Home Assignment – JUNK BOND Subject: Corporate Finance

JUNK BOND

A junk bond is typically a high-interest loan with relatively unfavorable terms to

compensate for a high risk of default. Junk bonds are a type of high-yield debt, and by far
the most common.

Bonds are rated according to the credit rating of the borrower. In the US, the major rating
agencies are Fitch, Standard and Poor's, and Moody's. The rating scheme in descending
order of value is: AAA, AA, A, BBB, BB, B, CCC, CC, C, D. Anything rated BB or
below is generally considered to be a junk bond because the credit risk is so great.

In the modern economy, bonds are traded like any commodity. Investment companies try
to maximize their profit by balancing the safety of an investment with the cost of the
bond on the market. Junk bonds are very attractive to some investment groups because of
their low cost.

In some cases, an investor may be prohibited by the bylaws of the group they belong to,
such as a company pension fund, from purchasing any bonds rated below A or BB. This
limitation makes the junk bond market considerably more limited than the market for
high-graded bonds, commonly referred to as investment-grade bonds.

The use of the junk bond is widespread throughout sectors that require significant
amounts of capital to operate. The telecommunications and energy sectors are two
industries which utilize the junk bond extensively. Recently it has come to light that a
number of companies have manipulated the appearance of their debt to help them receive
a higher rating on their bonds so they could more easily trade them on the market.

Enron is probably the best known example of a company distorting apparent debt to make
their portfolio not consist primarily of junk bonds. By hiding much of their debt off-book,
Enron received higher ratings than they would otherwise have earned. WorldCom,
similarly, was initially not rated as a junk bond company because of illicit accounting
practices.

The junk bond also plays an important role in the leveraged buyout and hostile takeover,
allowing groups of investment bankers to raise large amounts of capital to use in
acquiring a target corporation, paying off the junk bond interest with the newly acquired
corporation's cash flow.

By : Murad Sulaiman (BM-25175) Submitted to : Usman Ali Siddiqui, Teacher

Home Assignment – JUNK BOND Subject: Corporate Finance

For many investors, the term "junk bond" evokes thoughts of investment scams and high-
flying financiers of the 1980s, such as Ivan Boesky and Michael Milken, who were
known as "junk bond kings". But don't let the term fool you - if you own a bond fund,
these worthless-sounding investments may have already found their way into your
portfolio. Here's what you need to know about junk bonds. (For more, read our Bond
Basics Tutorial.)

What Is a Junk Bond?

From a technical point of view, a junk bond is exactly the same as a regular bond. Junk
bonds are an IOU from a corporation or organization that states the amount it will pay
you back (principal), the date it will pay you back (maturity date) and the interest
(coupon) it will pay you on the borrowed money.

Junk bonds differ because of the credit quality of their issuers. All bonds are
characterized according to this credit quality and therefore fall into one of two categories
of bonds:

Investment Grade - These are bonds are issued by low- to medium-risk lenders. A bond
rating on investment grade debt usually ranges from 'AAA' to 'BBB'. Investment grade
bonds might not offer huge returns, but the risk of the borrower defaulting on interest
payments is much smaller.

Junk Bonds - These are the bonds that pay high yields to bondholders because the
borrowers don't have any other option. Their credit ratings are less than pristine, making
it difficult for them to acquire capital at an inexpensive cost. Junk bonds are typically
rated at 'BB'/'Ba' or less.
Think of a bond rating as the report card for a company's credit rating. Blue-chip firms
that provide a safer investment have a high rating, while risky companies have a low
rating. The chart below illustrates the different bond rating scales from the two major
rating agencies, Moody's and Standard and Poor's:

Bond Rating Grade Risk

Moody's Standard & Poor's
Aaa AAA Investment Lowest Risk
Aa AA Investment Low Risk
A A Investment Low Risk
Baa BBB Investment Medium Risk
Ba, B BB, B Junk High Risk
Caa/Ca/C CCC/CC/C Junk Highest Risk
C D Junk In Default

By : Murad Sulaiman (BM-25175) Submitted to : Usman Ali Siddiqui, Teacher

Home Assignment – JUNK BOND Subject: Corporate Finance

Although junk bonds pay high yields, they also carry higher-than-average risk that the
company will default on the bond. Historically, average yields on junk bonds have been
between 4-6% above those on comparable U.S. Treasuries. (For related reading, see High
Yield, Or Just High Risk?)

Junk bonds can be broken down into two other categories:

Fallen Angels - This is a bond that was once investment grade but has since been reduced
to junk bond status because of the issuing company's poor credit quality.

Rising Stars - The opposite of a fallen angel, this is a bond with a rating that has been
increased because of the issuing company's improving credit quality. A rising star may
still be a junk bond, but it's on its way to being investment quality.
Who Should Buy Junk Bonds?
There are a few things you should know before you run out and tell your broker to buy all
the junk bonds he can get a hold of. The obvious caveat is that junk bonds are high risk.
With this type of bond, you risk the chance that you will never get your money back.
Secondly, investing in junk bonds requires a high degree of analytical skills, particularly
knowledge of specialized credit. Short and sweet, investing directly in junk is mainly for
rich and motivated individuals. This market is overwhelmingly dominated by institutional
investors.

This isn't to say that junk-bond investing is strictly for the wealthy. For many individual
investors, using a high-yield bond fund makes a lot of sense. Not only do these funds
allow you to take advantage of professionals who spend their entire day researching junk
bonds, but these funds also lower your risk by diversifying your investments across
different types of assets. One important note: know how long you can commit your cash
before you decide to buy a junk fund. Many junk bond funds do not allow investors to
cash out for one to two years.

Also, there comes a point in time when the rewards of junk bonds don't justify the risks.
Any individual investor can determine this by looking at the yield spread between junk
bonds and U.S. Treasuries. As we already mentioned, the yield on junk is historically
between 4-6% above Treasuries. If you notice the yield spread shrinking below 4%, then
it probably isn't the best time to invest in junk bonds. Another thing to look for is the
default rate on junk bonds. An easy way to track this is by checking out the Moody's
website.

The final warning is that junk bonds are not much different than equities in that they
follow boom and bust cycles. In the early 1990s, many bond funds earned upwards of
30% annual returns, but a flood of defaults can cause these funds to produce stunning
negative returns. (For more insight, read Basics Of Federal Bond Issues.)

Conclusion
Despite their name, junk bonds can be valuable investments for informed investors. But
their potential high returns come with the potential for high risk.

By : Murad Sulaiman (BM-25175) Submitted to : Usman Ali Siddiqui, Teacher