Issue #19, Volume #2
Saving Distressed Debt After The Swashbuckling 1980s
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Today we share with readers a special issue of Porter’s Daily Journal, on a day when both Porter & Co. and the U.S. stock markets are closed in honor of Presidents’ Day.
Next week, Columbia Business School Press will release Donald Chew’s new book on corporate finance that features an entire chapter on the legendary dean of high-yield debt, Marty Fridson, who oversees Porter & Co.’s Distressed Investing. Below, in place of our normal insight and analysis, and in advance of the book’s publication, we are offering an excerpt from that chapter, entitled “Martin Fridson, The Extraordinary Success Of The High-Yield Bond Market, And The Leveraging Of Corporate America.” Attached below is the full chapter.
After a brief introduction that provides some background on the high-yield debt market in the 1970s and 1980s, we begin with the excerpt from Donald H. Chew Jr.’s The Making Of Modern Corporate Finance.
Today, the high-yield debt market is a large and widely accepted segment of the investment landscape. But it wasn’t always this way. Until just 50 years ago, few mainstream investment firms would deal with non-investment-grade debt – that is, bonds that the ratings agencies designate lower than BBB because they believe the risk of the issuing company defaulting on the bonds is real. In fact, before the 1970s, there was no real public market for trading high-yield debt.
Then, beginning in the late 1970s, the high-yield debt market started to boom. Junk bonds, the informal term for debt with a rating below BBB, became a great source of financing during the advent of hostile takeovers and leveraged buyouts (“LBO”), as we recently detailed in the Daily Journal. When corporate raiders got shut out of others lending options, they turned to these more expensive, but easier-to-access debt instruments. And the high-yield-debt market flourished – with $30 billion in new issues a year by the end of the 1980s.
At the time, Porter & Co. Distressed Investing senior analyst Marty Fridson was head of credit research on bonds at Morgan Stanley, focusing on high-yield issues. Part of his job during this heyday of high-yield debt was to anticipate what companies would be the corporate raiders’ next target. The purpose, says Marty, was to get ahead of possible rating downgrades… which would mean that the prices of the target company’s bond would get crushed. The bonds of the company being purchased would suffer because the buyer would borrow money to pay for their acquisitions… which they’d then load onto the target company’s balance sheet.
The following excerpt from Chapter 10 of Donald H. Chew, Jr.’s upcoming book, The Making Of Modern Corporate Finance, the star of which is Marty Fridson, tracks the history of the high-yield market and focuses on the emergence of a new-issue market for high-yield bonds starting in the late 1970s. Before the public debt market opened to companies that didn’t qualify for top credit ratings, almost all bonds rated below BBB were called “fallen angels,” bonds that were originally issued with investment grade ratings and later downgraded.
The editor of the Journal of Applied Corporate Finance since its start in 1981, author Chew picks up the story during the high-yield market’s Great Debacle – the 1989-1990 trauma, at the end of the roaring 1980s, when defaults soared, prices plummeted, and the leading high-yield underwriter Drexel Burnham Lambert went bust. The big banks were looking to unload their distressed debt, as many saw no future in the high-yield bond underwriting business.
But, as Chew writes, Marty Fridson did see a future… and one not built on simply selling high-yield debt to the highest bidder, but establishing the asset’s true value. Chew explains…
Marty also politely declined a suggestion from junk bond king Michael Milken [pictured above], after he resigned from Drexel Burnham Lambert, that Marty assume Milken’s mantle in spreading the high-yield gospel. Marty replied that, however flattering he found Milken’s suggestion, his service and value to his employer Merrill Lynch depended not on proselytizing, but on producing objective research that helped high-yield investors maintain and even boost their risk-adjusted returns.”
An excerpt from Chapter 10 is below. And as a gift to readers, we have secured rights to the full chapter featuring Marty Fridson from Douglas H. Chew Jr.’s The Making Of Modern Corporate Finance: A History Of The Ideas And How They Help Build The Wealth Of Nations, to be published by Columbia Business School Press on February 24, 2025, available below the excerpt.
The Great Restoration
In the depths of the Great Debacle, many portfolio managers suspected that the “buy” recommendations of some sell-side analysts were motivated in no small part by the eagerness of their trading desks to unload damaged bonds from their inventories. Restoring the credibility of not only the would-be issuers and their bankers, but also of the supporting research, would play a significant role in the rejuvenation of the high-yield bond market that took place after the regulatory shutdown of high leverage in the early 1990s.
