Junk Bonds, also known as High Yield Bonds, are debt instruments issued by companies with poor credit ratings, or are the debt instruments of companies that were issued as high quality bonds from strong companies that have since fallen on hard times (“Fallen Angels”).

Typically these are any bonds that are not classified as Investment Grade (BBB rated or better).

Junk Bonds behave very differently from Investment Grade bonds. Their value depends only marginally on market interest rates and far more on the underlying economic strength and operational performance of the issuing company.

Junk Bond return characteristics

They don’t often the unlimited upside of ordinary equity, but with the high starting yield (10% to 25% depending on the circumstances) it can provide a very healthy return if the company doesn’t default. There is also a chance for rerating where if the strength of the company improves dramatically, the bond may be repriced to a lower market yield, resulting in a significant capital gain.

Founders keeping control

So company founders can issue junk bonds rather than diluting themselves by issuing equity and still provide attractive returns to investors and an opportunity for savvy investors (and those who just think they are savvy) to “pick” their company with the prospect of fantastic returns if it performs really well.

Did I mention the interest payments on the issued junk bonds are tax deductible for the business?

Why would investors be happy to invest in junk bonds?

Aside from the attractive returns possible, now is a particularly good time for investors to consider junk bonds. With low interest rates (particularly in the US, Europe, Japan sphere of the world) investors are looking for instruments to boost their yield. Junk Bonds can do just that.

Further, with the Fed (and to a lesser extent, other central banks) promising to keep interest rates low and therefore debt cheap for an extended period, the risks to investors are fairly low. Certainly, the perception is that the risk is lower in bonds than equities as an asset class – this is probably at least partly a mirage given the equity-like characteristics of junk bonds.

Moody’s has also shrunk it’s list of companies most likely to default, further encouraging views of low default probabilities.

I’ll be writing a few more posts related to bonds and junk bonds over the next few weeks so keep an eye out for those if you’re interested.

The reader “trymore” provides some details of a new deal apparently being run by Rudie Visagie. As I stated last time this gentleman’s name came up, I have no personal interest or involvement here at all. My interest was just to show how the deal made no business sense to Visagie given the significant interest rate, currency and credit risks involved. Thus, it sounded like a scam. At the time, I quite enjoyed hearing all the supporters claiming I just didn’t want him to succeed. Meanwhile, several regulators started to probe the dubious claims, and it became clear that apart from anything else, Visagie wasn’t licenced to carry out the business he was proposing.

They quickly quietened down when the whole thing fell apart and Visagie’s clients lost money. Several readers of this site gave their own stories to this extent.

“Trymore” had the following to say:

Our company was also approached to do bussiness with Mr Visagie’s new company , which is now called Better Life. Our clients would get Loans from them and on final approval would have to pay R5700.00, on enquiring about their company eg contact no’s , name of directors, physical address ect we were continuously stonewalled and eventualy given the name of their “attornies�(who had no knowledge of them) and their buss address in Blouberg Str(they are merely renting desk space).So my advise to anyone wanting to do buss with Better Life is, DONT GO THERE!!!!!!

This is a little out of my area of knowledge, but it sounds like the wheels are turning yet again. One doesn’t need sophisticated risk models allowing for the interaction of multiple risks, individual behaviour and an estimate of one’s risk appetite to know that a business that isn’t proud to show itself off isn’t one you should trust.

This reminds me of the example of the business premises of banks versus supermarkets. Banks typically spend large amounts of money on fancy head-offices, marble floors, giant pillars and so on. Supermarkets don’t. The key differentiator is that at a supermarket, you don’t care if they are in business tomorrow or not. You can tell the quality of the products by inspecting it and if they aren’t around tomorrow you aren’t affected. A bank, on the other hand, needs to show that it is not a fly-by-night operator. It needs to show that it has the resources to withstand economic crises, interest rate shifts and tilts and butterflies, poor credit events and the operational risks associated with any business. A bank needs to convince customers that it is solvent and good for the long term.

