Credit risk is hard to estimate. The negative events in credit markets, though significant when they occur, are infrequent. The market can chug along for years at a time without a major blowup, and each month the coupon payments roll in, risk grows: more capital pours into the market, leverage ratchets up and increasingly complex credit derivatives are added into the fray.
Because recent history does not provide a guide for the risk, to gain perspective on what can go wrong with credit markets let’s look back nearly two decades to the junk bond crisis. The components of that crisis – increasing leverage, a market shock, forced liquidation and an evaporating investor base – could all see a replay today.
Junk bonds were the mainstay of the LBO and hostile takeover strategies of the 1980s. These strategies started out as good ideas that were selectively applied in the most promising of situations. But over time more and more questionable deals chased after the prospect of huge returns, and judgement was replaced with avarice. Dealmakers continued working full throttle even as the universe of leveragable companies declined. They maintained deal volume by lowering the credit quality threshold of LBO candidates. The failed buyout of UAL in 1989 is one example of this; airlines are cyclical and until that time had not been considered good candidates for a highly levered capital structure. Leverage in the LBOs also increased over the course of the 1980s. Cashflow multiples increased from the 5x range in 1985 to the 10x range in 1988. This turned out to be fatal for many companies; by 1989 defaults started to increase.
On the other side of the issuers were the junk bond investors. High yield bonds wormed their way into the Savings and Loan industry. A number of Savings and Loans, many with the coaching of Drexel salesmen, found that government guarantees could essentially convert their risky bonds into government insured deposits; the S&L investors could capture the spread between the bond returns and the risk free return provided to the depositors. The government responded with the Financial Institutions Reform, Recovery and Enforcement Act in 1989, which barred S&L’s from further purchases of high yield bonds and required them to liquidate their high yield bond portfolios over the course of five years. Seeing the writing on the wall, S&L's had already begun to reduce their holdings; in early 1989 S&L junk bond holdings dropped by 8%, compared to an increase in holdings in the previous quarter of 10%.
Investors reacted quickly to the rise in defaults and the liquidations coming from the S&Ls. In July 1989 high yield bond returns turned negative. Over the third quarter of 1989 the N.A.V. of high yield mutual funds declined by as much as 10 percent. For investors who did not understand the risk of high yield bonds, the negative returns were a rude wake up call. The implications of erosion of principal – coupled with media reports of the defaults looming in the high yield market -- led to a wave of selling.
When things seemed like they couldn’t get any worse, they did. The insurance industry followed the S&Ls out the junk bond door.
In 1991 the California Insurance Commission seized Executive Life. In reaction to this seizure, insurance companies that had not participated in the high yield bond market lobbied for stricter constraints on high yield bond holdings. Insurance companies that did have junk bond exposure started to sell off their junk bond portfolios; they were loath to stand out from their competitors in their holdings of high yield bonds, many of whom were now trumpeting their minimal holdings of junk bonds as a competitive marketing point.
By this point there were not many people ready to take the other side of the trade. A broad range of investors spurned the market because it was considered imprudent. Everyone seemed to want to get rid of junk bonds, and the more prices dropped, the more they wanted to get rid of them. The low prices provided a confirmation that high yield bonds were an imprudent asset class. Rather than having the expected effect of increasing demand for the bonds, the price declines made the bonds look even worse than they actually were. Regulatory pressure and senior management concerns – not to mention losses on existing bond positions – stymied any traders who might have seen the emerging debacle as a great buying opportunity.
The result was a market laid to waste. Bond spreads widened four-fold and prices plummeted. The price drop was all the more dramatic because bonds, even non-investment grade bonds, are supposed to have much lower price volatility than stocks. By the time the dust settled, the impact on the market was equivalent to the US stock market dropping seventy percent.