From: acquiredfm
The concept of “junk bonds,” also known as high yield bonds or low-rated bonds, emerged from a historical perception of rigidity in the financial world [00:00:02].
Initial Perception and Challenges
In the early days, managing money in the bond department at Citibank was considered a “backwater” [00:00:13]. Most investment organizations had strict rules against purchasing bonds rated below A or Triple B [00:00:26]. There was a general sentiment that such bonds were undesirable for investment [00:00:23]. Moody’s manual in 1978 even defined a B-rated bond as one that “fails to possess the characteristics of a desirable investment” [00:02:21], regardless of its price [00:03:01].
The Influence of Michael Milken
Michael Milken, often referred to as Mike, showed interest in low-rated bonds from around 1969 [00:01:07], the same year he graduated from Wharton [00:01:12]. He reportedly found a significant insight in a book called “Hickman,” which analyzed bond experiences from 1900 to 1943 [00:01:24]. The “Hickman” book suggested that the lower a bond’s rating, the higher its actual rate of return was, not just its promised yield, but its realized total return [00:01:36]. This phenomenon held true despite defaults and bankruptcies, even during the Great Depression [00:01:46]. The excess yield provided as an inducement was more than sufficient to offset credit losses, which was a pivotal “aha moment” for Milken [00:01:53].
At that time, it was virtually “impossible to issue a low rated Bond” [00:02:03], as they were categorized as non-investment grade or speculative grade [00:02:05]. Major banks and underwriters did not deal with them [00:02:09].
Understanding the Risks and Rewards of Investing in Low Rated Bonds
The investment philosophy behind high yield bonds can be compared to that of life insurance companies [00:03:08]. Just as life insurance companies profit despite knowing everyone will eventually die, investors in junk bonds account for potential defaults [00:03:21]. This is because:
- Awareness of Risk The risk of default is known and not a surprise [00:03:41].
- Analyzable Risk The risk can be analyzed, similar to how a doctor assesses health for an insurance policy [00:03:48].
- Diversifiable Risk Risks can be diversified across many different bonds, avoiding concentration in specific risky categories [00:03:55].
- Compensation for Risk Investors are “well paid to take” the risk, meaning the yield compensates for the expected losses [00:04:07].
This approach allowed for “steadily and safely” investing in bonds from what were considered “the worst public companies in America” [00:04:26].
Contrast with the Nifty 50
The investment landscape of junk bonds stood in stark contrast to the prevailing wisdom of the “Nifty 50” era [00:04:44]. In 1969, the “Nifty 50” comprised companies believed to be the best and fastest growing, where it was thought “nothing bad could ever happen” and “there was no price too high” [00:04:47]. This was the “polar opposite” of the sentiment towards high yield bonds, for which there was “no price low enough” [00:05:04]. Both extreme stances proved to be incorrect [00:05:13]. The “Nifty 50” companies, often priced at P/E ratios between 60 and 90 (compared to a normal S&P P/E of 16 postwar) [00:05:30], led to significant losses for investors who held them for five years [00:05:19]. Companies like IBM and Xerox, once considered unassailable, faced significant challenges and disruption, demonstrating that “moats” were not always inviolable [00:05:55]. This highlighted the fundamental principle that even the best companies can be poor investments if priced too high [00:04:45].