I don’t deal with financial institutions that look like supermarkets. No matter how low the prices are.

Simplistic overview of causes

• High fuel costs – avgas has increased significantly recently.  However, this affects all airlines.
• High fuel costs combined with fuel inefficient planes.  Nationwide’s older aircraft are less fuel efficient. Fuel costs per flight are thus higher than some competitors. An increase in fuel prices hits them harder.
• Small capital base (now negative), high fixed costs and challenging break-even targets. Nationwide needed 75% capacity on its flights to break even. This reflects the high fixed costs per flight, and high fixed costs overall. A small capital base means that there was limited time to trade through difficult conditions and preserve the franchise / brand value of the operation.
• Loss of confidence due to safety concerns, regulatory intervention. Since one of Nationwide’s planes “lost and engine” in flight confidence from the flying public has plummeted.  It has since emerged that the engine was in fact designed to free itself from the plane under certain circumstances. Combined with the pilot’s successful landing shows that the outcome was pretty good compared with other possibilities. However, a large portion of the market was not prepared to fly Nationwide anymore. Combined with the chaos preceding and succeding the operational and safety crisis, I stopped flying Nationwide simply because we had concerns about their ability to get us to our destinations on time. This may not have been based on a thorough analysis, but was based on several specific events. I’m sure I wasn’t the only one to reach this conclusion.
• Price competition – pretty much the only customers prepared to fly Nationwide were those looking for the cheapest flight at any cost (safety, timeliness etc.). Thus, Nationwide’s pricing power diminished to virtually nothing. This exacerbated the need to fill planes to meet fixed costs.

Lessons for other organisations

Decreased capital bases have become a popular path to increased Return on Equity. Now, theory suggests that decreased equity will boost financial leverage if debt is involved (debt here including debt-like obligations such as fixed equipment leases). On a more practical level, decreased capital provides a smaller buffer against adverse trading conditions (default experience for banks, claims experience for general insurers, equity market declines for life insurers, interest rate shocks for most business). Assuming Nationwide had a viable business, a larger capital base would have allowed them to continue trading through the difficult times and emerge at the end of the tunnel a profitable business.

One of the standard counters to this is that if new capital were needed it could be raised from the efficient, deep, liquid, transparent, costless capital markets. Needless to say, those don’t exist. The practicalities of a bail-out package in sufficient time to keep an airline running make it especially challenging. Incidentally, it’s not unlikely that someone will take over Nationwide’s planes and staff – if our market does need those flights and employees that should find a home somewhere. If there was sufficient slack in the market for the other airlines to mop up the increased relative demand, then a company “exiting” the market is exactly what microeconomics would predict. Pity Mango has our tax money to shield them from a similar fate.

Financial services companies would do well not to dismiss Nationwide’s fate as ”nothing to do with me”. Northern Rock’s catastrophic loss of confidence might have been a little closer to home, but shares the same message of significant gearing, illiquid assets and a loss of confidence. Capital strength provides more leeway to ride out tough times, but also adds confidence to customers (deposit holders, policyholders) which is most critical in tough times. The costs of financial distress rise as companies’ capital positions worsen. Low probability events can be catastrophic when they hit, and there is plenty of evidence to show how human beings chronically underestimate the probability of low probability events.

Hedging. Again.

Fuel price skyrocketed. Margins destroyed. Airline no longer profitable. Now, if an increase in fuel price really would be that deadly to an organisation, surely hedging of this otherwise uncontrollable risk should have been sensible? As it turned out, Nationwide was partially taking a bet on fuel prices declining or staying constant. Lose the bet lose your business. If they had hedged, even partially, and fuel prices had declined, they would have still been in a sticky mess, but presumably better than they are now. If the competitive position they would have been in with locked-in higher fuel prices would have meant that they would also have gone out of business, then I’m afraid this sounds more like a wild speculative fling than a sustainable business. Rolling dice on that scale doesn’t inspire confidence.

