Reading: Lesson 6 - Junk Bonds, Bankruptcy & Reorganization

5.6.A - Junk Bonds, Bankruptcy & Reorganization

1. Financing with Junk Bonds

1. Recall that bonds rated less than BBB are noninvestment-grade debt, also called junk bonds or high-yield debt. There are two ways that a bond can become a junk bond. First, the bond might have been investment-grade debt when it was issued but its rating declined because the issuing corporation had fallen on hard times. Such bonds are called “fallen angels,” and there are many such bonds as we write this in 2012.
   
2. Some bonds are junk bonds at the time they are issued, but this was not always true. Prior to the 1980s, fixed-income investors such as pension funds and insurance companies were generally unwilling to buy risky bonds, so it was almost impossible for risky companies to raise capital in the public bond markets. Then, in the late 1970s, Michael Milken of the investment banking firm Drexel Burnham Lambert, relying on historical studies that showed risky bonds yielded more than enough to compensate for their risk, convinced institutional investors that junk bond yields were worth their risk. Thus was born the junk bond market.
   
3. In the 1980s, large investors like T. Boone Pickens and Henry Kravis thought that certain old-line, established companies were run inefficiently and were financed too conservatively. These corporate raiders were able to invest some of their own money, borrow the rest via junk bonds, and take over the target company, usually taking the company private. The fact that interest on the bonds was tax deductible, combined with the much higher debt ratios of the restructured firms, increased after-tax cash flows and helped make the deals feasible. Because these deals used lots of debt, they were called leveraged buyouts (LBOs).
   
4. In recent years, private equity firms have conducted transactions similar to the LBOs of the 1980s, taking advantage of historically low junk-bond rates to help finance their purchases. For example, in 2007 the private equity firm Kohlberg Kravis Roberts and Company (KKR) took the discount retailer Dollar General private in a $6.9 billion deal. As part of the transaction, Dollar General issued $1.9 billion in junk bonds. So KKR financed approximately 73% of the deal with its own cash (coming from its own equity and from money it had borrowed on its own account) and about 27% of the deal with money that Dollar General raised, for a net investment of about $5 billion. In late 2009, KKR took Dollar General public again at $21 per share with a resulting market value of equity of $7.1 billion and a very tidy gain!
   

2. Bankruptcy and Reorganization

1. A business is insolvent when it does not have enough cash to meet its interest and principal payments. When this occurs, either the creditors or the company may file for bankruptcy in the United States Bankruptcy Court. After hearing from the creditors and the company’s managers, a federal bankruptcy court judge decides whether to dissolve the firm through liquidation or to permit it to reorganize and thus stay alive.
   
2. The decision to force a firm to liquidate versus permit it to reorganize depends on whether the value of the reorganized firm is likely to be greater than the value of the firm’s assets if they are sold off piecemeal. In a reorganization, the firm’s creditors negotiate with management on the terms of a potential reorganization. The reorganization plan may call for a restructuring of the firm’s debt, in which case the interest rate may be reduced, the term to maturity may be lengthened, or some of the debt may be exchanged for equity. The point of the restructuring is to reduce the financial charges to a level that the firm’s cash flows can support. Of course, the common stockholders also have to give up something: They often see their position diluted as a result of additional shares being given to debtholders in exchange for accepting a reduced amount of debt principal and interest. In fact, the original common stockholders often end up with nothing. The court may appoint a trustee to oversee the reorganization, but usually the existing management is allowed to retain control.
   
3. Liquidation occurs if the company is deemed to be too far gone to be saved—if it is worth more dead than alive. If the bankruptcy court orders liquidation, then assets are sold off and the cash obtained is distributed as specified in Chapter 7 of the Bankruptcy Act. Here is the priority of claims: (1) past-due property taxes; (2) secured creditors who are entitled to the proceeds from the sale of collateral; (3) the trustee’s costs of administering and operating the bankrupt firm; (4) expenses incurred after bankruptcy was filed; (5) wages due workers, up to a limit of $2,000 per worker; (6) claims for unpaid contributions to employee benefit plans (with wages and claims not to exceed $2,000 per worker); (7) unsecured claims for customer deposits up to $900 per customer; (8) federal, state, and local taxes due; (9) unfunded pension plan liabilities (although some limitations exist); (10) general unsecured creditors; (11) preferred stockholders (up to the par value of their stock); and (12) common stockholders (although usually nothing is left for them).
   
4. The key points for you to know are: (1) the federal bankruptcy statutes govern both reorganization and liquidation, (2) bankruptcies occur frequently, and (3) a priority of the specified claims must be followed when distributing the assets of a liquidated firm.