The role of Junk Bonds in Corporate Finance

Term Paper (Advanced seminar), 2008

36 Pages, Grade: 1,3


Table of Contents

List of Abbreviations

List of Figures

1 Introduction

2 Corporate Finance
2.1 Short-term and long-term decisions
2.2 Credit risk and interest conflict at outside financing
2.3 The Credit risk rating and the Probability of Default

3 Junk Bonds
3.1 The history of Junk Bonds
3.2 Selected definitions of the High Yield Market
3.3 Downgrading to „Fallen Angel“

4 Junk Bonds in Corporate Finance
4.1 The use of Junk Bonds in Corporate Finance
4.2 The issuers perspective
4.3 The buyers perspective: JB similar to conventional investments
4.4 The perspective of the investment banks
4.4 Selected additional chances and risks

5 Conclusion


Appendix I §230.144A Private resales of securities to institutions

Appendix II Credit risk rating and Probability of Default

Appendix III Amount and Purpose of Junk Bond Issues, 1979 and 1988

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

Appendix V The Total Return on High-Yield Bonds Annually 1985-1989

Appendix VI High Yield emissions in the U.S.

Appendix VII Rating Scales, Investment Grade compared to High Yield


List of Abbreviations

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List of Figures

Fig. 1: Fields of Corporate Finance

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.

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.

illustration not visible in this excerpt

Fig. 1: Fields of Corporate Finance[3]

It distinguishes decisions into a long-term and a short-term horizon and techniques with the primary goal to increase the value of the firm by increasing the capital return and decreasing the costs for capital without meeting risks over the limit of risks the firm accepts.[4] Compared to the classical finance leads CF to closer reality proximity and supports a few of theoretical models to evaluate for making decisions.[5]

2.1 Short-term and long-term decisions

The short-term decisions in CF are named as Working Capital Management which manages the current assets and the current liabilities with a special view to the management of the cash flows, optimal storage capital, the current liabilities and investment funds.[6]

The long-term decisions in CF cover the question about choosing long-run investment projects and its financing by outside capital or equity and the payment of dividends to the share holders.

2.2 Credit risk and interest conflict at outside financing

In case of the later discussed role of Junk Bonds in CF the focus will be in following to the risks of outside financed credits in CF. In the sense of financing of investments with loan capital the risk depends of the environment of the company and the decisions of the current management, which possibly causes conflicts.[7] Due to that risk creditors will critical view how the value of their debts will develop.[8]

A model of Robert C. Merton, which was introduced in 1974 and further developed by Robert Geske in 1977, evaluates the demands of outside capital loaners or the probability of the loss as a credit risk via characterizing of options. The options enclose the following positions:[9] The credit period, the risks the company assets exposed to, the nominal height of the debts at the time of maturity; and the entity-value, that means the total of the equity and the value of the outside capital at the date of evaluation.

The value of the loan capital depends not only on the situation at current time and of risks of the company assets. Furthermore it depends of the further indebtedness policy, which intend the management and leads to the situation that creditors want to have impact to the further indebtedness policy of the company to protect themselves for future losses.[10] They will not accept that the management initiates measures to reduce value of creditor debts. That creates a target conflict in interests between management and creditors, which can lead to a situation were both parties hold back information to create own single-sided advantages.

2.3 The Credit risk rating and the Probability of Default

As described under chapter 2.2. creditors and investors want to reduce the risk of capital losses or losses of debts value. Investors and creditors are not able at any time to get access to fully information about the company of interest and need the support by tools to evaluate the risks easily.[11] Therefore creditors or investors use a credit rating, which measures the credit worthiness, the ability to pay back the loan capital and affects the interest rate applied to the loan. The credit rating is possible by an internal – rating by creditor - or external rating. In the case of German ratings are according to §41 SolvV in Germany only those external rating agencies recognized, which are prior to the ratings, used by banks, recognized by the state supervision of the banks.[12] If an external rating agency wants to be recognized in several states of the European Union so it has to be assessed in a joint assessment process.[13] Three international rating agencies – Moody`s, Standard and Poor´s, Fitch-Ratings - were recognized by the assessors in 2006, followed by the rating agency DBRS in April 2007.[14] Their ratings were used to provide the hight of such risks to the creditors or investors. Table A in Appendix II shows the rating nomenclature[15] – consisting of twenty classifications - which is currently used.

By rating agencies Standard and Poor´s as well Moody´s estimated the Probability of Default in percent that a credit applicant is not able to pay back the credit and supports the creditor / investor to evaluate the credit risk and probably to decide pros or cons to the investment. The estimated Probability of Default[16] according to ranking classification is presented in Appendix II / Table A.

