In the previous article, we discussed the junk bond market, what it is, and what its history was. Today, we will continue with this topic. More specifically, we will talk about why the junk bond market grew.
During the 1980s, there was a dramatic and rapid growth in the junk bond market. This growth was so significant that investors finally took notice of this market. They finally viewed it as an investible market with lower risk than they previously thought. You may remember from our previous article that the growth of the junk bond market was modest in the years previous.
However, in the fourth merger wave, it grew for several reasons. There were numerous studies about the growth of the junk bond market in the fourth merger wave. So, to make it simpler and easier to understand, we made this list for you.
We have created a list of the factors that affected the development of the junk bond market. You can read all about them below.
Reasons Behind The Growth of the Junk Bond Market
There were privately placed bonds.
Before the 70s, high-yield bonds were placed privately with institutional investors. These bonds had unique indenture contracts. And the contracts had restrictive covenants that varied based on the negotiation between different buyers. High-yield bonds were more difficult to market back then because of the lack of standardized contracts.
Another big factor was that these types of bonds were not certified with the SEC. What does this mean? Well, it simply means it is not possible to publicly trade them.
Because of this, high-yield bonds were somewhat illiquid. In the later part of this article, we will talk about how investment bankers realized this as an opportunity
The development of market makers.
Another great aspect that led to the improvement of the junk bond market was the presence of an active market maker.
What is an active market maker, you ask? Well, that’s a good question. It works as a liquidity agent. It works in facilitating sales between the seller and the buyer. Take the firm of Drexel Burnham Lambert as an example. The firm became a very active market maker in this very market.
Their growth in the 80s was mostly because of the firm’s involvement in this type of market. More on this later.
A Change in the Risk Perception
The growth of the junk bond market would not be possible if investors didn’t change their risk perceptions of the subject. When investors started to realize how valuable these bonds were, they began to believe that the risks associated with these types of investments were actually less than what they used to believe.
There were also a few research studies that inspected the sensitive nature of junk bonds. The results were that the risk of default was inferior than what they believed.
Deregulation
Another factor in this specific market growth is the deregulation. Junk bond markets were able to attract investment capital because of a more relaxed regulatory climate. Because of this, they were able to get investments from institutional investors who are traditionally conservative. Examples of these are pension funds. You can also look at thrift institutions and view them as a great example.
Managers were then allowed to invest in a broader range of assets. This is all thanks to the Employee Retirement Income Security Act from 1974. The assets include riskier securities. This is true as long as the portfolio was adequately varied.
Moreover, thrift institutions were able to spend in business loans and company bonds thanks to the Ganrn-St. Germain Act of 1982. Amazingly enough, a lot of thrift institutions chose not to spend on corporate bonds. However, they collected large portfolios of these securities.
Merger Demand
Lastly, there was the factor of merger demand. Those years, they found a major development in mergers and acquisitions. And as the target of mergers and acquisitions grew even larger, there was also an increase in the demand for capital to fund these purchases. You can also say the same for leveraged buyouts.
Where does the junk bond market come in, you ask? Well, investors relied on the junk bond market to administer a huge portion of this funding. They relied on these bonds heavily.
In fact, according to numerous research, over half of the junk bonds that were issued in the fourth merger wave were related to mergers and acquisitions.
The Role of Drexel Burnham Lambert in the Junk Bond Market Growth
Earlier, we talked about how investment bankers viewed the junk bond market as an incredible opportunity. One of those investment bankers was Drexel Burnham Lambert. They were very active market makers in this market.
Their famous improvement in the 80s was mostly because of its engagement in the junk bond market. They went out of their way just to make sure of the growth and the endurance of the market.
They were one of the few primary investment banks to create underwriting new-issue junk bonds. Their efforts were widely known to advertise the junk bond market as an enticing investment alternative. The efforts were led by Michael Milken, the former manager of Drexel Burnham Lambert’s Beverly Hills office.
These are only some illustration of why and how this specific market grew. It was a mixture of the factors we listed above. Namely, merger demand, deregulation, and a change in the risk perception. Let’s not forget the development of market makers and the privately placed bonds, too.
We hope that this article has aided a lot of you to understand how the junk bond market grew. To know more about the history of junk bond markets, feel free to check our article here.
In the next article, we will talk about investment bankers and highly confident letters, investment banks, and liquidity of junk bond investments. We will also talk about junk bond refinancing and bridge loans, and finally, the collapse of the junk bond market in the late 1980s.
© Image credits to Scott Webb