Now that we have finished our discussion about the private equity market, we will talk about the High-Yield Financing and the Leveraged Loan Market. More specifically, in this article, we will talk about the history of the junk bond market.
High-yield bonds, or also known as junk bonds, are debt securities that have below investment-grade ratings. Hence, the name junk bonds. This type of bond gets a rating of BB or worse.
Now, you may be asking what makes junk bonds important? Well, it’s pretty straightforward: the junk bond market is still a type of finance resource. This means that it can still be used to finance takeovers. It is especially useful in leveraged takeovers.
Junk bonds have played a crucial role in the fourth merger wave. To read more about the history of merger waves, please feel free to read our article here. The junk bond’s importance has significantly diminished in the years that followed.
Junk Bond Market History
Where Did the Term “Junk Bond” Originate From?
Despite it playing a merger role in the fourth merger wave, junk bonds weren’t created in this period. However, there are a lot of people who might believe this.
This is because for decades before the fourth merger wave, junk bonds were actually called “low-grade bonds”. Between the 1930s and 40s, they referred to junk bonds as “fallen angels.” By the time the 60s rolled in, the lower-grade debt that was issued to help finance conglomerate acquisitions were referred to as “Chinese paper.”
So, where did the term “junk bonds” come from? Well, according to financier Meshulam Riklis, the chief executive officer (CEO) of Rapid American Corporation, the term junk bonds was first used in a conversation that he had with Michael Milken. Milken was the former head of Drexel Burnham Lambert’s junk bond operation.
Riklis also stated that when Milken surveyed some of the bonds that the former had issued, he exclaimed “Rik, these are junk!” And so, the term was born.
Junk Bonds in the Early 1900s
In the 1920s and 30s, approximately 17% of all new corporate bond offerings were low-grade/high-yield bonds. To finance their growth, a wide range of firms used these securities.
In 1928, around 13% of all outstanding corporate bonds were low-grade bonds. However, by the time the 40s rolled in the percentage grew to 42%.
However, it was in the 1930s when the ranks of high-yield bonds swelled. This is when the Great Depression took its toll on a large number of United States companies.
A lot of the bonds had entered the low-grade class through downgrading from rating agencies. We will discuss more of the rating process in the next articles within this topic.
The Effect of the Great Depression
As we have previously mentioned, the Great Depression has affected most of America’s companies. As the economy fell deeper and deeper into the Depression, many firms have suffered from the impact of declining demand for their goods and services.
The businesses’ ability to service the payments on their outstanding bonds were called into question. Soon, a downgrading of the debt occurred.
After the overall level of economic demand fell, the revenues of some firms declined so much. This led to firms not being able to service the interest and principal payments on outstanding bonds.
This led to a 10% rise in the default on these bonds. Naturally, the investors became disappointed with the rising default rate in a category of securities that they believed were generally low-risk.
The said investors were previously attracted to the bond market by investment characteristics. These characteristics were dependability of income and low risk of default. However, as the risk of default rose, low-grade bonds became unpopular.
The Decline of Junk Bonds
In the 1940s, the low-grade bond market started to decline. This is due to old issues retiring or the issuing corporations entered into some form of bankruptcy.
The declining popularity of the low-grade bond market made new issues difficult to market. In the years between 1944 and 1965, high-yield bonds accounted for only 6.5% of total corporate bond issues.
However, this percentage wasn’t the end of it. It declined even further by the time the 70s began. In the early 1970s, only 4% of all corporate bonds were low-grade bonds.
The low-grade/high-yield bond market’s declining popularity paved the way to one form of debt financing to certain groups of borrowers. A lot of different corporations were now forced to borrow from banks in the form of term loans. These term loans were generally shorter maturity than 20- and 30-year corporate bonds. The corporations would have preferred to issue long-term bonds.
Moreover, those who could not borrow from a bank on acceptable terms were forced to forsake expansion. Or, they were forced to issue more equity. Naturally, this had the adverse effect of diluting the shares of ownership for outstanding equity holders
Not only that, but the rate of return on equity is generally higher than debt. This means that the equity is a more costly source of capital.
Junk Bond Changes in the 1970s
In the late 1970s, however, the high-yield/low-grade market began to change. Lehman Brothers underwrote a series of new issues of high-yield corporate debt. Lehman Brothers was an investment bank that was acquired in the 1980s by Shearson.
The bonds they issued are offered by Ling-Temco-Vought (LTV) ($75 million), Zapata Corporation ($75 million), Fuqua Industries ($60 million), and Pan American World Airways ($53 million).
This event was followed by the entrance of a relatively smaller investment bank, Drexel Burnham Lambert. This investment bank started to underwrite issues of low-grade/high-yield debt on a larger scale.
The first such issue that Drexel underwrote was a $30-million issue of bonds on Texas International Inc. in April 1977.
Drexel Burnham Lambert’s role in the development was the key to the growth of the low-grade/high-yield bond market. It served as a market maker for junk bonds. This was crucial to the dramatic growth of the market.
Junk Bonds Issuance Growth
In 1982, junk bond issuance had grown significantly. It has grown to $2 billion per year. No more than three years later, the total had risen to $14.1 billion. By the time the next year rolled in, the total jumped to $31.9 million. This Is the highest level the market reached in the fourth merger wave.
However, in the second half of 1989, it collapsed. It later rebounded in 1992 and rose to new heights. Although the market thrived in the 1990s, it took a different form from being a major source of merger and LBO financing, which accounted for its growth in the fourth merger wave.
© Image credits to Anni Roenkae