The Junk Bond King: How Michael Milken Revolutionized the Borrowing Landscape
From Magic Tricks to Wall Street Notoriety.
Hi there,
To kick things off, a warning, today’s article is a long read.
Here is the movie worthy story of Junk Bond King Michael Milken,
If you’ve ever heard the words ‘Junk bonds’, you have Michael Milken to thank for it.
He changed the way the world perceives junk bonds and consequently altered how companies would borrow money forever.
Before he entered this space, banks and lenders overlooked the junk bond market, making funding scarce and expensive.
Milken's participation in the market led to billions being raised for investment via the junk bond market, reshaping the way companies borrow money.
From 1977 till 1989, his company raised more than $98 billion.
As a result, Milken held significant influence over Wall Street. In 1987 alone his compensation was over $550 million making him the highest paid man in the Street’s history. Meaning for every minute of every day and night he earned $1,046 - until he was charged with securities fraud and sentenced to 10 years in jail.
A fun fact, he was one of the inspirations for Gordon Gekko the villain financier in the movie Wall Street.
Such was his impact that his strategy playbook is still being used today in a market that is worth over $4.5 trillion.
From Magic Tricks to Millionaire Dreams
Raised in a middle-class Jewish family in Los Angeles, California, Milken was a busy kid - active in student government, cheerleading and performing magic tricks. He was also elected prom king. While still in his teens, he resolved to become a millionaire by the time he was thirty.
While juggling his undergraduate studies at University of California, Berkeley, he got his first taste for business - trading for friends. He would keep 50% of the profits while promising to make them whole in case of losses.
His intellect was well known among his peers, with some students avoiding the classes Milken took because he skewed the grading curve, hurting their grades.
While at Berkeley he became fascinated with low-grade or high-yield bonds aka junk bonds after reading W. Braddock Hickman’s 1958 study Corporate Bond Quality and Investor Experience.
The author of the study found- portfolios of junk bonds sold in the U.S. from 1900 to 1943 usually outperformed the higher-rated, “safer” securities, “if the list is large and held over a long period.” The author also cautioned that these returns were “subject to extreme aberrations over time.”
This ‘Aha!’ moment would change Milken’s life forever,
Let’s take a short segway from Milken’s life to understand what Junk Bonds are.
Junk Bonds 101
What are junk bonds aka high-yield bonds?
Junk bonds are considered highly risky by credit rating agencies like Moody's or Standard & Poor's. These agencies believe there is a likelihood that the borrower may not repay the interest or principal borrowed. As a result, they assign a low rating to signify this risk to investors.
In simple terms, any bond that does not meet the criteria for an investment grade bond, which is typically given to global companies like Walmart or Nestle, is categorized as a junk bond.
Market dynamics of junk bonds
Junk bonds are not as actively traded as investment grade bonds due to lower demand from investors.
Additionally, in the global market, there is a wide array of borrowers issuing bonds with different characteristics and tenures, which provides investors with a vast pool of options to choose from.
Furthermore, many investors opt to hold onto junk bonds until they mature to capitalize on their higher coupon rates.
Consequently, the combination of lower demand, extensive options, and long-term holding strategies leads to relatively low liquidity in the market for junk bonds.
Going back to the study, the researchers found that if the issuer company repaid both the interest and the capital, the total return on investment was much higher for junk bonds compared to investment-grade corporate bonds, despite the higher risk involved.
While individual bonds are risky, a portfolio of them can generate higher returns.
In simple terms, the market was overlooking the benefits of diversification by focusing only on the individual risky nature of these bonds. The high coupon rate compensated for the risk of a few issuers defaulting.
After having read the study Milken became fascinated with junk bonds.
After graduating from Berkeley, Milken pursued further studies and received his MBA from the University of Pennsylvania's Wharton School of Finance, while working part time at Drexel Firestone, a second-tier investment banking firm.
In 1977, at age 31 Milken completed his firm’s first underwriting of a new issue of junk bonds. A $30 million offering for the oil and gas producer Texas International—earning Drexel a fee of 3% percent, higher than the 1% fee charged for underwriting investment-grade bonds.
Tasting success, Milken set out to change the world of Junk Bonds forever,
He did so at a time when the U.S. Economy was facing a host of issues,
High oil prices leading to transportation and food prices rising
The economic engine was faltering resulting in rising unemployment
Loss of confidence in the US dollar due to the collapse of the Bretton Woods Agreement
It was a complicated situation, made worse by bad policymaking on the part of the Fed and the government, leading to multiple recessions in the 1970s and early 1980s.
