When Michael Milken stood before a federal judge in April, 1990 and pleaded guilty to securities law violations, more than just his career appeared to be dying.
The "junk" bond market Milken had molded into a powerful financial force in the 1980s--a major capital-raising vehicle for legitimate companies and some not-so-legitimate chief executives and corporate raiders--was in the process of violent collapse.
Milken had in the 1980s convinced a large number of investors that high-yield, high-risk bonds weren't junk at all, but gold. While some of the deals would of course go bust, Milken insisted that the overall returns on the bonds would be so good that the effect of the bad bonds would be almost irrelevant.
But with junk-issuing companies' default rates soaring in 1990--which had as much to do with misguided federal regulations and the onset of recession as with Milken's demise as the junk market's chess master--high-yield bonds came to look like Wall Street's Big Lie.
Last week, Milken's name returned to the headlines, once again connected with allegations of wrongdoing. This time, he agreed to pay the government $47 million to settle charges that he advised companies involved in two large investment deals in the mid-'90s, even after the Securities and Exchange Commission had banned him from the business.
Clearly, the government never liked Milken or his bonds, and the hostility may be perpetual. But the marketplace's assessment of Milken's idea--if not its assessment of the man himself--has been quite different: Instead of fading away after its 1990 crash, the junk sector--officially, bonds deemed less than "investment grade" in quality--went on to become the single most successful segment of the U.S. bond market in this decade.
Last year, in fact, set a record for junk-bond issuance, as more than $142 billion worth of the securities were sold to investors. And issuance this year is running far ahead of last year's pace, with $22 billion sold since Jan. 1, versus $12 billion in the first two months of 1997, according to Securities Data Co.
Individual investors have made junk-bond mutual funds their favorite bond fund category, other than municipal bond funds: Junk funds' assets now total $94 billion, up from $21 billion in 1990. (In the same period, assets of funds that invest in long-term U.S. government bonds have actually fallen, from $45 billion to $33 billion.)
Perhaps most striking is the default experience of junk-bond investors in the 1990s compared with the 1980s. Data from the Bond Investors Assn. in Miami Lakes, Fla., show just how tough it has been to pick a true loser in the junk sector this decade:
* The junk default rate--that is, the percentage of each year's crop of newly issued bonds that eventually miss an interest or principal payment--has yet to exceed 20% in the 1990s, and has been 11% or less since 1992.
* By contrast, roughly half of the 1,037 junk bond issues sold between 1980 and 1985 eventually went into default.
The numbers suggest that many of the early-1980s deals underwritten by Milken through his now-defunct investment banking firm, Drexel Burnham Lambert, weren't nearly as sound as Milken expected them to be.
Indeed, as Milken and Drexel exited the scene in 1990, many of the junk-issuing companies they supported quickly ran aground as well--names like Charter Medical, U.S. Playing Card and Swan Brewery, for example.
By early 1991, the whole notion of high-risk companies raising capital by selling high-yield bonds was widely discredited. And the idea of using such bonds to finance takeovers and leveraged buyouts--the schemes Milken may (unfairly) be best remembered for--became virtually unspeakable.
The government sent Milken to prison on charges that basically amounted to market manipulation, and it was true that, at his peak, he exercised enormous control over who issued junk bonds, and who bought them.
Without Milken, the junk market initially appeared lost. But its collapse in 1990 was worsened by the global recession triggered by Iraq's invasion of Kuwait (as corporate earnings fell, so too did companies' ability to pay their debts), and by the government's ill-advised decision in the summer of 1989 to order savings and loans to dump their junk-bond holdings, a move ostensibly aimed at lowering the risk in S&L; investment portfolios.
As sellers flooded the junk market with securities, the face value of many of the bonds fell 30% to 50% or more in 1990.
It was, however, a fantastic buying opportunity for the brave: As the economy rebounded in 1991, so too did investors' assessment of many of the junk bonds that had been trashed in 1990. Merrill Lynch's index of junk bonds posted a spectacular total return (interest earnings plus principal gain) of 35% in 1991.
More important, junk bonds' returns throughout the 1990s have been almost consistently strong. The Merrill Lynch index gained 18.2% in 1992 and 17.2% in 1993. After dipping 1.2% in 1994--the year the Federal Reserve Board doubled short-term interest rates--the index rose 20% in 1995, 11.1% in 1996 and 12.8% last year.
To put those numbers in perspective, consider: The average junk mutual fund has gained 70% over the last five years, double the return of funds that own long-term U.S. Treasury bonds.
Whatever the government's opinion of his methods, the fact remains that Milken was brilliant in having seen a large and viable market in matching risk-tolerant investors with companies that were willing to pay above-average yields for the capital they needed.
Although Milken did raise money for unsavory corporate raiders, it's also fair to say that companies including MCI Communications, Enron Corp. and Mirage Resorts might not exist today had it not been for Milken's ability to raise junk-bond financing for them.
Still, the junk market's performance in the 1990s has been so good that it ought to raise flags. Has it been too easy to earn these high yields? Have default rates been held artificially low--creating a massive time bomb that will explode in the next recession?
Many veteran junk bond investors concede that everything that could have gone right for junk bonds in the 1990s has gone right: Interest rates overall have continued to decline, allowing companies to continually refinance at lower rates; the economy has remained healthy; and the stock market has boomed, giving many high-risk companies access to equity capital as well as to debt capital.
"The sun, the moon and the stars all lined up for the high-yield market" in the 1990s, says Ben Trosky, manager of the Pimco High Yield fund in Newport Beach.
But now, he and other pros say, many of the new issues flooding the high-yield bond market are far riskier than what could have been sold three or four years ago.
"I'm passing on almost every deal I'm seeing--but they're still getting done," says Thomas Ole Dial, investment chief for the Northstar Funds in Greenwich, Conn. He is particularly wary of the deals from up-and-coming telecommunications companies, a sector that accounted for nearly 25% of junk issuance last year.
There's no question that junk default rates will rise sharply at some point, most likely when the economy goes into recession, Trosky and Dial say. The challenge at that point will be for junk fund managers to be out of the true problem bonds--and for junk-fund investors to hold tight, even as they see otherwise decent bonds get temporarily pummeled in price as other investors bail out.
Nonetheless, it's a good bet that whatever trouble eventually visits the junk sector, the market's status as a legitimate asset class won't again be universally questioned, as in 1990.
Whatever people think of Michael Milken, we owe him this: He was right.
Tom Petruno can be reached at firstname.lastname@example.org
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Junk Defaults: The Long-Term Trend
A high percentage of junk bonds in the early 1980s eventually defaulted, meaning they failed at some point to make good on interest or principal payments. But the story so far in the 1990s is that a relatively low percentage of junk issues have defaulted. The question is whether many more defaults are inevitable in the next economic downturn. Here is the percentage of each year's junk issuance that ultimately defaulted:
'97: 1997: 0.3%
* Source: Bond Investors Assn.