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High Yield Bonds

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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  1. High Yield Bonds Christina Woo BA 543- Evening May 12, 2005

  2. 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

  3. 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

  4. 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

  5. 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

  6. 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”

  7. 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

  8. 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

  9. “Junk” Corporate Bond Rating System

  10. 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

  11. 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

  12. 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

  13. 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

  14. 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

  15. 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%

  16. 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

  17. 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

  18. 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

  19. Questions?

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