Let the Party Begin: The Rise of High Yield

From a humble library book to a roaring trading floor: how Michael Milken brought Junk Bonds to life.

University of California, Berkeley, mid-1960s

In a corner of the university library, an undergraduate student named Michael Milken pulled from the shelves a slim volume: Corporate Bond Quality and Investor Experience, written in 1958 by W. Braddock Hickman. The book’s main insight was that a diversified portfolio of low-rated bonds had historically outperformed portfolios of higher-rated bonds. Milken was struck by the claim, especially since no one on Wall Street had noticed it.

The corporate bond market of the postwar era was dominated by a handful of life insurance companies and pension funds who bought investment-grade paper from blue-chip issuers and held it to maturity. The small share of public corporate debt that sat below investment-grade consisted almost entirely of “fallen angels”, bonds which got downgraded after the issuing companies ran into trouble. They traded in thin markets at deep discounts to par and mostly between specialists. For companies outside the established investment-grade universe, this meant there was effectively no public bond market to issue into. They funded themselves through bank lines, private placements, or equity, all of which were more expensive or limited in scale.

Milken understood that if he could build an institutional base of investors around sub-investment-grade bonds, an enormous untapped market could open up. In 1970, fresh out of Wharton, he arrived at Drexel Firestone as director of low-grade bond research and was given some capital to trade. He read every prospectus and indenture to find companies that could service their debt, bought their bonds at deep discounts to par, and resold them as spreads tightened. By the time Drexel merged with Burnham and Company in 1973, the high yield desk had become one of the most profitable at the firm, and the new chairman gave him the autonomy to expand it. Over the next four years, Milken used the trading profits to hire credit analysts, build a sales team, and cultivate a small group of institutional buyers.

In April 1977, Lehman Brothers underwrote a public bond issuance for LTV, a Texas conglomerate that had been downgraded from investment-grade earlier in the decade. While for Lehman it was a favour to an old client, for Drexel this was the proof that the market it had been building for years was now ready to take off.

Milken picked up the phone and rang the CFO of Texas International, a small Oklahoma oil and gas exploration company. “I can raise you $30 million in 20-year unsecured paper at 11.5%”, Milken said. Then he called Executive Life, a large insurance company he had spent years building a relationship with: “You are holding 8% paper from blue chips. I have a single-B rated company issuing at 11.5%. Financials are solid and demand is strong. Deal closes tomorrow”. A few more calls and, like that, Milken underwrote his first high yield bond.

Through the rest of the year, the desk underwrote six more, and in the years that followed issuance boomed. Total volume of high-yield debt grew tenfold between 1977 and 1985, reaching nearly 20% of all public corporate debt outstanding in the US.

Milken and his team brought into the public bond market mid-cap companies that had previously been confined to bank lines and private placements: cable television operators, casino developers, healthcare services companies, and low-cost airlines. These were businesses that the investment-grade market had structurally excluded as it required predictable cash flows, low leverage, and established operating histories.

To place their bonds, Milken needed a base of buyers, and every spring he brought both sides together at Drexel’s high-yield conference at the Beverly Hilton in Los Angeles. By the mid-1980s it was known as the Predators’ Ball, named after the corporate raiders who came hunting for takeover targets, and had grown into one of Wall Street’s most important gatherings. Drexel spent millions on hospitality. Frank Sinatra and Diana Ross performed in the ballroom, while escorts entertained attendees in the evenings. Milken delivered the keynote, opening by telling the crowd they were the most powerful people in America.

Drexel had quickly become the dominant underwriter of leveraged buyout debt. In 1983 it cemented that position with the “highly confident letter”, a one-page note stating that the firm was highly confident it could raise the capital for a given transaction. It carried no legal weight, but corporate raiders and private equity firms used it to approach targets multiple times their size with takeover bids. The most notable example was the 1988 acquisition of RJR Nabisco by Kohlberg Kravis Roberts, the largest leveraged buyout in history at that point, financed in part through subordinated debt underwritten by Drexel. The deal made the cover of every business magazine in the country, and the asset class acquired its popular label of Junk Bonds.

By 1989, the Junk Bond market had become almost inseparable from Drexel. Then, in March of that year, Milken was indicted for fraud following a multi-year federal investigation into market manipulation and insider trading. At the time, it was the largest white-collar prosecution in American history.

Meanwhile, after a $650 million settlement with federal authorities and large losses on bridge loans, the money-market funds that had been buying Drexel’s commercial paper refused to continue doing so. Faced with an immediate funding pressure, Drexel’s CEO Frederick Joseph rang Gerald Corrigan, president of the New York Fed, and asked for emergency lending. Corrigan declined. Joseph then rang Treasury Secretary Nicholas Brady and SEC Chairman Richard Breeden, but neither of them were willing to step in. Joseph desperately tried to get funding from several other rival banks, but no one blinked an eye. At last, he called a board meeting, and everyone in the room voted to file for bankruptcy protection.

With Drexel gone and the savings and loan industry being forced by Congress to sell all of its $14 billion Junk Bond holdings, the asset class lost both its main underwriter and a large investor. The final blow came when the US recession of 1990-91 drove default rates on Junk Bonds to over 10%, the highest level since the 1930s.

Many investors assumed the Junk Bond market was finished, and it might have been, had a small group of contrarian buyers not stepped in. Leon Black, who until a few months prior had run Drexel’s mergers and acquisitions department, founded Apollo Investment Management. Together with a handful of former colleagues, he began buying the same high-yield bonds his old firm had underwritten, which were now trading at heavily discounted prices.

By 1992 the US had returned to strong growth, defaults declined and traditional investors started coming back. The boom of the 1990s also brought back many issuers and a broader set of banks who underwrote high yield bonds.

The asset class that Milken built in the 1970s now stands at roughly $1.4 trillion in the US, with most large institutional investors holding it as part of their fixed-income allocation. Newer forms of speculative-grade financing have emerged alongside it, with private credit absorbing much of the recent growth in mid-market and leveraged lending. High yield is also no longer the frontier of credit risk, as distressed debt has now taken that role. It consists exclusively of the debt of companies and governments in severe financial distress, often already in bankruptcy. What Milken created was therefore more than an asset class. He changed the way investors thought about credit risk and gave rise to new generations of leveraged finance.

If you enjoyed this article and found it insightful, subscribe for free below.