Tired of the three per cents

After a shaky start, the US high-yield market has risen, fallen and re-emerged to constitute roughly one-fifth of all dollar corporate bonds and is headed the sameway in Europe. Philip Moore follows the story and traces the market’s roots

Unlike the Eurobond market, which can accurately pinpoint its inauguration to the summer of 1963, there is no universally accepted date on which the high-yield market came into being. As far back as the Victorian era, British investors – described by satirical magazine Punch in 1845 as being “sick and tired of the three per cents” offered by government bonds – were losing a fortune in their pursuit of enhanced yields in the farthest-flung corners of the Empire and beyond.

When it comes to tracing the evolution of high-yield bonds, or ‘junk’, the 1970s witnessed the genesis of a market as we understand it today. The Bond Market Association maintains figures on high-yield corporate issuance in the US dating back to 1970, with deals in that year launched for companies such as MapCo Inc., Stop-N-Go Foods and Tenneco.

But it was only later in the decade that the market truly began to become an accepted part of the corporate bond universe. Martin Fridson, who now runs his own independent research operation, FridsonVision, after a distinguished career as head of high-yield research at Merrill Lynch, argues that the 1977–1978 period represents the beginnings of the market as a genuine asset class.

Fridson says that following average annual issuance of some $151 million in the early and mid-1970s, figures compiled by Merrill Lynch suggest that 1977 was the first year in which issuance reached the key psychological $1 billion level.

Others agree that 1977–1978 was a pivotal era for the US high-yield market. At Putnam Investments in London, managing director of European high yield Anton Simon, who began investing in high-yield bonds in the mid-1980s, says that 1978 is as good a year as any to recognize as the starting point for the modern high-yield market. That, he points out, was the year in which Drexel Burnham laid its cards most visibly on the table, allowing Michael Milken to lead his entire corporate bond team to Century City in California and set up shop.

Alternative interpretations would point to a number of other years as key landmarks in the evolution of the US high-yield market. There was 1984, for example, which saw the first rated transaction over $500 million, with a $506 million bond issue for the B3/CCC rated restaurant and hotel group, Rapid-American Corp. Or 1985, widely recognized as the first year in which junk bonds pushed their head above the parapet as a currency supporting hostile takeover bids of major public companies, which in turn opened the way for much larger issuance culminating in the giant junk-funded LBOs of the late 1980s. Or 1986, when the $1.2 billion deal for the B3/CCC rated Wickes was the first rated high yielder for a non-financial borrower raising more than $1 billion.

In tandem with this increase in issuance in the mid-1980s came an explosion in demand for bonds in general and higher-yielding issues in particular. In August 1985, the value of mutual funds’ bond assets overtook those of equities for the first time in living memory, and by September 1985 investors had channelled $110 billion into fixed-income mutual funds, up from a little over $26 billion at the end of 1982.

From the perspective of supply, the bond boom of the mid-1980s, of course, came at a time when the high-yield market was more or less synonymous with Drexel Burnham, although a number of commentators say that the firm’s influence on (and control of) the market has been highly exaggerated by the financial press.

How the mighty have fallen

Paradoxically, some say, the origins of the modern high-yield market can be traced back to the demise of Drexel Burnham, coinciding more or less with the meltdown in the market in the wake of the stock market crash of 1987 which dragged high-yield prices down with equity valuations. That sent yields on some of the more speculative junk bonds up to 30% and more, while in the broader market the average spread widened to between 500bp and 600bp above US Treasuries by the end of October 1987.

If that wasn’t bad enough news for the junk bond market in the US, worse was to follow with the confirmation in early September 1988 that the SEC had filed a 184-page civil case against Drexel Burnham, Michael Milken and a number of his associates alleging a torrent of securities law violations. That news prompted exaggerated concerns in some quarters that if Drexel was to be history, then so was the junk bond market.

The result was that many bankers and investors saw September 8, 1988 as a potential crunch time for the US high-yield market. Drexel itself was putting a brave face on things, sending letters to thousands of clients reassuring them about the firm’s resilience and probity, and encouraging its employees to wear T-shirts emblazoned with the motto: “When the going gets tough, Drexel gets going.”

