This Metromedia Broadcasting Corp. case study discusses junk bonds and high-yield securities. It focuses on the securities issued by the corporation as a public offering sometime in 1984. This offering was done to provide financial assistance to the company's bank borrowing taken out during the leveraged buyout.
Sally E. Durdan
Harvard Business Review (286044-PDF-ENG)
December 02, 1985
Case questions answered:
- Why were returns on Junk bonds less volatile than those on investment-grade bonds over 1982-1984, as depicted in this Metromedia Broadcasting Corp. case study?
- Why weren’t excess credit spreads on lower-grade bonds arbitraged away as the high yield market developed?
- How liquid was the secondary market for high-yield securities?
- Why does Kluge want to issue debt?
- Who are likely buyers of the various instruments?
- What is the basis for underwriting debt that even the prospectus suggests is highly speculative?
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Case answers for Metromedia Broadcasting Corp.
1. Why were returns on Junk bonds less volatile than those on investment-grade bonds over 1982-1984, as depicted in this Metromedia Broadcasting Corp. case study?
The Blume-Keim study that was mentioned in this Metromedia Broadcasting Corp. case found that a diversified portfolio of lower-quality bonds experienced less volatility, or risk, than higher-grade corporates or equities over the period 1982-1984. While this result is surprising, the authors suggested that much of the risk in low-grade corporate securities may be firm-specific, and thus diversifiable. Perhaps it had something to do with the generally fixed-rate nature of junk bonds.
Junk bonds, i.e., high yield debt, often offer fixed-interest payments. They pay a constant “fixed” throughout the duration of the bond. Investment-grade bonds, however, usually are structured as “floating-interest rate” – these tend to pay a variable interest rate throughout their duration and are tied to a market measure, e.g., LIBOR. As LIBOR changes, the interest that floating-rate bonds pay fluctuates accordingly.
In response to the crisis of stagflation, high inflation with stagnant output growth, in the United States, President Jimmy Carter nominated Paul Volcker as the Federal Reserve Chairman in 1979. Volcker insisted on running tight monetary policy to rein in the high levels of inflation. Floating-rate debt is impacted greatly by changes in the federal funds rate, given that it directly influences the amount of interest that they payout.
Fixed-rate debt, however, pays a consistent coupon payment, regardless of the movements elsewhere in the credit market. Given the great uncertainty associated with interest rates from 1982-1984 – as the US entered and exited a recession – the fixed-rate returns from junk bonds were less volatile.
2. Why weren’t excess credit spreads on lower-grade bonds arbitraged away as the high yield market developed?
Even as the high yield market developed, many institutions were unable or unwilling to buy securities rated below investment grade, perhaps due to legal or investment restrictions.
Due to the attractive features of high-yield debt, for both issuers and investors alike, there had been a large surge after Drexel Burnham Lambert, and other underwriters popularized issuances of the securities. The excess credit spreads on lower-grade bonds weren’t arbitraged away as the high yield market developed due to the surge in new-issue volume in the second half of 1984.
3. How liquid was the secondary market for high-yield securities?
Historically, before the date of the case, the high-yield security market was relatively small and illiquid. This situation was primarily due to the fact that most high-yielding securities were from fallen angels and weren’t new issuances.
Additionally, before Milken pioneered the high-yield investment industry, most firms were…