Download High Yield Bonds [Junk Bonds] and Their History

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High Yield Bonds [ Junk Bonds ]
and Their History
Mike Parker
5/3/2011
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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
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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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The Beginning
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Originally, it was thought that high-yield bonds would not be
attractive to public investors
o
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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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Advantages Over Commercial Banks

Shifting the risk from commercial banks to the investing public
presents several advantages:
1.
2.
3.
4.
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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
Junk bonds give corporations the opportunity to issue long-term,
fixed-rate debt vs. the short-term, floating-rate loans offered by
commercial banks
Commercial banks set interest rates based on their credit analysis,
while junk bonds interest rate on the public market is determined
by the public
Opens up funding and financing opportunities for firms that
previously had no means to it
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So what happened?
Why are they called “Junk” bonds?
Why the negative connotation?
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The Junk Bond King

Michael Milken – an American financier
and philanthropist
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Attended Cal-Berkley to graduate with
the highest honors
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Received his MBA from Wharton School at
the University of Pennsylvania

Joined Drexel Harriman Ripley – an oldline investment bank in 1969 as a summer
intern while finishing his MBA
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Drexel merged with Bunham and
Company in 1973
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Started a high-yield bond trading
department – 100% ROI
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Why Junk Bonds?

No exclusive monopoly on junk bonds, but was very powerful

Looked at corporate finance as a large game of chess
o

You just had to look at the combinations ahead
Insight came to him while working at Drexel in NY in the mid1970s
o
Specialist in “Fallen Angels”
o
Found that the actual risks of them defaulting were outweighed
by the premium interest paid
o
Questioned the structure of the entire capital market in the US
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“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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The Bond Rating System

Standard & Poor’s and Moody’s
o
o

Ratings based on size and historical stability of company
o
o
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Only 600-700 companies qualified for Investment-grade
Assets > $200 million and had been in business for decades
Rest of capital market was closed the other 24,000 American
corporations
o
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Anything above BB = Investment-grade
Anything at or below BBB = Non-investment-grade
Only allowed to borrow from commercial banks
The underlying “risk free” premise was wrong
o
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“There is no such thing as a risk free investment”
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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.”
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If bonds were pegged to their future cash flow, than
investment-grade labels would not matter
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Bonds looked more like common stock
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Compensate for extra risk by paying extra interest
o
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High growth companies could afford to pay premium interest
out of their future earnings (tax deductible, unlike dividends)
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Milken, The Marriage-Broker
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Custom designed his issues to be unrated bonds
o
Undercut the established rating system
o
Saw his role as, “bringing about kind of a marriage between
institutions and aggressive-new corporations”
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By 1976, “he understood credit better than anyone else in the
country”
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Campaign to challenge existing money manager’s
perceptions
o
Moved from Wall Street to LA
o
Taught top aides how to communicate ideas
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The Campaign

Worked tirelessly to spread the message: ratings were
irrational

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Compared rating services to movie reviewers
Bottom line: money managers could earn more money with
junk bonds in their portfolio
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Won over money managers with “billion dollar checks in
their pocket”
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Organized multi-million dollar conferences in Beverly Hills
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Fund managers began preaching Milken’s philosophy
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On an altruistic level, the US would benefit by making capital
available to growth companies
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The Creation of a New Market
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By 1986, entire industries were developed through junk
bonds
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Cable TV – Rupert Murdoch forged a global media empire
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Telecommunications – William McGowan through MCI
competed with AT&T
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Airlines – Frank Lorenzo grew a regional operation, Texas
International Airline, into Texas Air (airline holding company)
through acquisitions
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Too Much of a Good Thing…
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If they had been continued to be used for helping medium size
companies, junk bonds may have been more easily accepted
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Used to finance corporate raiders, which were seen has “Milken’s
creations”
Corporate raiders included:
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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)
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Raids led to leveraged buyouts and restructuring
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Rapidly changed the balance between owners and managers
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Present Status of Junk Bonds
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As of April 2011, investors have poured almost $72 billion into
high-yield bonds since the start of 2009
o
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Over saturated with all that interest
o
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Record $3.84 billion in the first week of April 2011
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
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Decline in default rates from 11% to 2.9% over the year
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Yields are down to 7% from 14% (two years ago)
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Be careful when investing in junk bonds
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Sources
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About Junk Bonds:
o
o
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About Michael Milken:
o
o
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http://www.econlib.org/library/Enc/JunkBonds.html
http://en.wikipedia.org/wiki/High-yield_debt
http://en.wikipedia.org/wiki/Michael_Milken
http://www.edwardjayepstein.com/archived/milken.htm
Present Status:
o
o
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http://money.cnn.com/2011/02/18/markets/bondcenter/junk_
bonds/index.htm
http://money.cnn.com/2011/04/12/markets/bondcenter/junk_
bonds/?section=money_latest
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Questions/Comments
Parker - Noon