The Role of Junk Bonds

in

Corporate Finance

Study Programme

Master of Business Administration (MBA)

Module:

Financial Management

Assignment:

No. 1/1

Authors:

Uwe Schindler

1st Academic Semester 2007

Place, Date:

Hamburg, January 4th, 2008

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The Role of Junk Bonds in Corporate Finance

Executive Summary

Financing the activities of companies is nowadays one of the most important

challenges in Corporate Finance. More and more companies and investors use

Junk Bonds as a stable part of their financial sourcing activities in Corporate

Finance. The use of Junk Bonds is as a source for financing such activities like

takeovers, merger and acquisitions, and restructuring instead financing activities by

conventional bank credits established. This tool provides benefits and risks to both

parties ­ buyers and issuers. The assignment at hand surveys some information

about the role of Junk Bonds in Corporate Finance by focusing on risks and

benefits from different perspectives.

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The Role of Junk Bonds in Corporate Finance

I

Table of Contents

I

List of Abbreviations

II

List of Figures III

1 Introduction

1

2

Corporate Finance

2

2.1

Short-term and long-term decisions 3

2.2 Credit risk and interest conflict at outside financing

3

2.3 The Credit risk rating and the Probability of Default

4

3

Junk Bonds

6

3.1

The history of Junk Bonds

6

3.2

Selected definitions of the High Yield Market

7

3.3

Downgrading to ,,Fallen Angel"

8

4

Junk Bonds in Corporate Finance

9

4.1

The use of Junk Bonds in Corporate Finance

9

4.2

The issuers perspective

10

4.3

The buyers perspective: JB similar to conventional investments 11

4.4

The perspective of the investment banks

13

4.4

Selected additional chances and risks

13

5

Conclusion

15

Bibliography

IV

Appendix I §230.144A Private resales of securities to institutions VI

Appendix II

Credit risk rating and Probability of Default

XII

Appendix III

Amount and Purpose of Junk Bond Issues, 1979 and 1988 XIII

Appendix IV

S&P Initial Ratings for Junk Bonds, 1979 and 1988

XIV

Appendix V

The Total Return on High-Yield Bonds Annually 1985-1989 XV

Appendix VI

High Yield emissions in the U.S. XVI

Appendix VII Rating Scales, Investment Grade compared to High Yield XVII

ITM-Checklist XVIII

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The Role of Junk Bonds in Corporate Finance

II

List of Abbreviations

BS Bear

Stearns

CF Corporate

Finance

cp. compare

CRS

Congressional Research Service

CSFB

Credit Swiss First Boston

DB Deutsche

Bank

DCR

Duff & Phelps Credit Rating Corporation

DLJ

Donaldson, Lufkin & Jenrette

e. g.

for instance

fig. figure

HYD High

Yield

Data

JB Junk

Bonds

LBO

Laverage Buy Out

Ltd. Limited

M&A

Merger & Acquisition

MBO

Management Buy Out

ML Merrill

Lynch

no.

number

p. page

PD Probability

of

Default

PIK Pay-in-kind

pp. pages

rev. revised

S&P Standard

&

Poor´s

SDC

Securities Data Corporation

SolvV

Solviditätsverordnung (German term)

U.S.

United States

USD US

dollar

vol.

volume

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The Role of Junk Bonds in Corporate Finance

III

List of Figures

Fig. 1: Fields of Corporate Finance

3

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The Role of Junk Bonds in Corporate Finance

1

1 Introduction

Based on the economical crisis in the United States approximately twenty years

ago and the requirement for gaining higher returns of investments a new market

were developed, which is named the High Yield Market. The bonds which are

traded on the market are lower than investment grade rated and are called Junk

Bonds. Over the past years ­ beginning in the United States ­ up to now these

bonds developed to an alternative source for supporting companies Corporate

Finance.

This assignment answers the question about the role of Junk Bonds in Corporate

Finance by focusing on risks and benefits from different perspectives. To answer

this question it uses results of the financial research of the past years and official

reports of institutions.

The assignment starts in chapter 2 with an briefly overview about the fields of

Corporate Finance, shows the credit risk and interest conflict at outside financing ­

based on short- and long-term decisions, and discusses the credit risk rating and

the Probability of Default and both impact and interdependences to the Corporate

Finance.

Chapter 3 provides an overview about Junk Bonds, its history and selected

definitions of investment banks. Further it provides a view to the rating of bonds,

introduces the classification of Junk Bonds compared to investment grade bonds,

and explains the downgrading of companies to Fallen Angels.

Chapter 4 discusses the Junk Bonds in Corporate finance by its use and from

different perspectives and shows the motivations of the players: issuers, buyers,

and investment banks. The chapter finishes with a discussion of additional chances

and risks.

The conclusion gives an evaluation by the author and an outlook.

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The Role of Junk Bonds in Corporate Finance

2

2 Corporate

Finance

The term Corporate Finance relates to a special range of the financial

management, which concerns of the capital structure, the dividend politics of the

enterprise, the evaluation of investment decisions and the determination of

enterprise value.1 Corporate Finance is concerned how business work, how to

allocate capital (capital budgeting decision) and how to obtain capital (financing

decision).2 Figure 1 shows the fields covered by Corporate Finance.

Corporate Finance

Foundation

Outside financing

Venture capital

Public subsidy

Bank credits

Obligations credits

Supplier credits

Private placing

Customer credits

Shareholder loan

Financing by own

Self financing by own reserves

capital funds

Equitiy financing

Takeover

concerted <-> genuine fusion

hostile <-> decentralized Integration

LBO (Going Private) -> financial

-> industrial

Sale of parts of the

Total dismantling

enterprise (Spin-Offs)

Continuation of core ranges

LBO / MBO characterized

Restructuring

Spin-off characterized

Pure foreign capitalization

Deduction contracts

Liquidation

Spin-off liquidation

Bankruptcy liquidation

Fig. 1: Fields of Corporate Finance

3

1 Cp. Schulte (2005), p. 23.

2 Cp. Constantinides / Harris / Stulz (2003), p. X.

3 Cp. Caytas / Mahari, p. 25.

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