The Role of Junk Bonds in Corporate Finance


Seminar Paper, 2016
14 Pages, Grade: 1,3

Excerpt

Table of Content

1 Introduction

2 Corporate Finance
2.1 Definition of the Term Corporate Finance
2.2 Long Term and Short Term Decisions

3 Junk Bonds
3.1 Definition of Junk Bonds
3.2 Fallen Angels
3.3 The Changing Role of Junk Bond Financing

4 Junk Bonds in Corporate Finance
4.1 The Use of Junk Bonds in Corporate Finance
4.2 Junk Bonds as Part of the Portfolio

5 Conclusion

1 Introduction

Companies in the United States and elsewhere are increasingly turning towards the bond markets as a predominant source of corporate finance referring to changing market conditions. Various reasons such as merger and acquisition activities, capital expenditures, or working capital needs, have contributed to the fact that corporate entities have always needed funds. Nelson Peltz, who transformed Triangle Industries in one of the largest and most successful high yield companies, summarizes: “the thing about capital is, if you don’t inherit it, you have to borrow it.”[1] During the decades, high-yield bonds have survived a dramatic rise and fall in popularity and heated controversy to the limit. The leveraged finance market as a segment of the general credit market, involves issuers, usually considered more risky and with a lower credit ranking than its counterparts, as well as investors, expecting a higher rate on return potential. Investors are attracted to many forms of bonds, but one threat, concerning all leveraged finance investors is that they all have a comparatively high return objective. Many analysts still hold back from the analyst of junk bonds, which can be a result of the bond’s rating that is below the investment grade and therefore known as having very high investment risks. However, the potential rewards of this specific field of credit analysis are worth the time invested. A new emission volume has been pushed by debt financing activities and maintained by high investor demands, looking for yield in the consisting low interest rate environments.

With this paper I would like examine the role of junk bonds in corporate finance. Starting with the term “Corporate Finance” in general, enlarging upon the objectives as well as long term and short term decisions of this field, the assignment continues by defining junk bonds and by giving an insight into the field of so called Fallen Angels. As the expansion of the junk bond market over the last decades has proceeded, I would like to take this occasion to provide background information about the changing role of high-yield bonds during the years. In the last chapter of this paper I will elaborate on the role of junk bonds in corporate finance and as part of the portfolio.

2 Corporate Finance

2.1 Definition of the Term Corporate Finance

According to Steffan “the nature of corporate finance is to maximize the financial wealth of companies and their shareholders.”[2] Steffan also claims that corporate finance will affect small firms as well as large multinational companies, although they differ in techniques and applications.[3] Depending on the size of the company, Managers have to take corporate financial decisions to meet the corporate objective of maximizing the value of the firm and to provide a sustainable resource management. Typical task fields of corporate finance are investment decisions (including a project evaluation), working capital management, financing decisions, dividend policy, and financial risk management.[4] Primarily, capital and labor are counted among the limited resources of a company. The corporate objective is met, when companies allocate these resources in the most effective way to ensure an optimal benefit to an economy. To meet the corporate objective, several decisions have to be made.[5] Corporate managers have to take decisions on investment, finance and dividends. The relationship between the value of a firm and the three main decisions can be made by “recognizing that the value of a firm is the present value of its expected cash flows, discounted back at a rate that reflects both the riskiness of the projects of the firm and the financing mix used to finance them.”[6] Damodaran also states that a firm’s investment decisions are formed expectations about future cash flows that have their origin in monitored current cash flows and the expected future growth, that is based on the quality of a company’s projects, as well as the firm’s dividend decisions that display “the amount reinvested back into business”.[7] Financing decisions in turn, usually concern “the mix of funding obtained from capital markets, in terms of proportional holdings of equity and debt.”[8]

2.2 Long Term and Short Term Decisions

Financing decisions reveal how companies raise capital to pay for their investments.[9] These decisions can be divided in long-term and short-term decisions. According to Watson and Head “long-term investment and financing decisions give rise to future cash flows which, when discounted by an appropriate cost of capital, determine the market value of a company.”[10] Capital investment decisions are categorized among the long-term decisions and reflect choices about the investment in certain projects - whether to finance the project by debt or equity. These decisions relate to fixed assets and the capital structure.[11] Long-term choices are also important in terms of meeting the firm’s goals in the long run and to arrange the respective financial basis, focusing on the effects of alternative financial strategies. However, to pave the way for a company’s long-term success, short-term decisions regarding current assets and liabilities must also be considered. The amount of current assets is a decisive factor in a firm’s liquidity position, as the company needs to be able to raise cash to meet its short-term requirements if it is to continue in business.[12]

