High Yield Bonds [ Junk Bonds ] and Their History Mike Parker 5/3/2011

Agenda for Junk Bonds Definition Role in corporate finance Advantages The Junk Bond King Present status of junk bonds Questions/Comments Parker - Noon

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: Issues that have been downgraded because the issuer voluntarily significantly increased their debt as a result of a leveraged buyout or recapitalization Issues that have been downgraded for other issues (fallen angels)  Parker - Noon

The Beginning Originally, it was thought that high-yield bonds would not be attractive to public investors 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 Estimated that two-thirds of the $90-100 billion of the junk bonds issued represent a replacement of commercial bank borrowing “No more a threat to the stability of the financial system than that bank debt itself was” Parker - Noon

Advantages Over Commercial Banks Shifting the risk from commercial banks to the investing public presents several advantages: 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 Parker - Noon

So what happened. Why are they called “Junk” bonds So what happened? Why are they called “Junk” bonds? Why the negative connotation? Parker - Noon

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 Parker - Noon

Why Junk Bonds? No exclusive monopoly on junk bonds, but was very powerful Looked at corporate finance as a large game of chess You just had to look at the combinations ahead Insight came to him while working at Drexel in NY in the mid- 1970s Specialist in “Fallen Angels” Found that the actual risks of them defaulting were outweighed by the premium interest paid Questioned the structure of the entire capital market in the US Parker - Noon

“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? Parker - Noon

The Bond Rating System Standard & Poor’s and Moody’s Anything above BB = Investment-grade Anything at or below BBB = Non-investment-grade Ratings based on size and historical stability of company 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 Only allowed to borrow from commercial banks The underlying “risk free” premise was wrong “There is no such thing as a risk free investment” Parker - Noon

Milken vs. Ratings Ratings measured the past, and did not account for a company’s future potential cash flows “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 interest High growth companies could afford to pay premium interest out of their future earnings (tax deductible, unlike dividends) Parker - Noon

Milken, The Marriage-Broker Custom designed his issues to be unrated bonds Undercut the established rating system 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 Moved from Wall Street to LA Taught top aides how to communicate ideas Parker - Noon

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 Parker - Noon

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 Parker - Noon

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 Parker - Noon

Present Status of Junk Bonds As of April 2011, investors have poured almost $72 billion into high-yield bonds since the start of 2009 Record $3.84 billion in the first week of April 2011 Over saturated with all that interest There’s not a lot of attractive product left Been popular over the last two years as investors have been looking for any return 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

Sources About Junk Bonds: About Michael Milken: Present Status: http://www.econlib.org/library/Enc/JunkBonds.html http://en.wikipedia.org/wiki/High-yield_debt About Michael Milken: http://en.wikipedia.org/wiki/Michael_Milken http://www.edwardjayepstein.com/archived/milken.htm Present Status: 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 Parker - Noon

Questions/Comments Parker - Noon