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High Yield Bonds [ Junk Bonds ] and Their History

Mike Parker5/3/2011

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Parker - Noon

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Agenda for Junk Bonds

Definition

Role in corporate finance

Advantages

The Junk Bond King

Present status of junk bonds

Questions/Comments

Parker - Noon

3+Definition

High-yield or junk bonds are issues with a credit rating below BBB

These bonds may have been issued as such by a startup or may have been downgraded to this level over time

Bonds that have been downgraded fall into two groups:o Issues that have been downgraded because the issuer

voluntarily significantly increased their debt as a result of a leveraged buyout or recapitalization

o Issues that have been downgraded for other issues (fallen angels) 

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4+The Beginning

Originally, it was thought that high-yield bonds would not be attractive to public investors

o The maximum return that an investor may obtain is capped by the coupon and face value, but the loss could be as large as the principal invested

Before the development of the high debt market, corporations that could not issue debt securities in the public market would borrow from commercial banks or finance companies

o Estimated that two-thirds of the $90-100 billion of the junk bonds issued represent a replacement of commercial bank borrowing

o “No more a threat to the stability of the financial system than that bank debt itself was”

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5+Advantages Over Commercial Banks

Shifting the risk from commercial banks to the investing public presents several advantages:

1. Risk is not accepted indirectly by all US citizens, who may not wish to accept risk Commercial bank liabilities are back by the Federal Deposit

Insurance Company (FDIC) If the FDIC has to bail out the bank, all taxpayers eventually

have to pay

2. Junk bonds give corporations the opportunity to issue long-term, fixed-rate debt vs. the short-term, floating-rate loans offered by commercial banks

3. Commercial banks set interest rates based on their credit analysis, while junk bonds interest rate on the public market is determined by the public

4. Opens up funding and financing opportunities for firms that previously had no means to it

Parker - Noon

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So what happened? Why are they called “Junk” bonds?

Why the negative connotation?

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Parker - Noon

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The Junk Bond King

Michael Milken – an American financier and philanthropist

Attended Cal-Berkley to graduate with the highest honors

Received his MBA from Wharton School at the University of Pennsylvania

Joined Drexel Harriman Ripley – an old-line investment bank in 1969 as a summer intern while finishing his MBA

Drexel merged with Bunham and Company in 1973

Started a high-yield bond trading department – 100% ROI

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8+Why Junk Bonds?

No exclusive monopoly on junk bonds, but was very powerful

Looked at corporate finance as a large game of chesso You just had to look at the combinations ahead

Insight came to him while working at Drexel in NY in the mid-1970s

o Specialist in “Fallen Angels”o Found that the actual risks of them defaulting were

outweighed by the premium interest paido Questioned the structure of the entire capital market in

the US

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9+“The World According to Milken”

Level One: What is a bank?

Level Two: How safe are these loans?

Level Three:What guarantees these loans?

Level Four:What does this tell us about bond ratings?

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10+The Bond Rating System

Standard & Poor’s and Moody’s o Anything above BB = Investment-gradeo Anything at or below BBB = Non-investment-grade

Ratings based on size and historical stability of companyo Only 600-700 companies qualified for Investment-gradeo Assets > $200 million and had been in business for decades

Rest of capital market was closed the other 24,000 American corporations

o Only allowed to borrow from commercial banks

The underlying “risk free” premise was wrongo “There is no such thing as a risk free investment”

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11+Milken vs. Ratings

Ratings measured the past, and did not account for a company’s future potential cash flows

o “And that’s what bonds are all about – getting paid off in the future.”

If bonds were pegged to their future cash flow, than investment-grade labels would not matter

Bonds looked more like common stock

Compensate for extra risk by paying extra interesto High growth companies could afford to pay premium

interest out of their future earnings (tax deductible, unlike dividends)

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12+Milken, The Marriage-Broker

Custom designed his issues to be unrated bondso Undercut the established rating systemo Saw his role as, “bringing about kind of a marriage

between institutions and aggressive-new corporations”

By 1976, “he understood credit better than anyone else in the country”

Campaign to challenge existing money manager’s perceptions

o Moved from Wall Street to LAo Taught top aides how to communicate ideas

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13+The Campaign

Worked tirelessly to spread the message: ratings were irrational

Compared rating services to movie reviewers Bottom line: money managers could earn more money

with junk bonds in their portfolio

Won over money managers with “billion dollar checks in their pocket”

Organized multi-million dollar conferences in Beverly Hills

Fund managers began preaching Milken’s philosophy On an altruistic level, the US would benefit by making

capital available to growth companies

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14+The Creation of a New Market

By 1986, entire industries were developed through junk bonds

Cable TV – Rupert Murdoch forged a global media empire Telecommunications – William McGowan through MCI

competed with AT&T Airlines – Frank Lorenzo grew a regional operation, Texas

International Airline, into Texas Air (airline holding company) through acquisitions

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15+Too Much of a Good Thing…

If they had been continued to be used for helping medium size companies, junk bonds may have been more easily accepted

Used to finance corporate raiders, which were seen has “Milken’s creations”

Corporate raiders included: Carl Icahn (TWA, US Steel, etc) Ronald Perlman (Revlon, and bidding over $9 billion on other

companies) T. Boon Pickens (Oil companies such as Gulf, Phillips, and

Unical)

Raids led to leveraged buyouts and restructuring

Rapidly changed the balance between owners and managers

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16+Present Status of Junk Bonds

As of April 2011, investors have poured almost $72 billion into high-yield bonds since the start of 2009

o Record $3.84 billion in the first week of April 2011

Over saturated with all that interesto There’s not a lot of attractive product left

Been popular over the last two years as investors have been looking for any return

o Low interest rate environment

Decline in default rates from 11% to 2.9% over the year

Yields are down to 7% from 14% (two years ago)

Be careful when investing in junk bonds

Parker - Noon

17+Sources

About Junk Bonds:o http://www.econlib.org/library/Enc/JunkBonds.htmlo http://en.wikipedia.org/wiki/High-yield_debt

About Michael Milken:o http://en.wikipedia.org/wiki/Michael_Milkeno http://www.edwardjayepstein.com/archived/milken.htm

Present Status:o http://money.cnn.com/2011/02/18/markets/bondcenter/ju

nk_bonds/index.htmo http://money.cnn.com/2011/04/12/markets/bondcenter/ju

nk_bonds/?section=money_latest

Parker - Noon

18+Questions/Comments