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Junk Bonds & Long Term Debt   Term Paper ID:27481 Click to get this paper

Essay Subject: Reviews traditional debt instruments including term loans, different types of bonds, & debentures. Specific features of debt contracts are analyzed. Details recent innovations including zero coupon bonds, floating rate debt, & junk bonds.... More...

8 Pages / 1800 Words 5 sources, 8 Citations, APA Format $32.00 Return to List of Papers

Paper Abstract: Reviews traditional debt instruments including term loans, different types of bonds, & debentures. Specific features of debt contracts are analyzed. Details recent innovations including zero coupon bonds, floating rate debt, & junk bonds. Paper Introduction: Introduction Chapter 15 in Brigham deals with the topic of long-term debt. The chapter first presents an overview of traditional debt instruments including term loans, different types of bonds and debentures. Specific features of debt contracts are then analyzed including agency problems for bondholders, call provisions and sinking funds. Recent innovations in bonds are then discussed including zero coupon bonds, floating rate debt and junk bonds. The chapter concludes with a more detailed discussion of bond ratings and the factors which influence long-term financing decisions. Issues Brigham defines a bond as a long-term contract under which Text of the Paper: The entire text of the paper is shown below. However, the text is somewhat scrambled. We want to give you as much information as we possibly can about our papers and essays, but we cannot give them away for free. In the text below you will find that while disordered, many of the phrases are essentially intact. From this text you will be able to get a solid sense of the writing style, the concepts addressed, and the sources used in the research paper. Thus, for instance, common equity(the owners' interest) amounted to just 3 percent and 4 percent of thecapitalization of junk-bond-issuing companies in 1987 and 1988. Specificfeatures of debt contracts are then analyzed including agency problems forbondholders, call provisions and sinking funds. (1988). In thefirst few years of the decade, it had averaged 35 percent. There appeared to be severaladvantages to such a shift. There does seem to exist within the financial structure of theeconomy an almost natural move toward overoptimism. Hence the risks of thisinvesting are primarily accepted by the specific investor group willing toaccept them. NY: Harper andRow. NY: Goldman Sachs and Co. (7th ed.).Orlando, FL: The Dryden Press. The end-result was a picture of decline in the quality of junk-bond issues, and a decline that apparently many junk-bond analysts hadmanaged to overlook or explain away. Between 1986 and 1988, Wigmore noted, over 75percent of junk-grade debt was incurred in the course of a merger orleveraged based. First, when commercial banks lend to highcredit risk borrowers, that risk is accepted indirectly by all U.S.citizens, who may not wish to accept that risk. If high credit risk corporations default on their loans,causing an FDIC bailout, all taxpayers eventually have to pay. Brigham argues that the development ofthe junk bond market has expanded the limits of a firm's debt capabilitiesbeyond the earlier parameters, and in spite of all the publicitysurrounding the use of junk bonds in mergers and acquisitions, he maintainsthat well over half of the junk bonds issued in recent years have been usedfor normal expansion purposes by companies with low bond ratings. corporations thatcould not issue securities in the public debt market would borrow fromcommercial banks or finance companies on a short-term to intermediate-termbasis or would be shut off from credit. Theliabilities of other investors (excluding thrifts that did invest in junkbonds) are not backed by the U.S. Altman, E. According tothe chapter, Milken, initially relied on the historical studies of W.Braddock Hickman (1958). Finally, the junk bond marketopens the possibility of credit for some firms that had no access (Fabozzi,1991). These events tarnished the junk bond market and perhaps point tosome weakness in the original analysis made by Milken. To these issues, 694 in all, he applied five standard tests of credit-worthiness. (1991). It certainly appears to be thecase that there is an apparent decline in credit quality in a period of"financial exhilaration" whether it is junk-bonds, or common stocks, orreal estate investment. The new high-yield debt market. They tended to show that risky bonds yielded morethan enough to compensate for their risk. Hickman statedin his analysis that there was some evidence to support the proposition ofdeteriorating credit conditions toward the end of major cycles and of apossibly tightening up of credit standards near the beginning of new majorcycles. Such an analysis would seem to suggest that someissues, perhaps those of marginal quality, can find a ready market onlywhen the market is buoyant, and that in periods of market pessimism onlythe top grade issues can be placed. Therefore,focusing exclusively on default rates merely highlights the worst possibleoutcome that a diversified portfolio of junk bonds would suffer, assumingall defaulted bonds would be totally worthless (Altman, 1989). However this pattern may, to a large extent, be determined bythe stage of the credit cycle in which it is enfolded. References Brigham, E.F. Recent innovations inbonds are then discussed including zero coupon bonds, floating rate debtand junk bonds. It would seem that a chapter on Long-Term debtshould be more sensitive to such an issue. Corporate bond quality and investor experience.National Bureau of Economic Research. With the advent of the junk bondstructure, financing shifted from commercial banks to the public market. Finally the speculative boomcollapses (whether in real estate, junk-bonds, or the stock market) and adrastic liquidation begins with, for example, Drexel Burnham collapsing andsomeone like Milken going to jail. What is interesting about Brigham's arguments is the possibility thatit ignores the broader credit cycle as did many of the studies of junk-bonds made in the mid-8 s. It indicated that defaults occurred with greater frequencyamong bonds and mortgages issued late in the 192 s than with those issuedearlier. Consequently in the next two to three cycles, while the cyclicaladvances become progressively smaller in industrial activity, they maybecome larger in speculative activity. Milken attempted to disprove that view. Wigmore published an analysis whichseemed to support some of the unpublicized pronouncements that Hickman hadmentioned in his 1958 study.Wigmore (1988) argued that the quality of junk bonds declined as the volumeof their issuance increased. (1958). Princeton, MA: Princeton UniversityPress. However in 1988, Barrie A. After a severedownturn industrial activity does rebound yet speculation is quite