Drexel was indeed going – rapidly down the pan. But to the surprise of many, the high-yield market remained firmly on its feet, with The New York Times announcing on September 9: “Yesterday, the $150 billion market in [junk] bonds felt barely a tremor.”

A number of explanations were offered for the refusal of the junk bond market to buckle in the wake of the goings-on at Drexel. First, the market had been anticipating the firm’s demise – and preparing for a junk bond market post-Drexel – for the previous two years. Second, by 1988 Drexel’s famed dominance of the high-yield market was conspicuously on the wane, even if it had still been responsible for underwriting close to 40% of all new US junk issues in the first half of that year. Between them, according to The New York Times report, Morgan Stanley, First Boston and Merrill Lynch had underwritten considerably more high-yield deals than Drexel Burnham, while other investment banks were joining the party, confident of the market’s prospects with or without Michael Milken. Goldman Sachs, the Times reported, would probably be replacing Merrill Lynch as “one of the leaders” in 1988.

Also, by this time heavyweight US institutions, warming to the Milken doctrine of diversification in the high-yield market, had built up very substantial portfolios of junk bonds that they were not going to unwind just because of the perceived misdemeanors of Drexel. By 1988, Fidelity in Boston, for one, was reported to be managing a high-yield bond portfolio worth $4 billion.

A combination of these influences meant that by the late 1980s, there was a growing belief that if the junk bond market could survive the ravages of the October 1987 crash exacerbated by the Drexel implosion, it could survive more or less anything.

Over and above that, a recognition was spreading across a wide cross-section of American industry that the junk bond market was no longer a single-shop game, which Fridson says marked a very important phase in its development. He argues that as long as the high-yield market was perceived (however inaccurately) as an area dominated by a single underwriter and market maker, a number of corporates remained uneasy about raising funds in the market.

But a further ordeal was looming in the shape of the 1990 recession, and the unprecedented spike in high-yield default rates that came with it. The high-yield market had to weather this storm before it could re-emerge as an accepted asset class. Once again, say bankers, this was a test that the US market passed with flying colors, which in turn encouraged more investment bankers and institutional investors to channel sell- and buy-side resources into its development, fueling something of a virtuous circle in terms of supply and demand.

The result was that the bounce-back in the junk market was impressive. In the downturn, issuance in the US high-yield market had collapsed from $25 billion in 1989 to $1 billion in 1990, with default rates in that year and 1991 reaching about 10%. In that period, high-yield prices fell across the board as investors slung out the baby along with the bathwater, indiscriminately offloading their positions.

That in turn provided the more far-sighted investors with a heaven-sent opportunity, and those who were able to identify companies that had seen an unwarranted fall in their bond prices were rewarded with very handsome gains as the market normalized in 1991 and 1992.

Investors and their consultants were sitting up and taking notice, and never more so than in 1992, a year described by Simon at Putnam Investments in London as “a pivotal date, like Luther pinning his paper on the door!” That was the year, he recalls, when the US consultancy firm, SEI, broke new ground by recommending US pension funds consider allocating between 10% and 15% of their domestic fixed-income assets under allocation into well-managed high-yield funds in line with the Milken doctrine of diversification. Given the low correlation characteristics of the asset class, this was a bold move.

At the time, says Simon, the suggestion that responsible pension funds should channel their funds into junk prompted an outcry – in much the same way as John Maynard Keynes fueled controversy in the Britain of the 1920s when he suggested, horror of horrors, that insurance companies should allocate some of their assets to ordinary equities.

But it did not take long for US institutions to warm to the SEI advice and, in a parallel move, issuers took notice that borrowing in the high-yield market was an important means of raising funding and optimizing capital structures. The result, says Tom Connolly, head of high yield at Goldman Sachs in New York, is that high yield emerged as a genuine asset class. “What happened in the early 1990s is that high yield went from being a product that was used largely to finance hostile takeovers to become a much more broadly accepted corporate financing tool,” he explains.

