Addled perhaps by too much turkey and a football triple header, I’ve decided to write a (very) brief outline of the development of junk bonds . Today’s post is the first of two installments:
The first junk bonds were “fallen angels,” that is, corporate bonds that were investment grade when they were issued but whose credit ratings fell as the issuing company encountered difficulties and its finances deteriorated.
In an investment banking class in business school in the late 1970s, I heard a speaker from Drexel Burnham Lambert, the junk bond kings, deride the corporate bond establishment as a bunch of clubby coupon-clipping Ivy Leaguers without a brain among them, who simply sold such poor-performing bonds without analyzing the underlying fundamentals. Drexel, he said, thanked God for creating these slackers, whose pockets they picked daily.
He then gave an example of a small oil exploration company that was in the midst of a sharp positive surge in profitability but whose bonds were still priced as if Chapter 11 loomed the next day. As it tuned out, working as an equity analyst, I covered the company he mentioned. Everything he said was accurate–and apparently unknown to the general run of bond managers.
The problem with the Drexel business at that time was that you used up the available pool of fallen angels pretty quickly. How did you make money then?
The innovation of evil (and I do mean evil, despite the SEO puffery you see if you Google his name) genius and convicted felon Michael Milken was to realize Drexel could offer junk bonds as original issues.
Companies with less than pristine credit were already getting financing from banks, which were making a fortune on the business. They were taking in retail deposits that they paid, say, 3% interest to customers on–and lending the funds to sub-prime corporates at, say, 12%. To state the obvious, that’s a gigantic spread.
Suppose, Milken, thought, Drexel were to float bonds for these companies at 9% instead and market them to junk bond mutual funds + pension investors. Retail investors would get around an 8% yield after fund expenses, the companies would get a cheaper interest rate, Drexel would collect enormous investment banking fees. Everyone, ex the banks, would be happy.
The banks would be “disintermediated” (cut out of the action), as the term goes, in the same way as money market funds were cutting them out of the market for time deposits.
As it turns out, there was another gigantic plus for the issuing companies. The junk bond fund managers appear to have had either terminal brain freeze, clubby Ivy League bond backgrounds, or absolutely no prior experience in corporate lending. Cluelessly, they failed to require that the junk bond issues they bought have any of the protective covenants that Banking 101 would have taught you to demand. No wonder sub-prime issuers were chomping at the bit to obtain Drexel’s underwriting services.
More on Monday.