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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.

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high yield bonds

High Yield Bonds

Christina Woo

BA 543- Evening

May 12, 2005

risk v reward
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
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
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
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
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
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 bonds8
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
how high yield bonds are rated
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
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
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
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 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
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
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
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
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
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