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In 1977, bond fund managers around the country received a peculiar document: it was the usual prospectus for a new offering, but this one wasn't investment grade. Bond managers were, of course, aware that not all bonds were rated investment-grade—but those non-investment-grade bonds had either been issued as investment-grade, or issued by conglomerates in exchange for either previously-issued bonds or in exchange for some acquisition target.¹ It was somewhat original to give investors the exciting opportunity to buy a bond that had a very real chance of not getting paid back at all, but enough of them took it that a new market was born.

Or, rather, an old market was reborn: the American railroad buildout was funded by what were pretty similar to modern-day junk bonds, and for a similar reason: they were capital-intensive enough that pure equity didn't make sense, but some of that capital would immediately lose liquidation value if the business didn't work out—the rolling stock would still be worth something, but the tracks themselves were only worth something if there was demand to move passengers or cargo on them. So, bond investors demanded, and got, a premium, and they knew—or found out the hard way—that this premium was meant to compensate them for the risk they took.

The reinvention of junk bonds was contingent on some mostly-unrelated historical factors:

• High overall rates meant that there was less sticker shock in paying, or paying for, double-digit yields.

• Inflation meant that bond investors raised their hurdle rates in general.²

• The general macro volatility of that period meant that there were companies that had decent underlying economics, but had gotten on the wrong side of some big macro factor—maybe they were locked in to buying a certain amount of oil, but paying five times as much for it as they expected, or maybe they were banks who hadn't hedged their duration risk and wanted to roll the dice on something else to get back to breakeven.

• Michael Milken was such a talented trader that he started getting capacity-constrained from the existing junk bond market, but was also strategic enough as a businessman that he realized he could profitably expand the investable universe through original-issue junk.

That market has had some pretty extreme ups and downs since then, but has returned to being a fixture of US financial markets after a long period where it wasn't much of a factor. With more complete capital markets and more sophisticated investors, it isn't as much of a vehicle for adverse selection as it used to be.

And junk bonds aren't the only financial technology that has been reinvented. There was a lively market in oil futures until 1895, when Standard Oil announced that going forward, it would be setting the price of oil. Futures didn't recover after Standard Oil was broken up, partly because they were still pretty cozy and partly because their business became increasingly dependent on drilling for oil in foreign countries, and opacity benefited them. Oil trading started to come back in the 1970s, when price volatility gave Marc Rich and other traders a wedge. And then, in a bizarre historical contingency, the New York Mercantile Exchange went through a scandal when J.R. Simplot defaulted on a big potato trade, and was put in a regulatory penalty box—they weren't allowed to introduce any new contracts until they'd cleaned up their act. Given that their biggest contract up to that point had been potatoes, this was bad news. But if you get a room full of traders and take away their favorite thing to trade, they'll instinctively find something to gamble on³, and they discovered that back before Standard Oil killed the market, NYMEX had listed a contract for heating oil! Heating oil correlates pretty well with oil, so suddenly NYMEX went from an exchange that had lost its biggest product to the one place where you could make live, intraday bets on the world's most important commodity.

Shareholder buybacks are another case study. They're a common corporate finance tool now, but until 1982, it wasn't clear if they were actually legal, or if the SEC would treat them as market manipulation. In an unclear regulatory environment, companies didn't want to risk being accused of either pumping their stock or exploiting shareholders, so they mostly avoided buybacks, or did them as one-time tender offers at a premium to the share price. But it turns out that they were well-understood in the 1930s, and some investment trusts that traded below net asset value used them to close that gap.

There are some products that only work when financial markets reach some threshold of size or complexity. And that threshold always changes—options got much easier to trade when Black-Scholes and pocket calculators meant that more people could estimate their fair value, though it's still a computational challenge to simultaneously quote so many contracts at once. Asset classes that seemed discredited by one cycle turned out to reach their peak in a later cycle, and that will probably happen again.⁴ There are lots of useful ways to slice up a stream of cash flows, or turn a risk into a tradeable asset, and there are lots of creative people who try to do this at what turns out to be the wrong time.

We've covered rereuns of financial history many times in The Diff. When something new is happening, you can learn a lot from figuring out how it's not so new, after all:

• Here's more on Milken and junk bonds.

• A profile of Teledyne, a pioneer in bringing back buybacks.

• The kind of risk-slicing that characterized the 2000s is back with AI.

• Learning from the rise of electrification.

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1  It says something about how sedate the bond business used to be that this worked in the first place. People would look at a bond paying 5% and, for at least some of them, assume that was worth about 100 cents on the dollar. If that bond were issued by a less creditworthy company, as many conglomerates were, it might have traded in the 70s. But if junk bonds were a bit taboo, this might not register, at least to retail investors who focused on equities.

2  And the smart ones wanted to trade credit risk for duration risk: if you have two ten-year bonds, with the same expected value, one of which pays 6% and the other of which pays 10%, with default probability accounting for that expected value, then the 10% bond has less negative sensitivity to inflation, because its expected cash flows arrive earlier. But it also gets a credit-quality benefit from inflation, since it's earning money in current dollars but paying a bond whose interest reflects an earlier price level. So if your mandate is that you have to buy bonds, and you're worried about inflation, junk is the closest thing you have to a hedge.

3  These days for many professional investors, who are outright barred or severely restricted from trading stocks in their personal account, this means gambling on crypto and prediction markets. These also have the added benefit of being tradable outside of market hours.

4  There are also examples of convergent financial evolution that arise naturally at wildly different points in time: venture capital, whaling expedition edition, was much smaller than venture capital, biotech edition, but both evolved to provide capital to end markets with similar meta-level characteristics (but very different object level characteristics!)