High Yield Bonds

Christina Woo

BA 543- Evening

May 12, 2005

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

“Junk” Corporate Bond Rating System

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

Questions?