Originally published in Nikkei Asia's “Henry Kravis: My Personal History"
Chapter 10
Inaccurately described, they benefit companies and investors
The early days of the high-yield bond market marked a transformative period for the credit markets, laying the foundation for what is now a robust system that includes both high-yield bonds and leveraged loans. In the early 1980s, the idea of companies with low credit ratings being able to attract significant investment, for example savings and loan institutions (S&Ls), was groundbreaking.
Back then, out of thousands of American companies, only about 1,700 had investment-grade ratings. The rest, considered non-investment-grade companies, had no choice but to borrow from banks and insurance companies.
The innovation of junk bonds opened new avenues for companies previously constrained by limited access to capital, fundamentally altering the landscape for mergers and acquisitions and changing the way companies and investors viewed corporate debt.
At the forefront of this transformation was Michael Milken from Drexel Burnham, who pioneered the high-yield bond market in the '80s. His vision was simple yet revolutionary: to create a market where non-investment-grade companies could raise capital by issuing high-yield corporate bonds. This approach not only broadened the investor base but also allowed companies to access funds more efficiently, thus accelerating their growth and expansion.
One notable example of this transformation in action was our acquisition of toy chain Cole National in 1984. At the time, we were in the process of acquiring the company for $330 million but found ourselves short by $100 million in acquisition funds. In a pivotal moment, I remembered Mike Milken and the idea of leveraging the high-yield bond market surfaced. So, I said to KKR co-founder George Roberts, "Maybe I'll call Milken."
As the story goes, after presenting the acquisition plan to Milken and his team at Drexel Burnham's Beverly Hills headquarters, "all members of the team reacted positively." Milken then suggested that the KKR team go out for lunch. Upon our return, Milken had already assembled a group of investors from savings and loans institutions and other organizations. We repeated the presentation, and when Milken asked, "What do you guys think? They need $100 million," the investors nodded in agreement.
Just like that, KKR secured the $100 million needed for the company to complete the acquisition.
This anecdote highlights the critical shift in how capital was raised during this era. Traditionally, securing funds for acquisitions involved extensive efforts, including weeks of wooing institutional investors. However, the introduction of the high-yield bond market simplified this process dramatically, showcasing the efficiency and power of this new financial tool.
As KKR and other firms made a series of large acquisitions, they became some of Drexel's largest clients, further expanding the market for high-yield bonds. Investors, in turn, were drawn to these bonds due to their higher yields, despite the associated risks.
High-yield bonds, despite their nickname "junk bonds," offer higher returns to investors while giving companies greater flexibility in financing. The default rate on high-yield bonds is actually not that high, and today's market comprises the highest quality credit we have ever seen -- majority BB-rated.
Although the market faced challenges, including legal and regulatory scrutiny, the innovations introduced during this period have had a lasting effect. The mechanisms that were developed for high-yield bonds are now integral to the broader credit markets, including leveraged loans, representing a significant fundraising channel in the broader financial ecosystem for companies across various sectors that continues to drive economic growth and innovation.
This evolution in the credit markets has not only provided capital at critical points for many companies but also created a robust investment avenue for those seeking yield beyond traditional fixed income.