For calculation the Probability of Default the following steps[17] will commonly used:

- Analysis of the credit expects of the counterparty
- Map of counterparty to an internal risk grade, which has an associated PD
- Determine of the facility specific PD, which will give a weighted

Probability of Default for facilities that are subject to a guarantee or

protected by a credit derivative and takes account of the PD of the

guaranty or seller of the derivatives

The rating classification has a direct impact to the company, because the lower the solidity of a company, the higher the interest rate for outside capital.[18] Without such a rating it would be quite impossible or strong limited for a company to organise outside capital at market conformity prices.[19] In such cases were the management of a company or an investor needs financial capital to finance an investment, were instead of classical bank credits other forms of outside financing required. Those forms use the principle of maximization of profits by achieving higher returns compared to interest rates at a bank by taking higher risks of losses.

A common and interesting form of financing investments in Corporate Finance is the possibility to get outside financial capital by issuing or buying of company bonds. If a company is not positive rated and did not achieve a lower rate of the Probability of Default so issuing of High Yield Bonds (non-official named as Junk Bonds[20] ) to get outside capital can be an alternative to offer high returns to outside creditors / investors.

3 Junk Bonds

3.1 The history of Junk Bonds

The Junk Bond market derives from the financial conditions of the U.S. in the first half of the 1970s, which was followed by the bad performance of traditional investments in long-term, fixed-rate-mortgages and government and corporate bonds, common stocks, resulted in the search for new investment opportunities.[21]

In 1974 a credit crunch took place, which caused in a big change in the capital marketplace by a change of political and economic developments in the U.S. and abroad and – forced by many factors – brought the productivity to historically low levels. The policy of that time tried to source financing a war in Southeast Asia and an aggressive expansion of domestic social services, it went together with lifting of wage and price controls led to the highest inflation in the history of the U.S.[22]

The consumer prices increased by the oil shock in 1973, thirty years interest rate stability ended abrupt and short-term borrowing costs were doubled in less then two years. During two years the market value of US-firms slipped down for more then 40% by a slide of equity prices as the result of declining economic activities.[23] The banks own capital was inadequacy as a result of declining asset values in real estate and stock markets. As open market yields rose above the interest rate line on the bank deposits, deposited funds flow out of the banking system followed by declining asset values which constrained further lending, so that the further process of the crisis led to increased job losses, declined security prices of sound companies and increasing defaults in real estate and retailing.[24]

These circumstances led to cancelling of credit lines by financial institutions, so that money for the most companies was unavailable at any price and companies had to reduce their level of business operations and cancelled their expansion plans. Economical stagnation was the result and led to the situation that successful, profitable and growing companies had no access to capital they needed to operate and build and investors were blocked from financing growth firms and firms with lower growth or negative net present values[25], so that providing capital to businesses was one of the main challenges until the early 1980s.[26]

Innovation in financial markets and institutions were designed to offer quite all sizes of firms access to capital that previously was only available to a selected group of businesses. By designing securities that provide higher returns could their capital structure compensate for any additional risk to investors while increasing the entrepreneur´s chance for success. So the high yield market supported some of the most powerful and innovative corporations like Time Warner, Mattel, Cablevision, and TCI Telecommunications to enter later on the investment grade market.[27]


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

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

[3] Cp. Caytas / Mahari, p. 25.

[4] Cp. Schulte (2005), p. 23.

[5] Cp. Schulte (2005), p. 23.

[6] Cp. Schulte (2005), p. 23.

[7] Cp. Spremann (2007), p. 403.

[8] Cp. Spremann (2007), p. 403.

[9] Cp. Spremann (2007), p. 404.

[10] Cp. Spremann (2007), p. 413.

[11] Cp. Spremann (2007), p. 415.

[12] Cp.

[13] Cp.

[14] Cp.

[15] Cp. Schelhowe (2007), p. 22.

[16] Cp. Schelhowe (2007), p. 22.

[17] Cp.

[18] Cp. Hansen (1991), p. 45.

[19] Cp. Hansen (1991), p. 45.

[20] Cp. Caytas / Mahari (1988), p. 187.

[21] Cp. Yago (1999), p. 24.

[22] Cp. Yago / Trimbath (2003), p. 8.

[23] Cp. Yago (1993), p. 128.

[24] Cp. Yago (1993), p. 129.

[25] Cp. Walter / Milken (1973), pp. 54-56.

[26] Cp. Yago / Trimbath (2003), p. 10.

[27] Cp. Yago / Trimbath (2003), p. 10.

Excerpt out of 36 pages


The role of Junk Bonds in Corporate Finance
The FOM University of Applied Sciences, Hamburg
Master of Business Administration (MBA)
Catalog Number
ISBN (eBook)
ISBN (Book)
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Junk, Bonds, Corporate, Finance, Master, Business, Administration
Quote paper
Dipl.-Kfm. (FH) Uwe Schindler (Author), 2008, The role of Junk Bonds in Corporate Finance, Munich, GRIN Verlag,


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