The recent rapid rise in values of the more speculative sectors of the public stock markets struck me as somewhat familiar. The fact that people recently burned by recklessly speculative behavior in public stocks would suddenly, at the first sign of a sustained rally, plow back into stocks at valuations completely unhinged from the prospects of the underlying businesses is mystifying, but somehow unsurprising.
After all, barely more than a decade ago, investors did the exact same thing with that scourge of the 1980s: the junk bond. A look at the rise and fall (and rise and fall) of the junk bond may be illustrative of the unhinged nature of certain company stock prices to their underlying businesses.
Two seconds on a story requiring hours
The story of junk bonds will sound a great deal like the IPO market of the late 1990s. "Junk" bonds are issued by companies with below-investment grade ratings. The rating agencies -- Fitch, Moody's (NYSE:MCO), and Standard & Poor's determine these companies have substantially higher risk for default than higher-rated issuers.
Bond investors have traditionally been a risk-averse bunch, and as such have tended to stay away from low-grade bonds regardless of the potential return. Prior to the 1970s, the only junk bonds came from companies that had previously been investment grade, but had gone into decline. Their interest yields at face value had not been very high, but with the bonds selling at a fraction of face value, the implied yield for secondary purchasers was quite high.
In 1977, Bear Stearns (NYSE:BSC) underwrote the first bond offering for a company with a below-investment grade rating, giving a substantially larger coupon (interest payment) to investors than was otherwise available on the market. At about the same time, Michael Milken was getting his start at what would become Drexel Burnham Lambert, armed with academic studies showing that a well-diversified portfolio of non-investment grade bonds would outperform higher-quality bond portfolios. He began preaching the gospel of high-yield bonds, and companies that otherwise were shut out of the bond market were only too happy to see this avenue opened for capital funding. Drexel created the appearance of a vital marketplace by guaranteeing liquidity.
By the early 1980s, investment banks were underwriting nearly as many junk bonds as investment-grade ones. And investors, who were starved for good investment avenues at the time, were only too eager to make the leap of faith. By the mid-1980s, all of the big investment banks -- Salomon, J.P. Morgan (NYSE:JPM), Merrill Lynch (NYSE:MER), Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MWD), and so on -- had built out infrastructures to push junk bonds to investors.
Early successes and massive profits for investors in junk bonds led to what can only be described as a frenzy, as the promoters pushed junk bonds not just as a way to make a quick buck, but also as the savior instrument that would pull the U.S. out of the doldrums. From the big houses to issuers on down to individual investors, the incentive of the easy money from junk debt caused many participants to rationalize their lowered investing standards. Investors accepted increasingly worse terms (including zero-coupon junk bonds) and demanded higher yields until suddenly, in 1989, the defaults began to rise. Soon afterwards, the entire market collapsed, and investors found that they couldn't get out at any price.
What went wrong?
Unadulterated greed drove the junk bond market over a cliff. There's nothing inherently wrong with junk bonds; they're perfectly valid instruments of commerce, and remain quite common today. But the basis upon creation of the market -- those academic papers showing outperformance of a junk bond portfolio -- was rendered irrelevant by factors that most participants either did not see, or ignored.
First and foremost, part of the outperformance of fallen angel high-yield bonds came from appreciation of the bonds themselves. New junk bonds were issued at 100 cents on the dollar -- no appreciation was possible. The other problem with junk bonds in this environment was that their very acceptance spurred on increasingly risky activity. Junk debt carries enough risk by itself; when used as a currency to buy other assets, the risk compounds. When people began to recognize their errant assumptions, it was simply too late to get out whole. And so the market burned extremely hot for a few years, burned out magnificently, and then people went to jail. Sounds a bit like the IPO markets of the late 1990s.
Parallels to the current environment
In fact, it sounds a great deal like the late 1990s. In both cases, there were dissidents standing on the sidelines -- yelling loudly that the whole affair was a house of cards -- who, of course, had the difficult task of explaining to people growing filthy rich that their actions were inherently unhealthy.
Both IPO excess and junk bonds were (and are) hailed as being "good for America." In both cases, promoters touted them as ways for companies to get capital for innovation, growth, and job creation that they otherwise may not have been able to garner. Perhaps most instructively, both crazes attracted participants of all types, from the highly experienced to the newcomer, and while some made out extremely well, most of these participants lost enormous amounts of money.
But given that until the 1990s the stock market was largely the realm of the proven company, the early offerings of Yahoo! (NASDAQ:YHOO), theglobe.com (OTC BB: TGLO), and other Internet companies likely were made possible only by the change in environment brought about by the higher-risk debt offerings in the 1980s. Once again, the markets have changed and won't be changing back -- companies that don't even have revenues, much less earnings, can be found on the major stock markets.
Perhaps the most amazing event of the junk bond craze occurred in 1991. After junk bonds had been completely discredited, billions had been lost, and recriminations abounded, the junk bond market suddenly rallied. In spite of all of the evidence that the risks of buying newly issued high-yield debt far outweighed the rewards, big money poured back into junk paper for one last cleansing hurrah.
Just as before, this type of investing proved to be an expensive folly. Just the same, after the insane stock market speculation in 1999 turned into big losses in 2000, the market went into a retrenchment, with people insisting they would be smarter next time, that they recognized what a bubble looked like. And yet, here we are, with companies of questionable merits trading at valuations to their businesses that discount a great deal of growth that has not yet (and may never) happen. It seems that those lessons have been quickly forgotten.
The problem isn't the instruments; it's the excess. Every time money seems to come too easily, too fast, and to too many people, it ought to be a sign that something is wrong. Because equity and debt instruments sometimes have a reflexive component to the underlying business ("It's going up, therefore the business is healthier due to cheaper capital"), these feedback loops can remain in place for a long time. It only hurts when they stop.
Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards
Bill Mann tried to read Intelligent Investor in German. Chastened, he went back to finance books in English and Winnie the Pooh in German. He owns none of the companies mentioned in this article. For those who are interested in yield, consider a trial subscription toMathew Emmert's Income Investor.