3 Junk Bonds

3.1 Definition of Junk Bonds

According to Wilson and Fabozzi, junk bonds are counted among the speculative-grade bonds, which are rated below the investment grade by respective rating agencies.[13] They offer a relatively high credit risk, as demonstrated by ratings lower than BBB- by Stanford & Poor’s or lower than Baa3 by Moody’s Investor Service, the two main debt-rating agencies,[14] and a certain amount of nonrated bonds that do not necessarily need to be tracked by the major rating agencies.[15] This typically precludes obligations that are transmutable to equity securities, even if the bonds offer other equity-related option, e.g. warrants.[16] Bond ratings are supposed “to measure the perceived risk that the bonds’ issuer will not make interest payments or repay the principal at maturity.”[17] Junk Bonds can be rated anywhere between Baa (BB) and D as the lowest-rated nondefaulted bonds are rated C, and the highest are rated AAA or Aaa. High-yield Bonds have a reputation to imply higher rates of return than investment-grade bonds as they bear a higher risk compared to other forms of debt.[18] According to Altmann and Nammacher[19], these securities have commonly been sold with a risk premium of between 2.5 and 5.0 % over equivalent long-term government securities. Supporters of this type of bond are known for using euphemisms such as high-opportunity debt, high-interest bonds (“HIBS”), and high-yield securities. These terms can be quite confusing to the uninitiated, which is why one will primarily encounter the wording “junk” and “high yield”. The whole less-than-investment-grade spectrum is obfuscated by the term “junk”, although these special rated bonds are nor useless neither rubbish nor trash.[20] The term has its source in the mid-1970s “… to describe those corporate securities that lost their investment grade status due to a fundamental deterioration in the quality of their operating and financial performance.”[21] After a term of four to five years, the bond conditions are usually providing a call of the issuer, therefor the right to terminate the bond at a certain redemption date and with a redemption price that has been negotiated before. In many cases exceptional rights of termination are used, for instance, when the issuer has strengthened his equity after going public, also known as Equity Clawback.[22]

3.2 Fallen Angels

Fallen angels are bonds that were given an investment grade credit but have then declined in credit quality due to the decreasing financial situation of the issuer. It is very common that fallen angels hold a considerable amount of tangible assets, which can be sold in times of economic decline. Recently issued junk bonds are supposed to have only a few tangible assets behind them, whereas they possess more goodwill. The loss is even greater since they are issued at par.[23] A primary cause for a bond’s downgrade can be a decline in revenues which endangers the capabilities of issuers to repay debts. When declining revenues go along with expanding debt levels, the probability for a downgrade increases gravely. Especially contrarian investors are attracted to fallen angel bonds as they are counting on the capability of the issuer to recover from a momentary setback. The real downgrade of a security to junk status is accompanied by a higher selling pressure, in particular from funds being restricted to exclusively hold investment-grade debt. This leads to chance of presenting value within the high-yield category, providing that the likelihood of the issuer to recover from the circumstances that caused the downgrade is proportional to the risk.[24] Two of the most considerable fallen angels are the Ford Motor Company and General Motors. Stanford & Poor’s rated GM triple-A from 1975 to 1981. Ford was rated double-A from 1971 to 1980. The rating of both companies was lowered by Moody’s to high-yield bond status.[25]

