High Yield Bonds And Their History “The point has always been to see the assets in the liabilities. To look beyond the debt and see what value really exists and how more can be created.” - Michael R. Milken Presentation by Carl Toresson 02/18/09 Joe Imatani Table of contents • What is a high yield bond? • Return and risk of high yield bonds • The history of high yield bonds High-Yield Bonds • Officially known as Noninvestment Grade Bonds • “Junk Bonds” • Rated below S&P BBB or Moody’s Baa when purchased • Pay a fixed coupon throughout its life and principal at maturity • High Risk, High Reward Financing through High-Yield Bonds • Originally, businesses were financed through bank loans • High interest rates • Short/Intermediate – term loans • Application denied • Offers risky businesses financing options • Long-term debt • Fixed interest rates • Varying payment structures Structures • Deferred-Interest • Bonds that do not pay interest until after an initial period ranging 3-7 years • Split Coupon (Step-up) • Bonds that pay an interest from the beginning, but at a low rate • Interest rates are increased after the initial period • Payment-In-Kind (PIK) • Issuer has option to pay interest in the form of cash or a similar bond Return and risk of high yield bonds • Analyzing high yield securities risk • Investors do not evaluate the default risk themselves, they rely on grades presented by credit rating agencies • Return and the yield spread • The yield spread is the the extra yield that is provided above the risk-free interest rate • It is a compensation for taking the risk of providing the funds instead of placing them in risk-free T-bills Yield spread • Spikes occur when the market is unstable during a crisis • The risk has often been overpriced historically Question • How would you exploit a situation where you realize that an investment has too high return compared to its inherent risk? The Beginning • High-yield bond issues began in 1920s • U.S. Steel • General Motors • Companies using high-yield issues were predominately fallen angels • Bonds were paying low interest rates • Investors were averse to high-yield bonds • Companies were effectively shut out from the public market Late 1970s • Bretton Woods system of fixed exchange rates collapsed resulting in: • High inflation • High interest rates • Oil chocks • Commercial banks curbed lending to noninvestment grade companies • 1977 – Bear Stearns and Company underwrote the first high-yield bond issue in decades The 1980s • Dramatic developments in the 1970s increased demand of financial innovation • Michael Milken – As a student realized the high pricing of default risk in high yield bonds • Drexel Burnham Lambert - Raised money for badly rated companies by issuing high yield bonds • Leveraged buyouts (LBOs) • Advantages of high yield bonds • Without, commercial banks would lend the money, indirectly forcing the risk on U.S. Citizens • Possibility of long-term, fixed rate loan • Opens the possibility of funding for some firms that previously could not borrow money Issuing volume 1982 - 2006 The decline of the high yield market in the early 90s • The downfall of the economy in the late 80s caused many firms to default on their loans • The market for issuing high yield bonds disappeared • Drexel went into bankruptcy (1990) • Milken was sentenced to 10 years in prison for fraud Question How do you think that the high yield market has been, and will be, affected by the current financial crisis? Current State • US Corporations accounted for 3/4ths of global corporate default in 2008 • S&P estimates that 209 companies will default in 2009 - 15 % of noninvestment market • $760 billion worth of debt is set to mature this year • 40% of debt set to mature is noninvestment grade • High-yield rates are estimated to average 17% during 2009 • Investment grade bonds – 8% Annual Default Rates Summary - the role of high yield bonds in corporate finance A way for corporations with a current bad credit status to acquire funds they need to develop Gives the opportunity to investors to earn a higher return - often better on risk- adjusted basis than investment graded bonds Cheaper way of obtaining capital than equity Question As Michael Milken put it, the last century has shown us that junk bonds put out a higher rate of return compared to their risk, so why does the skepticism against them still exist? Questions for us?