Milken’s magic touch
A soft-spoken workaholic, Milken was known for his analytical nature and attention to detail. He would meticulously scrutinize balance sheets and cash flow statements, while working long days of up to 16 hours, thriving under pressure.
During his time at Drexel in the early 1970s, Milken consistently advocated for junk bonds over investment-grade bonds to his expanding client base. These high-yield bonds proved to be resilient even during the 1975 recession.
He looked at situations that others often overlooked. Everything goes into the mix, he says, “I like the idea that I have to take all sorts of information from a variety of sources—everything from what I think the President is going to do next to what is going to happen in interest rates. I like to turn it all around and come up with a projection of what will happen.”
Furthermore, he acted as a market maker, providing an exit strategy for investors. He kept track of which clients held which bonds, allowing him to find new buyers for bonds that others wanted to sell.
Through his expertise and success in generating profits for a diverse range of clients, including insurers, savings and loan institutions, and mutual funds, Milken built strong relationships based on preaching the advantages of high-yield bonds. This led to a loyal client base that continued to seek his services.
There were also macro trends that helped grow the market,
The appetite for junk bonds grows
In the 80s, US Savings and loan institutions (S&L) seemed to have an insatiable appetite for junk bonds.
Their primary function was to collect deposits from members and lend them back to a few of the members to finance their home purchases.
However, in the late 1970’s and early 1980’s, due to inflation and interest rates rising dramatically, S&L suffered massive losses.
This happened because the S&L institutions were straight jacketed by regulations,
Firstly, the interest rates that they could pay on deposits were set by the federal government and were substantially below what could be earned elsewhere, leading savers to withdraw their funds.
Secondly, S&Ls primarily issued long-term fixed-rate mortgages. When interest rates rose, the amount they earned on long-term fixed-rate mortgages didn’t change leading to dramatically reducing the S&L capital.
Seeking to resolve the crisis, policymakers permitted S&L institutions to pay market rates to attract deposits, invest their deposits elsewhere, all while increasing the government guarantee to repay the deposit holders in case of the institutions inability to do so.
As a result of these changes, from 1982 to 1985, the industry’s assets grew 56%. To monetize these assets, S&Ls were engaging in a “go for broke” strategy of investing in riskier and riskier projects including junk bond issuances, hoping they would pay off via higher returns.
Loose monetary policy super charged the junk bond market
In 1981, President Reagan announced major tax cuts rallying the markets. By 1982, after an era of expensive money, inflation was under control thanks to Fed Chairman Paul Volcker. To jumpstart growth and increase economic activity interest rates were cut.
This led to junk bond issuances growing in popularity as people looked to them for higher yields. Both the number of transactions and the average size of the deals increased significantly during the 1980s.
As the junk bond market was boomed, new issues of junk bonds increased in total value from less than $2 billion a year between 1980 and 1982 to about $13 billion a year in the next three years, and about $31 billion annually between 1986 and 1989.
From 1983 to 1989 newly issued junk bonds accounted for 21% of all newly issued corporate debt compared to between 3 and 7% during the previous six years.
Drexel Burnham’s share of this highly profitable business averaged almost 50% between 1980 and 1989.
The boom benefited companies as they wanted to fix their cost of capital and rely on sources of funding other than banks - who would pressure them for repayment in times of stress.
The side effects of increased junk bond issuances
The ease of borrowing money via junk bond issuances led to two trends in the market, both aided by Milken,
1. Investments in small but growing firms
Junk bond issues offered a new way for many small but growing firms, which had been starved of capital by stodgy snotty banks, to raise capital by themselves.
As per The Economist,
“Drexel also funded Bill McGowan's MCI, the firm which successfully challenged AT&T's fixed-line telephone monopoly. Drexel financed Mr Wynn's Golden Nugget casino in Atlantic City and the Mirage in Las Vegas, replete with a fake volcano. His firm now owns several luxury hotels in Las Vegas, a city whose rapid growth owed much to high-yield finance. Mr Malone's Tele-Communications Inc became the biggest cable-TV firm in the world. Its growth was financed by Drexel-issued junk. Mr Turner pioneered 24-hour news television at CNN, a channel powered by junk.”
