm denied . The depiction of Drexel as an innocent victim , however , overlooked certain factors that differentiated it from the many investment banks that survived the tough period . These included extreme concentration of business in a single product line , speculative grade bonds and a highly unusual capital structure featuring leverage at both the operating and parent company levels .
Many observers thought Drexel ’ s demise spelled the end of the high yield market itself . Even at the investment banks that resolved to carry on , some suspected the business had seen its best days . The author ranked as the most optimistic member of Merrill Lynch ’ s high yield management team in predicting that annual new issue volume would one day rebound to $ 10 billion . He proved to be not optimistic enough ; in 2021 volume totaled $ 465 billion , according to Leveraged Commentary & Data .
Propelled by that dramatic growth in issuance , the high yield asset class has advanced from a not completely respectable backwater of the financial markets to a core holding of many leading institutional investors . The speculative grade market has bounced back from additional shocks , including the early-stage telecom crash of 2000 and the Great Recession , which reduced holders ’ wealth by onethird in an asset class that most sources classify as fixed income . ( The comparable fraction for investment grade corporates was one-eighth .) Lest they get too full of themselves , however , high yield practitioners should consider that at the end of 2021 , the global face amount outstanding of high yield bonds was less than the equity market capitalization of a single company , Apple Inc .
Much of the foregoing discussion recaps debunking of high yield market lore by the author and others over the past several decades . Publishing such findings has not laid the myths to rest , nor should readers expect this article in a prestigious journal to quash the errors and omissions for all time . Popular accounts of high yield market history tend to follow the ( frequently misquoted ) advice of the newspaper editor in the 1962 film , The Man Who Shot Liberty Valance : “ When the legend becomes fact , print the legend .” Even if passions about high yield bonds do not run as high as they did in the modern era ’ s early days , commentary on this market continues to reflect a variety of not all that well-hidden agendas .
Martin Fridson is Chief Investment Officer of Lehmann Livian Fridson Advisors LLC . He is a longtime strategist and researcher whose innovations include the distress ratio , econometric modeling of the high yield risk premium and the equalized ratings mix approach to valuation .
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