Another key development of the late 1980s and early 1990s that supported the metamorphosis of the high-yield bond into a more broadly accepted asset class, says Fridson, was that the balance of power began to swing back in favor of investors rather than issuers. He argues that in the early days of the US junk bond market its rapid growth was explained in part because of the exceptionally favorable terms that issuers were able to command, which probably led to a number of unsuitable companies being given access to incorrectly priced funding.

“In the 1970s and early 1980s there was no meaningful call protection for investors,” says Fridson. “But as insurance companies came into the market in greater numbers, loopholes were closed and the quality of covenants improved substantially.”

Conquering Europe

In terms of the evolution of a more global asset class, as opposed to one that remained anchored in the US, the recovery from the recession of the early 1990s brought with it another critical development viewed by many as an important milestone in the development of the high-yield market.

Buoyed by the success they had enjoyed in helping the US market on its way – and encouraged by the fees they had earned in the process – a number of investment banks turned their focus toward a region where they believed capital markets were becoming increasingly integrated and liquid, but which remained remarkably unsophisticated as far as credit markets were concerned. For a handful of US investment bankers, it was time to turn to Europe, and in their vanguard, in 1993, came John Wotowicz of Morgan Stanley.

Wotowicz recalls that when he arrived in London 10 years ago, Morgan Stanley already had a small team on the ground in Europe dedicated to the distribution of high-yield issues from US corporates. He also recalls that at the time Donaldson Lufkin Jenrette (DLJ) had originated one or two high-yield deals for European borrower NTL, which had to all intents and purposes been US transactions, denominated in dollars, drafted and documented in the US and distributed almost entirely to US accounts.

“But I think it would be fair to say that Morgan Stanley was the first to have high-yield origination professionals on the ground in Europe,” says Wotowicz. “Certainly when I arrived in 1993 there was nobody in the banking world in Europe that understood high yield or took it upon themselves to advance the product.”

Small wonder. As Wotowicz says, in those early days most European investors were effectively prohibited from investing in high-yield bonds either because of internal guidelines on ratings thresholds or because they were unable to buy dollar-denominated assets, or both. The result, he says, was that evangelists of the asset class would from time to time generate small orders from discretionary money managers. “But if you got an order for a couple of million dollars out of Europe it was an exciting event,” says Wotowicz.

Aggravating the challenge for Wotowicz on the origination side was the enduring belief amongst the European corporate universe that a rating in triple-B territory or below was somehow a badge of shame. Adventurous new telecoms companies, unencumbered by the historical baggage that more traditional corporates were still hauling around, would help to break that mould, as would private equity firms that started to contemplate larger LBOs financed by high yield.

Undeterred by the obvious constraints, Morgan Stanley pushed forward with its European marketing effort, scoring a memorable coup in September 1995 when the UK’s Telewest raised $1.2 billion in the high-yield market. “That was the largest corporate financing transaction in 1995,” says Wotowicz, “not just the largest high-yield deal or the largest European bond issue, but the largest full stop. That really put Europe on the map and suggested to many people that there would be significant new issuance going forward.”

Those observers were not to be disappointed: Wotowicz recalls that from a total of $2.8 billion in 1995, high-yield issuance in Europe rose to more than $18 billion (equivalent) in 1999, or 17.7% of total global issuance.

By the time of the Telewest deal, a number of other investment banks were starting to chalk up some notable firsts in the European high-yield market. The high-yield team at Bankers Trust, for one, added the words ‘Architects of Value’ to their business cards and started to preach the gospel of what they described as “value bonds” (emphatically not “junk” or even “high yield” instruments) to finance directors in Britain. Initially that message was successfully transmitted to UK-based borrowers such as Independent Newspapers and ComputaCenter Services, generally recognized as being the first issuers of high-yield or value bonds in the UK in 1995.

