High Yield Bonds [ Junk Bonds ] and Their History

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)  Parker - Noon

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 $90-100 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” Parker - Noon

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 Parker - Noon

6. So what happened?Why are they called “Junk” bonds? Why the negative connotation? Parker - Noon

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 Parker - Noon

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 Parker - Noon

9. “The World According to Milken” Parker - Noon

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 600-700 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” Parker - Noon

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) Parker - Noon

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 Parker - Noon

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 Parker - Noon

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 Parker - Noon

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 Parker - Noon

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: • http://www.econlib.org/library/Enc/JunkBonds.html • http://en.wikipedia.org/wiki/High-yield_debt • About Michael Milken: • http://en.wikipedia.org/wiki/Michael_Milken • http://www.edwardjayepstein.com/archived/milken.htm • Present Status: • http://money.cnn.com/2011/02/18/markets/bondcenter/junk_bonds/index.htm • http://money.cnn.com/2011/04/12/markets/bondcenter/junk_bonds/?section=money_latest Parker - Noon

18. Questions/Comments Parker - Noon