In the middle of 1989 – just as the market was going into the tank – Merrill Lynch had persuaded Marty to leave Morgan Stanley to head its High Yield Bond Research Department. When Merrill’s team convened to discuss the future of the business, it was Marty who proved to be the greatest optimist in the group, projecting that the high-yield underwriting business might one day rebound to annual issuance as high as $10 billion. (His projections proved way too cautious in light of the $400 billion of U.S. non-investment grade issuance in 2020.)
Marty urged his team to follow the rule they’d all been indoctrinated with since fourth grade: show your work! The goal was complete transparency, proceeding step by step to the conclusion that the bond being analyzed was attractively priced. This way, the worst response from a buy-sider would be something like, “Though I disagree with some of your assumptions, your conclusion follows from them, and so your analysis looks like a genuine attempt to get to the right answer.” That principle informed Marty’s own work. With data becoming more widely disseminated, the point was to enable anyone who wished to replicate the work and determine its validity for themselves. The curtain had come down on the era of Wall Street strategists whose conclusions had to be accepted solely on the basis that everyone “knew” them to be geniuses.
Remaining faithful to his Morgan Stanley boss Robert Platt’s injunction to be an analyst and not an advocate, Marty also politely declined a suggestion from junk bond king Michael Milken, after he resigned from Drexel Burnham Lambert, that Marty assume Milken’s mantle in spreading the high-yield gospel. Marty replied that, however flattering he found Milken’s suggestion, his service and value to his employer Merrill Lynch depended not on proselytizing, but on producing objective research that helped high-yield investors maintain and even boost their risk-adjusted returns. Marty viewed his research as part of a larger collective effort to increase the “information content” of high-yield prices and, along with it, the efficiency of the market in which they traded.
Taking full advantage of greater data availability, Marty tackled a variety of analytical issues, sometimes in collaboration with colleagues like Christopher Garman, Jón Jónsson, and Michael Cherry. Among his most notable insights was that senior bonds could carry larger risk premiums (spreads over Treasurys) than like-rated subordinated bonds if the subordinated bonds were obligations of higher-rated, and presumably more creditworthy, corporate issuers. It was not unreasonable to expect such issuers’ lower-default probabilities to more than offset the more senior bonds’ higher expected recoveries in the event of default. In another research initiative, Marty debunked the popular industry claim, by Drexel and others, that bonds systematically became underpriced when downgraded from investment grade to speculative grade. His price data showed that the values of such fallen angels were equally likely to continue falling as to rebound from the supposedly “oversold” levels resulting from forced selling by managers of investment-grade portfolios. Consistent with this finding, some of the largest pension-plan sponsors told Marty that their investment rules gave them flexibility in timing their liquidations of fallen angels to avoid fire sales.
Another phenomenon that got Marty’s attention was the stock and bond price changes accompanying “leveraging events” – say, large one-time distributions to shareholders – that led predictably to surges in stock prices (or returns) and plunges in the prices of existing bonds. Having identified this phenomenon, Marty devoted considerable effort to keeping bondholders informed about possible leveraging events that could inflict significant losses on their portfolios.
Further Vindication By The Academy
But as Marty himself has pointed out, probably the most important and credible piece of high-yield research – one that, with the 1980s “junk”-fueled takeover wars now over, likely did the most to help the high-yield market enter the mainstream of institutional investing – was a study published in the Journal of Finance in 1991 by Wharton School professors Marshall Blume, Donald Keim, and Sandeep Patel called “Volatility And Returns Of Low-Grade Bonds.”
The study analyzed the risks and returns of long-term speculative-grade bonds for the period 1977-1989 and found not only higher returns but also lower volatility for high-yield bonds relative to investment-grade bonds.
One effect of the Wharton study was to discredit the claims of the “Harvard study” [“Original Issue High Yield Bonds: Aging Analyses Of Defaults, Exchanges, And Calls,” by Paul Asquith, David W. Mullins, Jr. and Eric D. Wolff, from the September 1989 Journal of Finance] that high-yield bonds become more default-prone as they age. But an even more important finding – and it’s one that the finance scholars celebrated in this book would have predicted – was that speculative-grade bonds were neither systematically overpriced nor underpriced. Despite its lower volatility, high-yield investing clearly carries greater credit risk as reflected in the higher default rates and losses. The higher yields and eventual returns represent the expected compensation – neither too much nor too little – for bearing such risk.