limited. At that point the issuebecame whether such a spread was justified based on a higher potentialdefault rate. Brigham notes that bonds are similar to term loans,but a bond issue is generally advertised, offered to the public and usuallysold to many different investors. Furthermore commercial bank loans are typically short-term, fixedrate loans, which made debt financing less attractive to corporations.Junk bond issues give corporations the opportunity to issue long-term,fixed-rate debt. Hickman, W.B. Before development of the junk bond market, U.S. This meant that if depreciation was treated as an imaginaryexpense, a marginal debtor could be made to look nearly solvent. But Hickman (1958) actually said a great deal more. Fundamentals of financial management. (1995). Earnings beforeinterest and taxes had sufficed to cover interest expense by two to one inthe early 198 s but by less than one to one in 1986-1988.Summary Brigham makes the point in chapter 15 that despite the debacles of thelate 198 s the junk bond market still has an important role to play incorporate financing. The promised yields offeredon junk bonds were substantial. Armed with such evidence Milkenbegan to convince certain institutional investors of the merits ofpurchasing risky debt. As Chapter 15 points out, the phenomenal growth of the junk bondmarket was impressive but also controversial. Thus generally in the field of investmentit may indeed be the case that the buying public, swayed by over-optimism,seeks more and more after securities of higher yield and investmentbankers, under the stress of competition, issue securities of higher yield,greater risk and poorer quality. Fabozzi, F.J. The maximumreturn that an investor was perceived as obtaining is capped by the couponand face value, but the loss could be as large as the principal invested(Hickman, 1958). Measuring corporate bond mortality andperformance, Journal of Finance, 9 9-922 Wigmore, B.A. However as the Brigham chapter points out, by early 1989 DrexelBurnham Lambert was forced into bankruptcy and Michael Milken was sent tojail. This view supposedly rested on thenature of the skewed outcomes offered by the instrument. Hickman's statistical work appeared to support the proposition thatprosperity seemed to tarnish the quality of corporate debt. For example, the yield spread overTreasury bonds between 198 and 1989 ranged from 3 to 65 basis points.In late 1989 and 199 , a more turbulent time for the junk bond market, theyield spread increased to 7 to 8 basis points. Hickman also observed that the trends in default rates werecomparable with trends in net and gross new financing; default ratestending to be high on securities issued during years of high financialvolume and vice versa. His study alsoanalyzed the apparent decline in credit quality of bonds issued late in theCoolidge boom. This rise in the default rate stood out, according to Hickman,because the tendency since the turn of the century was one of decliningrates of default. Some have argued, from an investment perspective, that default ratesby themselves are not of paramount significance, meaning that it isperfectly possible for a portfolio of junk bonds to suffer defaults and tooutperform Treasuries at the same time, provided the yield spread of theportfolio is sufficiently high to offset the losses from default.Furthermore it is maintained that because holders of defaulted bondstypically recover at least 3 % of the face amount of the investment, thedefault loss rate is substantially lower than the default rate. In essence the junk bond market shifted the risk from commercial banksto the investing public in general. Wigmore (1988) examined every underwritten junk-bond issue from 198 to 1988 except those issued by financial institutions and public utilities. The chapter concludes with a more detailed discussion ofbond ratings and the factors which influence long-term financing decisions.Issues Brigham defines a bond as a long-term contract under which a borroweragrees to payments of interest and principal on specific dates to theholder of the bond. Leniency in creditmarkets seems to eventually turn to stringency, although the timing isnever predictable. It was Hickman'sstudy (1958) that supposedly showed that high-yield bonds had produced aparadoxically higher investment return than high-grade bonds over the firstfour decades of the century. In addition commercial banks set interest rates based ontheir credit analysis, when junk bonds are traded in a public market theinterested public establishes the rate. The analysis which follows will look more closelyat the nature of junk bonds, the evidence supporting the Hickman data aswell as the consequences for corporate America and the American financialsystem of its infatuation with "junk."Analysis The introduction of high-yield (junk) bonds became a very importantfinancial innovation with wide impact throughout the financial system.Before Milken there was a common view that high default risk bonds wouldnot be attractive to the investing public, at least at interest rates thatwould be acceptable to the borrower. He believes that outside of takeovers and LBOs thejunk bond cannot be written off. The reason is thatcommercial bank liabilities are backed by the Federal Deposit InsuranceCorporation. In fact it can be argued that the history of thebusiness cycle shows that the stage of prosperity in general is marked byan ever-increasing inefficiency. It may indeed be the case as Milken used to argue that the debt ratingof a triple-A-rated corporation has nowhere to go but down whereas therating of a speculative-grade company (barring a bankruptcy) has nowhere togo put up. (1989 September). The standard test became earnings before interest, taxes anddepreciation. Then the entire process starts up againwith the junk bond market again gradually showing new strength and investorinterest. The chapter also points out that whilebonds normally have a fixed interest rate, in recent years there has beenan increase in the use of various types of floating rate bonds. No longer were earnings before interest and taxes theconventional parameter in bond-market analysis expected to cover interestexpense. Then perhaps there is a mild contraction which leads people to be lesscautious. The decline in credit quality of junk bondissues: 198 -1988. government. Introduction Chapter 15 in Brigham deals with the topic of long-term debt. Certainly there was a buoyant market in junk bonds between 1985 and1988. Thechapter first presents an overview of traditional debt instrumentsincluding term loans, different types of bonds and debentures. Thechapter attributes the innovations in this instrument to Michael Milken ofthe former investment banking firm Drexel Burnham Lambert. Brigham notes that junk bonds became quite popular in the 197 s. If this paper is not what you are looking for, you can search again: Search for: or Click here to request an essay written just for you.