How much will you offer to pay me for the contents of my wallet? Think carefully – if you must back a horse, don’t bet with the trainer.
How much will you pay me for the contents of my wallet? It would be sensible to begin by considering how much cash someone like me would be likely to have on them at any time. Fifty pounds, perhaps. So you should knock off a bit to compensate for the uncertainty and give you a margin for profit. Why don’t you offer £35?
Some further thought – any further thought – should warn you that this is not a sensible proposal to make. If I accept your offer with alacrity, you can be sure that there is less than £35 in my wallet. If, on the other hand, I turn the offer down, then the likely reason is that my wallet has more than £35 in it. This is a no-win transaction for you. At any price at which I am willing to sell, you ought not to be willing to buy.
But no one, you might think, would be foolish enough to get involved in a financial transaction of this kind. After all, my example is simply a pointed demonstration of the first lesson in finance: don’t buy a financial instrument from someone who is better informed about its value than you are. There is an elaborately documented modern theory of transactions in markets subject to asymmetric information which elucidates more clearly the problems which such issues raise. But the basic principles have been familiar for centuries, if not millennia.
Still, these principles seem to be easily forgotten in every wave of speculative euphoria. They were forgotten by Peregrine Securities when they bet the bank’s capital in the reassuringly named Steady Safe bus and taxi company in Indonesia. They were forgotten by western investors when they jumped into emerging market bonds. And by many of those who believed – no doubt correctly – that China and the countries around it are the wave of the future.
Michael Milkin made his reputation, and his fortune, from a piece of research which showed that the extra returns from low-quality debt were more than enough to compensate for the additional risks involved. But the theory of markets subject to asymmetric information would even then have explained why there was a crucial difference between the junk bond market he analysed and the one he invented.
Traditionally, most junk paper was not intended to be junk. It was debt incurred by the Russian government when the power of the Tsars had seemed impregnable: securities issued by companies with fine reputations and credit ratings which had subsequently fallen on hard times. Such bonds were traded in a secondary market between people who were more or less equally ignorant about the likelihood of a return of the Romanovs to the throne.
You would expect the price of such junk to reflect a general expectation within the market of the probability that the debt would indeed be repaid. People who were more than averagely optimistic would buy from people who were more than averagely pessimistic. If there were no systematic bias in these expectations, or in the way in which the market worked, then the return from a diversified portfolio of junk bonds should be much the same as the return from a portfolio of blue chips.
But there are at least two possible sources of such systematic bias. It is likely that even a diversified portfolio of junk bonds will be riskier than a comparable portfolio of investment grade securities, and with greater risk comes greater reward. To compare returns properly, they need to be adjusted for differences in risk.
But there is another reason why even risk-adjusted returns from junk bonds may be high. There are a lot of people who exclude themselves entirely from the market for low quality paper – regardless of its price. After all, that is what the phrase investment grade means. Bonds that are acceptable to buy: you won’t be fired for purchasing them, even if they go wrong. But if the security is below investment grade, everyone will find it easy, in the event of failure, to be wise after the event. Better not to have such securities in your portfolio. And if demand for junk securities is limited because most investing institutions stay away, the price will be lower and the expected rewards greater: just as the profits from brothel-keeping and drug-dealing are greater than from other businesses because many people are unwilling to engage in these professions, or are frightened off.
The more recent market for junk is rather different. Issuing houses – like Drexel Burnham Lambert or Peregrine Securities – were selling paper that was junk from the day of its issue. Now there is a big difference between buying junk in a primary market and buying it in a secondary market. It is one thing for you and me to trade paper whose value is contingent on the prosperity of the Tsar. It is quite another to buy such securities from the Tsar himself. You should expect that he will be over-optimistic about his prospects of retaining the throne. And even if he is entirely realistic in his own personal projections, you can be sure that he will be over-optimistic in describing them to prospective owners of his debts.
Which is why engaging in such transactions is like buying the contents of my wallet. The asymmetry of information between the parties is fundamental to the transaction. It may often be the main reason why the transaction occurs. If you are tempted to buy speculative paper, you should always ask why a well-informed vendor is willing to sell at that price.
And that is why there is rarely a sustainable market for securities which are priced to reflect their high risk. There are good reasons why the spreads on securities may not exactly match the risks involved even in otherwise efficient markets.. If you must back a horse, don’t bet with the trainer. Especially if the trainer’s horses are described as tigers.