And this is just what one would expect in a vigorous, highly competitive – and what we have been identifying as an efficient – market, a market that, in promising and providing higher returns for larger credit risks, would succeed in attracting legions of new investors. By providing investors with “fair,” though not outsized or “abnormal” (of the kind sometimes claimed by Drexel and other enthusiasts), rates of returns, the high-yield market would ensure that corporate issuers would also perceive it as providing them with a fair deal and economic source of capital – at least when set against their main alternatives of private placements – and so keep returning year after year.
The Great High-Yield Rebound And Expansion
After the Great Debacle of 1989-1990 and during the several-year hiatus of LBOs and other highly leveraged transactions that followed, access to high-yield financing expanded to a wider range of companies that were simply seeking funding for continuing and expanding their operations. In the decade from 1989 to 1999, the amount of U.S. high-yield bonds outstanding nearly doubled to $274 billion, of which over 90% was original-issue paper. In some quarters, the impression lingered that “junk” companies were all failing remnants of one-time blue chips, but the reality was that highly leveraged but clearly healthy – and even a good number of rapidly growing – companies began to account for a substantial portion of the total.
At the end of 1999, the largest industry within the ICE BofA U.S. High Yield Index was telecommunications, whose issues then accounted for some 20% of total face value. Sensing that the growth of the industry had become too rapid, especially for debt-heavy financing, Marty began to warn investors that it was natural to expect a shakeout in the telecom industry.
While venture capitalists are accustomed to high failure rates offset by one or two big winners, high-yield bond investors have limited upside, and tend to look to an issuer’s asset values to provide downside protection in the event of bankruptcy. But when the dot-com bubble burst in 2001, such protection did not materialize for the early-stage telecoms of the 1990s. Many of these enterprises were little more than “business plan” companies with no tangible assets or operating cash flows – just plans for constructing telecommunications networks and eventually obtaining customers. And in Marty’s view, such growth companies had been able to raise capital in the high-yield market only because of the same “Fed-spurred” investment boom that was also encouraging and enabling dubious dot-coms to go public.
This “game” continued for several years before culminating in a high-yield “TMT” (telecom/media/technology) bust that paralleled the dot-com crash in the stock market. In 2001, telecom and broadcasting recorded the highest default rates among 35 industries tracked by Moody’s. During the period 2001-2003, the US High Yield Telecom Index produced an annualized return of negative 25.1%, as compared to the positive 3.7% eked out by the rest of the High Yield Index. And telecom continues to hold the record for the lowest recovery rate (based on prices immediately after default) of the 35 industries for the entire 1983-2021 period.
But the high-yield market would once again emerge from the wreckage to reach new heights. In the decade from 1999 to 2009, the face value of U.S. original-issue high-yield bonds once again more than doubled, to $618 billion. At the same time, the new issuers were joined by a growing host of newly fallen angels. Thanks to the Global Financial Crisis and Great Recession, and the large number of downgradings that came with them, the $618 billion of original-issue high-yield issuers now represented only 75% of the total high-yield outstandings, down from over 90% ten years earlier.
Nevertheless, in the decade that followed the Global Financial Crisis, the high-yield market showed remarkable resilience, with original-issue outstandings growing by almost 80%, to $1.1 trillion by June 2019. At that point they once again represented over 90% of the high-yield total, by then over $1.2 trillion. And at last count, these figures were 93% and $1.3 trillion.
And as we mentioned above, as a gift to readers, we have secured the full chapter from Douglas Chew Jr.’s The Making Of Modern Corporate Finance, to be published by Columbia Business School Press on February 24, 2025. Click here to down the PDF of Chapter 10.
As the excerpt from the book above makes clear, Marty is the best in the distressed investing business. He’s seen it all… from the legendary bond trading floor of Salomon Brothers, to the high-yield research teams at a who’s-who of Wall Street banks, to the sector’s resurrection from The Great Debacle. And that’s why we asked him to lead Porter & Co.’s Distressed Investing advisory.
Month after month, Marty and his team have shown that distressed bonds – the right distressed bonds – are a fantastic place to put your money. In fact, 11 of the 14 open positions have increased in value since being recommended, and overall, the portfolio is up about 30%. If you’re not already a subscriber to Distressed Investing… see what we’re talking about here, or call Lance James, our Director of Customer Care, at 888-610-8895 or internationally at +1 443-815-4447.
Excerpted from The Making Of Modern Corporate Finance: A History Of The Ideas And How They Help Build The Wealth of Nations, published by Columbia Business School Publishing. Copyright ⓒ 2025 Donald H. Chew. Used by arrangement with the Publisher. All rights reserved.
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