Dangerous Dreamers by Robert Sobel

As the stock market of the 70's sank into irrelevance, Milken made a large market and a small fortune in trading equity-like bonds. It wasn't until the leveraged buyout mania of the 80's that he made his large fortune.

Hundreds of professionals lost their jobs. It had happened in the 1930s, and it would happen again in the late 1980s. As recently as 1972, there had been some 600 NYSE member firms; over the following six years, almost 250 of them vanished.

There was just one money market funds in 1971, Reserve Fund, with assets of under $100 million. As interest rates rose (and stocks and bonds fell), more such funds came to market. By 1981, when yields averaged around 16 percent and went as high as 20 percent, these funds had assets of $170 billion.

Wigmore noted that the yield spread between AAA and BAA rails in 1929 had been betwen 90 and 142 basis points; by 1934, the spread had risen to 433-497 points. In the same period, AAA and BAA industrials went from a spread of 38 to 111 basis points to 225-599. Yet the default rate even for those issues whose ratings declined sharply was quite low. According to Wigmore, not a single railroad issue of more than $40 million went into default, and the same was true for industrial issues over over $20 million.

Salim "Cy" Lewis of Bear Stearns had prowled the fallen-angels market since the 19420 and had done very well purchasing bonds of distressed railroads. Lewis' reasoning was simple enough: All the bad news about those railroads was public and was fully reflected in the prices of their securities. Few people had any faith in their recoveries; yet, some were bound to come back. Even if they didn't, the companies would be restructured, not put out of business. The common stockholders would probably lose all, and the same might be true for the owners of preferred stocks. But bondholders could come out of the restructuring with new equity....

By the mid-1980s, junk had a track record, and it was a good one. Drexel asserted that in the 1970s, there had been average annual failures of 1.6 percent of all junk bonds (including fallen angels). The figure for 1980 was 1.5 percent, an dropped to 0.2 in 1981. More important, during the 1981-1982 recession, the failure rate for junk bonds rose only slightly; in 1982, it rose to 3.1 percent, then fell to 1.1 percent in 1983. Failures of original-issue junk bonds, which had been 0.9 percent in 1980 and 0.6 percent in 1981, went to 0.8 percent in 1982 and 0.7 percent in 1983.