Under Milken's rebranding, junk bonds became a new method of financing that facilitated innovation and business expansion.
2. Leveraged Buyouts (LBO)
A leveraged buyout is a transaction wherein a group of investors borrow money to purchase the target company.
One of the core characteristics of LBOs is that 50 to 90% of the total financing comes from debt. Given the risky nature of such deals the debt issued to fund these deals pays out higher returns,
In an ideal situation - the target company would be a conglomerate, with low debt burden, running multiple businesses generating free cash flow which can pay the higher interest burden on the junk debt. Once the takeover was completed the capital structure of the acquired company would reflect the junk debt issued which made the takeover possible.
The goal for the buyer is to extract value from the company by - breaking it up and selling its parts, closing loss making divisions, firing employees, or taking the company public. Firms could even use this method to change the equity and debt mix of the company’s capital structure by making it more debt oriented as interest payments are tax deductible.
Milken found that he could sell these millions of dollars of debt to his clientele and engage them in these buyouts.
He financed “corporate raiders” such as Carl Icahn who then had the dry powder to force big companies to slim costs and generate returns for shareholders through aggressive business development strategies. The junk bonds were associated with rapid growth in sales, productivity, employment and capital spending.
But in certain situations, servicing the debt became a burden and the acquired company could not generate additional cash flows to meet the debt obligations, forcing the company into bankruptcy and people losing their jobs.
The darker side of LBOs
Take the case of RJR Nabisco, a cigarette-and-biscuit conglomerate, where Drexel funded much of the financing in 1989 for the $25 billion purchase by Kohlberg Kravis Roberts (KKR).
As per The New York Times,
“When Kohlberg Kravis first bought RJR Nabisco, the expectation was that it would hold on to it for a few years, improve the operations and then sell it back to the public. The magic of leverage would mean that a small growth in the overall business value would translate into a large profit for the equity holders.
[…]
Kohlberg Kravis's equity investment of $3.5 billion came from its 1987 fund, which raised a total of $5.6 billion from institutional investors. That fund will wind up losing $730 million on the RJR Nabisco and Borden investments…”
The entire saga went on for 15 years with bits and parts of the company sold here and there.
The bubble bursts
Post 1985, the market started slowing down, due to various reasons.
The market crash on Black Monday 19th October 1987 - a chain reaction of market distress sending global stock exchanges plummeting in a matter of hours. The Dow Jones Industrial Average (DJIA) dropped 22.6% in a single trading session.
The quality of newly issued junk bonds also deteriorated sharply as the volume surged.
Between 1986 and 1989, many companies started selling junk bonds in the hot market.
However, they could only make the required interest payments if their cash flow grew quickly or if they could sell their assets at high prices. But most of these companies found that their financial performance wasn't good enough to deal with the risky financial structures that came with issuing junk bonds.
The higher acquisition prices, along with buyouts of companies in less stable industries increased the debt load to unsustainable levels.
New regulations forced troubled savings-and-loans to unload their junk bond holdings.
In 1989, junk-bond defaults exceeded $8 billion, more than the amount of junk bonds issued in any year before 1984.
The year 1990 was even worse. The deteriorating economy, combined with a scandal-wracked junk-bond market that had absorbed so many risky issues since 1985, pushed defaults to almost $20 billion.
Milken’s Era Ends
In 1990, Milken pleaded guilty to six criminal charges related to securities transactions and was fined $600 million.
One of the allegations against Milken was that he demanded warrants from borrowing companies that did not end up in his clients' portfolios. Instead, these warrants were placed in a separate partnership owned by Milken, his family, Drexel employees, and various mutual-fund managers who had participated in Milken's offerings.
This action deprived pension and mutual fund holders of their rightful returns.
Milken's sentence was later commuted, and he was released in 1992 after serving 22 months. In 2020, President Trump pardoned his sentence, highlighting Milken's contributions to cancer research.
Following its legal battles, Milken's firm Drexel was forced into bankruptcy in 1990.
LBO and junk bond market today
Today, the global market for high yield bonds has burgeoned to $4.5 trillion.
Banks and private credit funds such as KKR and Apollo lead the race to provide financing for LBO’s. Drexel has been replaced but the playbook is still the same.
I hope you enjoyed this long read. It takes a significant amount of research to uncover these intriguing stories. I look forward to sharing more captivating narratives with you in the future.
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Filtered Kapi #49
Great read, they should make a movie on his life