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

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

3. 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) 
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4. 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 $ 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”
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5. 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
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6. So what happened. Why are they called “Junk” bonds
So what happened? Why are they called “Junk” bonds? Why the negative connotation?
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7. 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
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8. 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
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9. “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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10. 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 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”
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11. 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)
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12. 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
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13. 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
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14. 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
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15. 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
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16. 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

17. Sources About Junk Bonds: About Michael Milken: Present Status:
About Michael Milken:
Present Status:
bonds/index.htm
bonds/?section=money_latest
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18. Questions/Comments
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