In continental Europe, others were also marketing their high-yield credentials, with Merrill Lynch – to the frustration of Wotowicz – edging out Morgan Stanley when it led the first high-yield transaction denominated in a continental European currency. Its DM157.5 million 10-year deal for Geberit, paying 423bp over the German government curve, was followed within hours by another DM-denominated deal led by Morgan Stanley for France’s Exide Holdings.

Deals such as these looked as though they were forming the ideal base from which the European high-yield market would grow and flourish, given that companies such as Geberit (a maker of bathroom fittings) and Exide (the subsidiary of the US automotive battery maker) were solid if dull industrial companies with established business plans and cashflows.

Almost immediately, however, issues such as these were swamped by a cascade of deals from telecoms and cable companies which, with the benefit of hindsight, was precisely what the fragile European high-yield market did not need. At Barclays Capital in London, head of credit research Gary Jenkins says that in retrospect, too many companies that ought to have been equity financed were funded with high-yield debt.

The good news for the telecom issuers was that the high-yield market helped – as it had done in the US – to finance companies that would otherwise have failed to access the capital they needed to expand. Colt Telecom was one obvious example of a new entity that owed much of its growth to the high-yield bond market. But Colt was by no means an exception. As Martin Reeves, director of European credit research at Alliance Capital puts it: “If there had been no high-yield market there is no way sectors such as the UK cable industry would have been built. Investors were prepared to take risks, and that lowered the cost of finance, which in turn was positive for the broader economy.”

The bad news was that the concentration of supply in the telecom and cable sector flew in the face of orthodox Milkenomics, which stated that for the high-yield market to function satisfactorily for investors, portfolios needed to be widely diversified. As Goldman Sachs’s Connolly says: “A portfolio that is not adequately diversified runs the risk of performing poorly, and that is precisely what happened to a lot of investors in Europe.”

There you have the bare bones of the high-yield market’s evolution over the past 25 or 30 years. But beyond the story’s value as a historical curiosity, does it have any use to investors in the market today? Many would say no. Indeed, Marty Fridson, who has done more than most to revisit the history of financial markets, says that there is a general lack of interest among today’s investors in pivotal historical events such as the bankruptcy of Penn Central in 1970 and its re-emergence in the early 1980s. That was an important if drawn-out saga, introducing a number of investors to the concepts of event risk, default and recovery.

Others, however, say that there is value to be drawn from reappraisals of the history of the high-yield market, for at least two very important reasons. First, while past performance should never be taken as a reliable barometer of future trends, the track record of the high-yield market over the past two decades can provide helpful guidance into potential developments over the coming cycle. Second, it is only by identifying where the principal misjudgements of recent years were made – which were potentially ruinous to the market’s longer-term health – that similar mistakes can be avoided in the future.

So what can investors in today’s high-yield market learn from historical performance patterns? A great deal, believes Putnam’s Simon. He points out that as an asset class, solid high-yield bonds should typically outperform Treasuries by between 400bp and 600bp, and investment-grade bonds by between 300bp and 400bp. In only six of the past 25 years, Simon explains, have high-yield bonds failed to perform as they should – and as he rightly observes, for an asset class to deliver on its promise in 19 out of 25 years is not bad. He sees uncanny similarities between 2003 and the early 1990s, and says that with default rates falling, rating agencies more effective and technical demand strong in the absence of viable alternative asset classes, the high-yield bond market could once again be set fair for five to seven years of outperformance.

If the high-yield market is to provide the returns that it should, however, it is essential that the lessons learned from the mistakes of its early life are taken on board: above all, that for the market to thrive in a sustainable manner, high-yield portfolios need to be diversified across a broad range of industries. For that to happen, say bankers, misconceptions and prejudices about ratings need to be cast aside in boardrooms across the globe.

“The question in the European market has never been about whether or not there is a real investor base able and willing to buy high-yield bonds,” says Connolly at Goldman Sachs, who relocated from New York to London in September 1998, having worked on key transactions such as ITT/Promedia and Orange prior to his arrival in Europe. “You can always find buyers for good bonds. The issue in Europe is persuading CFOs to accept high yield as a respectable corporate financing tool. I believe the high-yield market will grow at an increasing rate when that happens.”