Changes in Ratings (2)
by MaestriThe emergence of junk bonds as an important type of debt is another example of how the investment banking industry adjusts to and facilitates new developments in capital markets. In the 1980s, mergers and takeovers increased dramatically. People like T. Boone Pickens and Henry Kravis thought that certain old-line, established companies were run inefficiently and were financed too conservatively, and they wanted to take these companies over and restructure them. Michael Milken and his staff at Drexel Burnham Lambert began an active campaign to persuade certain institutions (often S&Ls) to purchase high-yield bonds. Milken developed expertise in putting together deals that were attractive to the institutions yet feasible in the sense that projected cash flows were sufficient to meet the required interest payments. The fact that interest on the bonds was tax deductible, combined with the much higher debt ratios of the restructured firms, also increased after-tax cash flows and helped make the deals feasible.
The development of junk bond financing has done much to reshape the U.S. financial scene. The existence of these securities contributed to the loss of independence of Gulf Oil and hundreds of other companies, and it led to major shake-ups in such companies as CBS, Union Carbide, and USX (formerly U.S. Steel). It also caused Drexel Burnham Lambert to leap from essentially nowhere in the 1970s to become the most profitable investment banking firm during the 1980s.
The phenomenal growth of the junk bond market was impressive, but controversial. In 1989, Drexel Burnham Lambert was forced into bankruptcy, and “junk bond king” Michael Milken, who had earned $500 million two years earlier, was sent to jail. Those events led to the collapse of the junk bond market in the early 1990s. Since then, however, the junk bond market has rebounded, and junk bonds are here to stay as an important form of corporate financing.
Taken From : Five-Minute MBA – Corporate Finance
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