Three conclusions

1. High gearing and a small capital base has definite costs they aren’t completely factored into a naive RoE analysis.
2. Customer confidence is critical to a sustainable business and should be nurtured.
3. Hedging of major, uncontrollable and potentially fatal risks must be included in an organisations risk and strategic management.

1Time down 11.4% today. Comair up nearly 9%.  Market taking bets on which company is better positioned for the new competitive landscape?

Perhaps a warning is required for the overally optimistic. Basel II required 5 QISs before maturing to be ready for roll-out. Many acknowledge that Solvency II is more complicated, with a greater number of complex risks to consider so it could arguably take much longer. Also, Basel II had the framework of Basel I to start with, where many European insurers have had very simplistic capital requirements to date. Watch this space!

I’ll provide some more feedback on the actual results of Solvency II when I’ve had a look through the material.

Ok, but what about the hedge itself? Why was it terminated? Ian Cockerill, Chief Executive Officer of Gold Fields said:

1. “We terminated the Western Areas hedge book because we believe in gold. “
2. “The hedge book was significantly under water and was a crippling liability to the South Deep mine. Now we can bring the asset to account in a transparent manner.”
3. “Gold Fields is of the view that the price of gold remains firmly in a long-term upward trend and, with that outlook, it does not make any sense whatsoever to be hedged.”
4. “It also ensures that Gold Fields remains fully transparent to investors, and that its balance sheet remains simple to understand.”

Let’s take each of these statements in turn.

1. So Mr Cockerill is stating quite clearly that Gold Fields view is that gold is a good investment, that they expect to make profit about increases in the price of gold over time. Fair enough. And since they are in the gold mining industry, perhaps they will have a more informed view than the average Joe. However, since they are in the gold mining industry, maybe they have a biased view of gold. Most management teams are notoriously optimistic about their company, their industry and can never understand why their share prices are so far below fair value! Also, this doesn’t address my major point that shareholders can easily adjust their exposure to gold in any case. This doesn’t present any arguments for operational improvements or similar efficiencies from terminating the hedge book.
2. A crippling liability? Raising cash to pay off a liability simply accelerates the cost to now. Not necessarily a bad thing, but not clearly a good thing either. This probably makes sense within the context of point 4 below.
3. Hmmm, a rehash or point 1 then. Except Mr Cockerill takes it further. “It makes absolutely no sense to hedge”. Well, as I described before, there is more to the decision to hedge than a simple view on the prospects of the gold price. One wonders whether Mr Cockerill couldn’t have expanded on his logical thought process that helped him conclude that there was absolutely no sense.
4. Ah. Yes! A very valid point, and possibly the only valid point we’ve seen so far. Hedge books are complicated derivative structures and an excellent mining analyst should know about mines and mining and minerals and prices and not necessarily a thing about fancy derivative structures. Fully agree on this one.

So this leaves us with 1/4 or 25% relevancy score. Ok, this is a bit harsh, but it does support my view that hedging decisions are made more on emotion and rhetoric than on rationality and facts.

Now, there is another side to the story. From http://www.mineweb.co.za:

Western Areas also stated that “the hedge banks may be able to terminate the derivative structure as a result of existing circumstances or as a result of an acquisition of control of Western Areas by Gold Fields and in that event, Western Areas may need to make a material payment to the hedge banks and would seek to raise this amount from shareholders, in proportion to their shareholdings. If Gold Fields acquires 100% of Western Areas, then Gold Fields will need to deal with this issue with Western Areas and the hedge banks�.

So, in other words, regardless of what Mr Cockerill and his management team think about gold, they were probably close to forced to close out the hedge book in any case. Let’s hope this was a happy coincidence and not pure spin.

