Reaganomics, junk bonds and the Laffer curve (i)

junk bonds

In 1978, I realized I wasn’t going to get a teaching job I’d accept and, more by accident than design, stumbled into a career as a securities analyst. From the steel analyst a few desks away, I learned that the US was making steel in blast furnaces built during the 19th century. In contrast, Europe and Japan, whose industrial bases were flattened in WWII, were churning out superior products at lower cost from the much more efficient factories they rebuilt with. I gradually learned that many other domestic manufacturing industries were similarly in desperate need of modernization. The biggest stumbling block: CEOs didn’t want to take the risk of revamping, with the lower profits (meaning lower stock price and lower bonuses) and the risk of being fired if things didn’t go smoothly. Better to paper over problems and leave them for one’s successor.

Then came junk bonds.

In the earliest days of Drexel Burnham Lambert, high-yield, aka “junk,” bonds were all about “fallen angels,” that is, once high-grade bonds, already in the market, whose issuers had fallen on hard times. These were typically highly illiquid, and traded at deep discounts to their redemption value. DBL would do equity-style company analysis aimed at finding down-at-the-heels firms that were turning operations around and whose improving fortunes weren’t yet reflected in the bond price.

Under Michael Milken, DBL soon expanded to original issue junk. The idea is that they would substitute for bank loans, in similar fashion to the emergence around the same time of the money market fund as a rival to bank savings accounts.

Junk proceeds were often used to finance the takeover, and modernization, of the kind of sleepy companies described in the opening paragraph. Arguably, this was the kind of tough love American industry needed. And the country’s industrial base certainly was modernized during the Milken era.

Several issues, though:

–corporate raiders often, in my view, took very little care for the welfare of the employees of target companies or the funds put aside for their pensions, creating a chronic unemployment problem in some areas of the country

–in 1985? DBL ran out of economically viable takeover candidates to fund with new junk bond issues. By this time, there was a robust junk bond category of mutual funds, however, happy to take up new deals. So–again, in my view–DBL decided to promote issues that would target companies where chances of the bonds eventually being repaid were not good. The pension plans of firms corporate raiders had used junk bond financing to take private were one class of buyers of these dubious bonds. It also appears Milken used hefty under-the-table payments to induce junk bond fund managers to buy these clunker issues, despite their lack of investment appeal

–mutual fund pricing was not as highly developed in the 1980s as it is now. Typically, funds would outsource pricing to a third party, which, again typically, would use the last trade in an issue as the current value. The problem with junk bonds was that many rarely traded. So the outside service would be using a price from, say, six months earlier, that would not reflect deteriorating prospects with the issuer. And as long as junk bond funds were getting large inflows–“all the capital gains potential of stocks, all the safety of bonds” was the sales pitch–there was no need for any fund to sell

–the catalyst for the inevitable collapse came in the failure of the United Airlines leveraged buyout in late 1989.

So, yes, the Reagan era produced a much-needed modernization of American industry, but at a substantial social cost in callous disregard by both major political parties for displaced workers.

more tomorrow

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