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Principles of Finance: Unit 5, Rocky Road: High Yield or "Junk" Bonds 5 Views


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High yield (or "junk") bonds are just like they sound... junky. They're bonds that pay a high interest rate, because they're so gosh-darn risky.

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Transcript

00:00

principles of finance a la shmoop... rocky road high-yield or junk bonds

00:08

high-yield bonds aren't really a type category unto themselves that is a bond [High yield bond description]

00:13

that has a high-yield today could have started out as a really safe low

00:18

yield bond a while ago and then the company backing it stumbled they put out

00:23

bad product they didn't pay attention to competition they just stunk one way or

00:27

another and I think Sears or Toys R Us well let's say you had a bond that was [Toys R Us store]

00:31

issued with a 5% coupon at par or a hundred cents on the dollar or a

00:35

thousand dollars as being the price paid to get 50 bucks a year paid each year

00:39

for 15 years until that bond was paid off but then all the sudden the specter

00:44

of the b-word you know bankruptcy came along and the credit worthiness of the [Ghost appears in a corridor]

00:49

bond suddenly came into question as the company was just barely able to make its

00:53

interest payments last quarter....well, nervous nellie bond investors desperate

00:58

to get out from a messy illiquid bad returned bond situation actively dumped

01:04

units of the bonds which started out in a thousand bucks and declined [Bond declining face value]

01:07

precipitously to finish the first weeks trading selling for only 500 bucks while

01:12

the coupons remained 5% only now investors paying $500 for that stream of

01:18

50 dollars a year for the remaining years on the bonds duration were

01:21

getting a 10% yield instead of a 5% yield...In the scheme of things these days

01:27

that's very high yield also known as yes junk bonds while high-yield bonds gained

01:33

fame and infamy as junk in the 1980s when they were used as openly highly [Woman answers telephone]

01:38

risky vehicles to make acquisitions in real estate, Midwestern factory produced

01:43

stuff and a bunch of other edgy targets for example, yeah Michael

01:47

Millikin... prominent financier ended up going to [Michael Millikin behind bars]

01:51

prison for having "falsely marketed the quote junk bonds" and

01:55

well, that era is long gone but bonds that have high-yield are here to stay so

02:00

what are the specifics that make a bond high-yield well usually risk if a

02:05

company has a hundred million dollars in operating profits pre-tax and has a

02:09

billion dollars of debt which cost the company 80 million dollars a year just

02:13

to pay the interest meanings 8% bonds well it's likely that the billion bucks

02:18

of debt carries a very high yield wait how does that work? well, the company

02:23

probably had at one point two hundred million dollars in operating profits and

02:27

they raised a billion dollars with an 8% coupon thinking that they'd quickly pay [Company example of operating profit]

02:32

down the principal such that after year one the two hundred million dollars less

02:36

eighty million dollars of interest would make their billion bucks of debt stand

02:40

at eight hundred eighty million and if they did the same for two to three more

02:44

years well they'd be at a very easily digestible leverage ratio and all would [Person gives a thumbs up]

02:49

be just fine but then something bad happened the market changed the new

02:53

Barbie product was laced in arsenic instead of silk trade treaties killed

02:57

the foreign marketplace whatever so instead of having projected operating [The Queen and Trump talking]

03:02

profits of two hundred million, two hundred fifty million and three hundred

03:06

million the company had two hundred million one hundred million and oof yeah

03:10

that is if the management had projected plan a to Wall Street and been oh, so

03:15

wrong well why would the street trust them now guess what they wouldn't and so

03:20

it's likely that the common equity of a company with this kind of stumble is [Person removes stock]

03:23

trading it pennies a share the "smart money" is betting that the company

03:27

goes bankrupt but here's where real investors can make real money if you

03:31

look at the new release of product from the company and it actually clicks and [Man checking companies on computer]

03:35

you see evidence from the Amazon trending data that people are actually

03:39

starting to buy it well then all of a sudden you wonder if the company wasn't

03:42

fully wrong in their leveraging maybe they were just early if the company was

03:47

teetering on the edge of bankruptcy with bonds with a coupon of eight percent now

03:50

trading at 50 cents on the dollar to give a very high yield of 16 percent

03:54

would you want to buy the bonds here if you believe the new products are really

03:58

gonna work well if you only could buy bonds then probably odds are good that

04:02

16 percent is money good in 16% that's great return for a bond so maybe you're [Person giving thumbs up]

04:08

really smart and good and lucky and you have really good returns more than

04:10

doubling your money and then some as the bonds go back to par and have a yield of

04:14

8% you know trading from 50 cents on the dollar to a hundred cents on the dollar

04:18

and maybe the company pays off the debt and you do slightly better than doubling

04:22

your money or at least doubling your yield that is so you do way better than

04:25

doubling your money it's nice-ish...but if you had a

04:29

thrill for the edge and you were smart and you were good and you had enormous [Man holding a bowling ball]

04:32

cojones that say Brunswick on em, well you'd probably buy the stock here the

04:36

common equity trading at seventy three cents a share what was likely trading in

04:40

the 20 or $30 a share range just a year or two ago and if the company returns to

04:45

anything close to parity with its old self instead of doubling your money and

04:49

change in the bond land you'd make like 30 times your money and more in the

04:53

equity land why are we focusing on equity and a discussion of high-yield

04:57

bonds here well because often high-yield bonds trade like or are highly

05:03

correlated with how the equity is performing and a lot of money is left on [Money appears on the table]

05:07

the table by being "too safe" and buying bonds when investors should have

05:11

just bought the stock...High-yield bonds are risky in a lot of ways in which

05:15

equities are risky but their upside is capped at most you just get your

05:19

principal back with all the back interest equities are uncapped they can

05:23

go really high anyway high-yield bonds generally live in the [High-yield bond with professional investor]

05:26

domain of professional investor to have access to company management and all

05:30

kinds of data not available to a joke consumer investor, at least not easily

05:34

so if you're buying junk be sure you're okay you know with the smell [Man with a junk bond walking through landfill]

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