3.3 The Changing Role of Junk Bond Financing

According to Yago “young companies, and companies requiring new strategies and structures to survive, have always relied on high yielding debt.”[26] The contemporary high-yield market has its origin in the 1970s, when the under-whelming performance of traditional investments in common stocks, fix-rated, long-term mortgages as well as government and corporate securities, lead to the search for new, more promising investment opportunities. The junk bond market evolved into an extremely microeconomic, credit- and firm-specific investment policy with the aim to reconstruct the U.S. industry. The 1980s, also known as “the decade of restructuring”, yielded a surge of takeovers, ne start-ups, divestitures, leveraged buyouts, and spin-offs that where financed through latest financial technologies.[27] High-yield bonds played an important role in the financing of leveraged buyouts. The share of high-yield bonds used for this purpose amounted to 50 % of all emissions in the years from 1987 to 1989. With the strengthening of market for hostile LBI takeovers, criticism grew. In particular, this criticism aimed especially at Corporate Raiders who used this form of financing to buy significantly larger companies, generally to break them up and to profitably resell them afterwards.[28] The oil shock in 1973 resulted in a decline in asset values in the real estate market and in the stock market.[29] It also lead to inflation, a rise of global competition, spiking interest rates, and the fluctuating of U.S. economic dominance. The situation at this point of time was described by Yago as follows: “The pieces of this financial-economic puzzle existed. Now, all that was necessary was for someone to put them together”.[30] Corporations, particularly those that did not qualify for investment grade ratings, needed to draw on short-term floating-rate bank debt. When the interest rates and inflation soared dramatically, firms started to prospect for more stable and cost-effective ways to raise capital. Together with the matter of fact that investors were seeking for higher yields, these needs were the beginning of “the new issue junk bond market”. Michael R. Milton, a former student from the University of Pennsylvania, became known as he proved that the spreads between noninvestment grade and investment grade bonds have steadily increased since the mid-1950s.[31] He demonstrated that the high-yield market was nascent and established a new standard for financial innovation in modernizing, renewing, and pioneering traditional industries. The supply of capital to businesses was one of the decisive challenges in the 1970s and 1980s as new industries needed financial means to grow. Already consisting companies, such as the mining, steel, and automobile sector needed remarkable sums to adjust and rebuild in order to survive this time. With the provision of long-term, fixed rated funds and the concomitant higher rates of return through new and innovative high-yield bonds, adapted from the high-yield market, economy was propelled forward. These innovations in financial markets and institutions were established to grant all sizes of company access to capital being available for just a selected group of businesses before. By constructing securities accompanying higher returns, the capital structure of firms “… could compensate for any additional risk to investors while increasing the entrepreneur’s chance for success”.[32] Companies, entrepreneurs and industries that were not included before, were able to go along with the economic mainstream and the high yield market engendered a number of today’s leading and most innovative firms. Corporations like Barnes and Noble, Time Warner Inc., MCI, and many others started with the junk bond market and later ascended into the investment grade market. It is not unusual that the company’s technologies and strategies infused bigger corporate giants and demonstrated them how to get through changing times.[33]

[...]


[1] cf. Yago, 1991, p. 9

[2] cf. Steffan, 2008, p. 190

[3] ibd.

[4] cf. Opresnik, Rennhak, 2015, p. 132

[5] cf. Frino et al. 2013, p. 2

[6] cf. Damodaran, 2011, p. 5

[7] ibd.

[8] cf. Frino et al. 2013, p.2

[9] cf. Au Yong, et al. 2011, p. 7

[10] cf. Head, Watson, 2010, p. 70

[11] cf. Verma, 2009, p. 59 f.

[12] cf. Head, Watson, 2010, p. 70

[13] 1996, p. 171

[14] cf. Milken, 2003, p. 223

[15] cf. Altman, Nammacher, 1987, p.1

[16] cf. Milken, 2003, p. 223

[17] cf. Library of Economics and Liberty, 2008

[18] ibd.

[19] cf. Altmann, Nammacher, 1987, p.2

[20] cf. Wilson, Fabozzi, 1996, p. 172

[21] cf. Altmann and Nammacher, 1987, p. 4

[22] cf. Hasler, 2014, p. 51

[23] cf. Klarman, Lowenstein, 1999, p. 234

[24] cf. Investopedia, N.D.

[25] cf. Antczak, et al. 2009, p. 12 f.

[26] cf. Yago, 1991, p. 15

[27] ibd.

[28] cf. Kracht, 2010, p. 107

[29] cf. Trimbath, Yago, 2003, p. 7

[30] cf. Yago, 1991, p. 20

[31] ibd.

[32] cf. Trimbath, Yago, 2003, p. 10

[33] cf. Trimbath, Yago, 2003, p. 10

Excerpt out of 14 pages

Details

Title
The Role of Junk Bonds in Corporate Finance
College
The FOM University of Applied Sciences, Hamburg
Grade
1,3
Author
Year
2016
Pages
14
Catalog Number
V350848
ISBN (eBook)
9783668373952
ISBN (Book)
9783668373969
File size
621 KB
Language
English
Tags
junk bonds, finance, accounting, high yield bonds, schrottanleihen, ramschanleihen
Quote paper
Valea Adams (Author), 2016, The Role of Junk Bonds in Corporate Finance, Munich, GRIN Verlag, https://www.grin.com/document/350848

Comments

  • No comments yet.
Read the ebook
Title: The Role of Junk Bonds in Corporate Finance


Upload papers

Your term paper / thesis:

- Publication as eBook and book
- High royalties for the sales
- Completely free - with ISBN
- It only takes five minutes
- Every paper finds readers

Publish now - it's free