Changes in Ratings
by MaestriChanges in a firm’s bond rating affect both its ability to borrow long-term capital and the cost of that capital. Rating agencies review outstanding bonds on a periodic basis, occasionally upgrading or downgrading a bond as a result of its issuer’s changed circumstances. For example, in October 2001, Standard & Poor’s reported that it had raised the rating on King Pharmaceuticals Inc. to BB from BB due to the “continued success of King Pharmaceuticals’ lead product, the cardiovascular drug Altace, as well as the company’s increasing sales diversity, growing financial flexibility, and improved financial profile.”17 However, S&P also reported that Xerox Corporation’s senior unsecured debt had been downgraded from a BBB to a BB due to expectations of lower operating income in 2001 and 2002.
Junk Bonds
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 that risky bonds yielded more than enough to compensate for their risk, began to convince institutional investors of the merits of purchasing risky debt. Thus was born the “junk bond,” a high-risk, high-yield bond issued to finance a leveraged buyout, a merger, or a troubled company.18 For example, Public Service of New Hampshire financed construction of its troubled Seabrook nuclear plant with junk bonds, and junk bonds were used by Ted Turner to finance the development of CNN and Turner Broadcasting. In junk bond deals, the debt ratio is generally extremely high, so the bondholders must bear as much risk as stockholders normally would. The bonds’ yields reflect this fact—a promised return of 25 percent per annum was required to sell some Public Service of New Hampshire bonds.
Taken From : Five-Minute MBA – Corporate Finance
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