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: uncertainty Bond risk: possibility of default Reward: 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 era 1980s: record number of buyouts/recapitalizations = market crash 1990s: issues increased 2002: market collapsed due to recession Due 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 trading Banned from working in securities Decided 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 return Aggressive 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 bonds Downgraded 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/recapitalizations Example:  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 investors Helped to support gains in speculative grade market Warren Buffet seen looking into high yield bonds

Questions?