Most investors place the origins of the high yield market in the late 1970s, which would not necessarily be wrong if by the high yield market we mean “original issue” high yield. Truthfully, high yield lending has been going on for centuries. Back in the 1700s, the Rothschild family was a dominant high yield lender (lending at higher interest rates/yields to more risky borrowers) but their focus was on countries rather than companies. Over the last two centuries, as commerce and the modern corporation developed, the bond market developed right along with them. However, for decades, the focus of both sides (issuer and investor) was on highly rated companies, aided by John Moody’s development in 1909 of the basic ratings system (Moody’s Rating Service), which is used today.
The earliest modern era data we have on the high yield market came in 1958, when W. Braddock Hickman, a researcher for the National Bureau of Economics Research, produced a seminal piece of work entitled Corporate Bond Quality and Investor Experience. As the title suggests, he reviewed the corporate bond market and investors’ experience with it from 1900-1943. Hickman used the terms “low grade” and “high grade” to differentiate what we now refer to as “high yield” and “investment grade.” His conclusions were as follows:1
On the average and over long periods, the life-span yields realized on high-grade bonds were below those on low-grade bonds, with the result that investors, in the aggregate, obtained better returns on the low grades.
The foregoing may be summarized as follows: (1) Investors, in the aggregate, paid lower prices for, and thus exacted higher promised yields on, the low-grade issues; (2) default rates on the low grades were higher than on the high grades; (3) loss rates, which take into account not only default losses but also capital gains, were higher on low-grade issues; (4) the higher promised returns exacted on the low grades at offering proved to be more than sufficient to offset the higher default losses; (5) in consequence, life-span yields realized on low grades were higher than on high grades. The results were quite typical within major industry groups. Similar results were obtained for most of the longer assumed chronological investment periods.
The finding that realized returns were higher on low-quality corporate bond issues than on high-quality issues has implications for investment theory as well as for practical investment policy.
Hickman’s findings turned everything about investing in fixed income on its head. His conclusion was unmistakable in that low-grade bonds outperformed high-grade bonds over this period. The increased default rates of low-grade paper were more than offset by higher-coupon income and recovery rates on the defaulted bonds. Apparently, this superb piece of work was ignored until the late 1970s, when Michael Milken—a graduate student at the Wharton School—dusted this script off and launched what became the original issue high yield market as we know it today. Michael Milken and Drexel Burnham Lambert ultimately became synonymous with high yield.
The high yield bond market as we know it today first started to really gain traction in the mid-1980s and has steadily grown since.2
There were several distinct periods of growth that assist in understanding the development of this market. Prior to 1985, the market consisted almost entirely of securities that were once investment grade but had since been downgraded. These securities became known as “fallen angels.” It was in the 1980s that Drexel Burnham, and eventually all of Wall Street, began to embrace the concept of original issue high yield bonds to finance everything from leveraged buyouts to significant new industries, including modernizing Las Vegas (Caesars World, Circus Circus, Bally’s), creating cable networks (Turner Broadcasting-CNN) and ultimately even financing the beginning of the wireless age (MCI and McCaw Cellular). It is important to note both then and now that the high yield issuers are not start-up companies, but generally, mid-sized companies with well-established product lines or services looking for an alternative form of financing to sustain or grow their businesses.
The high yield market offered several important advantages to issuers. Prior to the original issue high yield market, companies would have to finance themselves with equity and/or traditional bank debt. The problem is that equity financing is often very expensive and massively dilutive to existing shareholders, while bank debt is short term, has amortization payments and comes with restrictive covenants. Bank financing would not be effective in building out the massive infrastructure required in many of these cases. Thus, the long-term nature and fixed coupon payments provided by high yield bonds allowed for the stability needed for these companies, and the market growth began.
However in 1990, the growth of the market stalled as the country entered a significant recession and default rates climbed. Given the limited size and breadth of the market at the time, many wondered whether this asset class would survive. But survive it did and as the country emerged from this period, the high yield market growth resumed. Yet the truly exponential growth in the market would not begin until 1996 and did not take another breather until the end of 2003.