The Role of Junk Bonds in Corporate Finance

Table of contents

Executive Summary

List of abbreviations

List of figures

List of tables

1. Introduction

2. Corporate finance
2.1. Definition of the term corporate finance
2.2. Long term and short term decisions
2.3. Sources of finance

3. Junk bonds
3.1. Definition of junk bonds
3.2. Fallen angels
3.3. History of junk bonds

4. Junk bonds in corporate finance
4.1. Raising capital using junk bonds
4.2. Junk bonds as part of the portfolio
4.3. Recommendations
5. Conclusion

I. Bibliography

List of abbreviations

illustration not visible in this excerpt

List of figures

Figure 1: Junk bond correlations between 1990 and 2004 10

List of tables

Table 1 Default by original rating of issued bonds between 1971 and 2002 9

The Role of Junk Bonds in Corporate Finance

Executive Summary

Junk bonds in corporate finance seen from the perspective of an issuer and an investor define the assignment scope. Giving both some hints when to use junk bonds is the main question to this assignment.

From the issuer point of view it is important to have safeguarding mechanism inside a bonds contract. Having a callable option on the bond is target number one. Information have to be past to the investor, putting the notice about the high interest rate into the view of the investor.

Information around the issuing firm according her actual economical status and her strategy are the most important source for any decision an investor should have before buying a junk bond. Taking care of an issuer safe guarding mechanisms could be a big pitfall to an investment. Taking a close look to the portfolio will help to find the right proportion for junk bonds regarding the selected return.

1. Introduction

What are the main points to handle a junk bond from the investors’ and from the issuers’ point of view? These are the two main questions to be answered by this assignment.

Junk bonds have existed ever since the first bond ratings were published by John Moody in 1909, but what is their role in the modern investment world? Junk bonds always attracted investors. In economic downturns some had to pay back for the risk they were taking. The default rate increased and some investors lost money instead of gaining.

For issuers junk bonds are the chance to gain money for investments from the market. Banks would not give the same amount of money with these conditions. They probably would not give the money at all to the issuer.

Firstly, a short introduction of the term corporate finance with its short term and long term decisions is given. Afterwards, some sources of finance in modern economies are presented. Secondly, the term junk bond is defined. A short history overview, after some aspects regarding fallen angels completes the third chapter.

Both things will be put together into a discussion. After looking at the junk bonds from the issuer perspective, the investor who would like to buy a junk bond to finance a company comes into view. Looking at some aspects of Markowitz portfolio selection theory, and how that fits into with investors buying junk bonds gives some straight lights, why junk bonds issuers are successful.

At the end some advices for the issuer and for the investor are given. Junk bonds positive and negative aspects show up differently in the advisory list, because of the different perspectives and the different targets of the players.

2. Corporate finance

Firstly, this chapter gives a short definition of corporate finance. Secondly, the difference between long term and short term decisions in the respect of corporate finance is shown. Finally, it shows some sources of capital to companies.

2.1. Definition of the term corporate finance

When talking about corporate finance, one talks about the financial decisions to be taken inside a company. Sometimes it’s even broader regarded and governmental institutions are included. Usually, there is no difference between cash and financial risks among the different industries, More precisely and the primary goal of corporate finance overall is to maximize corporate value while managing the firm's financial risks, see Aswath Damodaran (2005).

Corporate finance defines an inside view of a company. One of the most valuable information one can have about a company, is the actual money on the bank account. The finance statement is the result of the day to day work of corporate finance.

In bigger companies, corporate finance is organised in a separate department managing all cash flows. This includes the day to day business where the cash flow of each banking account is managed, as well as the long term contracts regarding debts of any kind. Even simulation of the future behaviour of markets is done to ensure that in future all needed cash flows are available just in time.

The closely monitoring of the different monetary markets, a company needs too, if for example different currencies are used in the daily business. Other markets like the interest curve or the bonds market for issuing as well as from an investor point of view have to be observed.

2.2. Long term and short term decisions

In general, two parts of corporate finance can be distinguished, the short and the long term decisions. Short term decisions are mainly dealing with the current cash flow of the company. This is also called cash management. The task is to ensure the balance between current assets and current liabilities.

Furthermore, investments have to be financed. This is the task of the long term decisions, finding the optimal way for the company and never loosing the view of the risks. Different ways of long term financing are shown in the next chapter.

2.3. Sources of finance

The sources of corporate finances are mainly dividable into two different kinds. The first one is equity, the second is debt. It is quite obvious what happens if a company gives out new shares. Additional shares will increase the need of the shareholders to get their part of the profits. On the other hand new shares also mean new money for investments and there are no coupons to be paid regularly.

Using shares and no debts to finance all companies’ investments therefore seems a good thing, because there is no constant interest to be paid on the shares. But share holders are usually expecting a high return rate with dividends. All kind of interest in the contrast will leave the company as well, but has the advantage, that interest is tax¹ relevant.

Debts can differ by a wide range. It can start with a bank loan. A company can get an asset secured loan² from the bank. Coming from a bank loan the next step could be a bond. These are issued from a company to the market. The difference to shares is that like with bank loans, the issuer promises to pay a constant interest, so called coupons. That means every period, usually once a year, the bonds owner get a fixed sum of money from the issuer. There are different kind of bonds, which can be read from in textbooks like Berk (2007), Brealey (2008) and Ross (2005).

Bonds are rated as well as companies from the well know rating agencies³ like Moody’s and Standard & Poor´s . These ratings strongly influence the interest to be paid for the bond. In chapter 3 rating will have a mayor impact.

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¹ The tax aspects are blanket out of this assignment. Please read Roos (2005) or Berk (2007) for details on this.

² An asset secured loan means a loan with some guarantee. The ownership of this guarantee, the asset, would go over to the bank, if the company fails to pay back the loan.

³ Rating agencies are paid by issuers to rate the risk of default for a bond or to rate the risk of bankruptcy of the company. This rates range from an AAA to D with Standards & Poor’s and from Aaa to D with Moody’s, where the triple A stands for a strong ability to repay the interest and principal. D in contrast stands for the default of a bond or the bankruptcy of a company. For the rest of the assignment, only the Standards and Poor’s rating levels will be used.