Some more background on the story:

yahoo business
www.mineweb.net

Gill Marcus on Moneyweb in early 2006

Botoxing a bling deal, also from Moneyweb

Common sense tells us that this is a sensible thing to do. Companies all over the world have been using debt capital to reduce their WACC by sharing the cost of financing the business with Mr Tax Collector. (The interest payments made to holders of the debt are tax-deductible expenses for the companies that issue the debt. Dividends paid to ordinary shareholders must be paid out of net-of-tax income.)

Take the example where the pre-tax cost of debt (yield to maturity on current debt or equivalently, the annualised coupon required on newly issued debt for the debt to be placed at par value) and cost of equity (a little more complicated, since the cost of equity depends on whether the equity is retained earnings or equity freshly issued through a rights offer, but will generally be based on a CAPM or APT-type model of the return required by shareholders) are equal at, say, 10%. The generic formula for the WACC is:

WACC = (1-t)*cost of debt*w + cost of equity*(1-w)

where t is the corporate tax rate and w is the percentage of total capital (measured at current market value and not book value) contributed by debt.

Thus, if w is 50%, then our WACC = (1-29%)*10%*50% + 10%*50% = 8.55%, which is lower than the 10% cost of equity. Thus, magically, but incorporating debt financing into our capital structure, we have lowered our cost of capital and increase the value of our company to our shareholders.

Or have we?

Way back in the day, two gentlemen by the names of Modigliani and Miller spent a great deal of time analysing the impact of capital structure on the value of a company. One of their key conclusions was that as we increase the amount of debt in the capital structure, we increase the risk for shareholders. This operates through increasing financial leverage because fixed costs have increased (interest payments are fixed costs in that they don’t depend on sales revenue) and thus the sensitivity of profits to shareholders to small changes in revenue increases.

Most people would agree (although some would not, and most would not agree on what really constitutes risk or a fair return thereon) that increased riskiness of profits to shareholders would result in a higher cost of equity. Without getting into a theoretical debate over the extent to which all of this really applies, I do expect that few would disagree that increased risk would result in some level of higher cost of equity. The exact size of the increase is of secondary importance here (although an interesting discussion in itself).

So, when life insurers issue debt, do they consider the increase in risk to the remaining shareholders as a result of the increased financial gearing? Well, no. And for good reason.

The reason why there is no increase in financial leverage is because most life insurers have been “matching” the liability they now have on their balance sheet with risk-free debt or corporate paper that has approximately the same duration (a specifically calculated “average term”) as the debt they have issued. The result being that, regardless of what happens to revenue, the interest expense on the issued debt is closely offset by the coupon received on the corporate paper held as an asset. Brilliant, increase in risk for shareholders begone!

Now that we have neatly side-stepped the risk implications for shareholders of raising debt capital, we should turn out attention to one of the principle motivations for issuing debt: tax deductibility of payments to providers of capital. What sounds like a good idea on the surface tends to look a little less attractive once we scratch beneath that polished exterior. The interest / coupon payments made on the issued debt are indeed tax deductible, but the interest proceeds on the debt held as assets incurs a tax charge. If the interest payments on assets and liabilities are matched, then the tax savings and payments are matched too. Net result, no impact.

(What I have described above is a simple scenario. It is possible that through some careful footwork, there might be tax advantages through, for example, generating lots of investment income within policyholder funds to utilise assessed tax losses there to reap the benefits of tax deductible interest payments in the corporate fund. However, there isn’t enough time or space to write about that here, and my perception is that this has not been the core motivation for debt issuances anyway.)

We can also look at this situation from another angle. What would happen if a company issued debt, then purchased all the debt back? Would there be tax or WACC advantages? No cash raised, all company profits and losses accrue to shareholders, and not tax advantages that SARS would permit. Surely in this case nobody would think the transaction such a bright idea?

In effect, this is what insurers have done. To be fair, they have swapped their own default risk with that of another entity (or even a pool of other entities), but whether this sophisticated credit arbitrage is a good thing is mostly beside the point since I don’t believe this was even thoroughly considered at the time.
Now, after writing this note, I can’t help but feel I must be missing something for all these insurers to be making the same decision. What have I missed?