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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

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High Yield Bonds

Christina Woo

BA 543- Evening

May 12, 2005

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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 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

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  • 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

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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

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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”

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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

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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

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“Junk” Corporate Bond Rating System

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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

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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

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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

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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

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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

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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%

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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

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  • 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

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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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