Slide 1Agenda for Junk BondsDefinitionThe BeginningAdvantages Over Commercial BanksSlide 6The Junk Bond KingWhy Junk Bonds?“The World According to Milken”The Bond Rating SystemMilken vs. RatingsMilken, The Marriage-BrokerThe CampaignThe Creation of a New MarketToo Much of a Good Thing…Present Status of Junk BondsSourcesQuestions/Comments+High Yield Bonds [ Junk Bonds ] and Their HistoryMike Parker5/3/2011+Agenda for Junk BondsDefinitionRole in corporate financeAdvantagesThe Junk Bond KingPresent status of junk bondsQuestions/CommentsParker - Noon2+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:oIssues that have been downgraded because the issuer voluntarily significantly increased their debt as a result of a leveraged buyout or recapitalizationoIssues that have been downgraded for other issues (fallen angels)6Parker - Noon3+The BeginningOriginally, it was thought that high-yield bonds would not be attractive to public investors oThe 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 oEstimated that two-thirds of the $90-100 billion of the junk bonds issued represent a replacement of commercial bank borrowingo“No more a threat to the stability of the financial system than that bank debt itself was”Parker - Noon4+Advantages Over Commercial BanksShifting the risk from commercial banks to the investing public presents several advantages:1. 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 pay2. Junk bonds give corporations the opportunity to issue long-term, fixed-rate debt vs. the short-term, floating-rate loans offered by commercial banks3. Commercial banks set interest rates based on their credit analysis, while junk bonds interest rate on the public market is determined by the public4. Opens up funding and financing opportunities for firms that previously had no means to itParker - Noon5+So what happened? Why are they called “Junk” bonds? Why the negative connotation?Parker - Noon6+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 - Noon7+Why Junk Bonds?No exclusive monopoly on junk bonds, but was very powerfulLooked at corporate finance as a large game of chessoYou just had to look at the combinations aheadInsight came to him while working at Drexel in NY in the mid-1970soSpecialist in “Fallen Angels”oFound that the actual risks of them defaulting were outweighed by the premium interest paidoQuestioned the structure of the entire capital market in the USParker - Noon8+“The World According to Milken”Level One: What is a bank?Level One: What is a bank?Level Two: How safe are these loans? Level Two: How safe are these loans? Level Three:What guarantees these loans?Level Three:What guarantees these loans?Level Four:What does this tell us about bond ratings?Level Four:What does this tell us about bond ratings?Parker - Noon9+The Bond Rating SystemStandard & Poor’s and Moody’s oAnything above BB = Investment-gradeoAnything at or below BBB = Non-investment-gradeRatings based on size and historical stability of companyoOnly 600-700 companies qualified for Investment-gradeoAssets > $200 million and had been in business for decadesRest of capital market was closed the other 24,000 American corporationsoOnly allowed to borrow from commercial banksThe underlying “risk free” premise was wrongo“There is no such thing as a risk free investment”Parker - Noon10+Milken vs. RatingsRatings measured the past, and did not account for a company’s future potential cash flowso“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 interestoHigh growth companies could afford to pay premium interest out of their future earnings (tax deductible, unlike dividends)Parker - Noon11+Milken, The Marriage-BrokerCustom designed his issues to be unrated bondsoUndercut the established rating systemoSaw 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 perceptionsoMoved from Wall Street to LAoTaught top aides how to communicate ideasParker - Noon12+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 companiesParker - Noon13+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 - Noon14+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