high yield bonds christina woo ba 543- evening may 12, 2005
TRANSCRIPT
Risk v. Reward
Balancing act between desire for low risk and for high returns
Balance between: Low risk Low payoff High risk High payoff
Risk: uncertaintyBond risk: possibility of defaultReward: monetary payout
High Yield Bond Risk
Maximum return is the coupon and face value Loss is total investment amount Risk shifted to investors Historically, the longer out the maturity date is,
the more risk, the more return 4 types of risk
Economic risk Interest rate risk International risk Market specific risk
History
Alexander Hamilton First to issue “junk securities” in the US
Allowed smaller companies/large investors to use the bond market to finance takeovers
Finance companies who’s industries had limited access to capital markets
History cont.
1970s: modern era1980s: record number of
buyouts/recapitalizations = market crash1990s: issues increased2002: market collapsed due to recessionDue to Milken and others, government
established policies that companies can only invest in investment grade bonds
Michael Milken
Drexel Burnham Lambert Michael Milken, “Junk Bond King” Went looking for companies who needed capital
to grow their business & were willing to add debt to balance sheet
Got companies to issue $2.5B high yield debt at 24%
“Unethical practices”
Michael Milken cont.
Found guilty for violating federal securities and racketeering laws
Charged with insider tradingBanned from working in securitiesDecided to become consultant
SEC fined $42M+interest
Now runs cancer foundation
High Yield Bonds
Type of bond that companies use to gain capital
Example: Loomis Sayles Institutional HIG 17.2% annual
returnAggressive business development
strategies Allows corporations to issue long term fixed rate
debt
How high yield bonds are rated
Traded on public market so market establishes interest rate
Original-issue high-yield bondsDowngraded bonds
Fallen Angels Issuer voluntarily increased debt Poor company performance Unable to repay back debt
Voluntarily downgraded
Recent Fallen Angles
General Motors April 5, 2005 Moody downgraded GM’s bond
rating to Baa3
GMAC Rating shifted to Baa2
May 6, both GM and Ford bonds downgraded even further to “junk” status
Voluntary Bond Downgrade
Leveraged buyouts/recapitalizationsExample:
Takeover of RJR Nabisco in late 1980s After takeover occurred, company’s debt
increased dramatically when compared to its equity
Investors demanded higher payouts to compensate for the risk
Bond Ratings Change
Event Risks Corporate restructuring Change in business
Leveraged Buyouts Need to service large amounts debt, bond
quality rating decreases CF constraints Companies issue bonds with deferred coupon
payments to delay using cash to pay interest
Deferred Coupon Structures
Deferred-interest bonds Sell discount, do not pay interest for initial
period
Step-up bonds Coupon rate initially low, then gradually
increases
Payment-in-kind Gives issuer option to pay cash at coupon
payment date, or give another bond
Who uses high yield bonds
“Rising Stars”Companies with high credit risk
Market dictates that these firms pay higher interest rates back to investor
High yield bond market share: Manufacturing: 31.9% Radio/Television: 11% Electric service: 7%
How to invest in high yield bonds
Mutual funds Several different bonds combined together
Diversifies investor’s bond portfolio Investor’s money not directly tied to high yield bond
Shorter bond length, less risk, less return Depends on bond and rating Bonds called within one year, 2-14% return Bonds called after 3 years, around 20% return
Rates
Yield rates dropping 25.7% September ’03 to 12.22% December ’03
Default rates decreasing 27 issuers globally on $5.4B, 1996 Second lowest in 10 year window Manufacturers defaulted the most
Good investment?
Spread between speculative and investment grade market decreasing
1996, returned 12.4% average to investorsHelped to support gains in speculative
grade marketWarren Buffet seen looking into high yield
bonds