In continuation of our discussion regarding the history of the junk bond market, we will talk about the junk bond refinancing and bridge loan. We will also dive into the disintegration of the junk bond market in the latter part of the 80s. Moreover, we will go through the LTV bankruptcy, the financing decline of 1989, and more.
Junk Bond Refinancing and Bridge Loans
All companies need initial capital when they do a cash acquisition. This is needed so they can pay the target company’s shareholders for their shares.
In times like these, companies may intend on utilizing high-yield bonds to bankroll the deal. However, there are instances when the seller might not want to replace its shares for the high-yield bonds that the buyer plans to issue.
So, how do they reach an arrangement? Well, the buyer can then enlist the services of its investment banker. The investment banker will then raise the short-term financing that the buyer requires.
Now, in times like these, the financing can come in the form of a bridge loan from the bank. In return, this loan can be “refinanced” at a later date. It can be refinanced through the issuance of high-yield bonds.
The Downturn of the Junk Bond Market in the 80s
Now that we have gone through how junk bond refinancing works, let’s discuss the collapse of the junk bond market in the late 80s. We all knew that the junk bond market had rapid growth in the mid-80s. However, the market would crash in the later years of that decade.
There were certain major events that caused this collapse. This includes the liquidation of the LTV Corporation. It also includes the bankruptcy of Integrated Resources. Additionally, there were also legal problems with regard to Michael Milken. More specifically, his investment bank, the Drexel Burnham Lambert.
We will deliberate more of this later on. First, let’s discuss the LTV Bankruptcy.
LTV Bankruptcy
In the year 1986, the flexibility of the junk bond market had doubts cast on it. This was the year when the LTV Corporation evaded the high-yield bonds that it had circulated in the years prior.
At the time, the company’s liquidation was the largest company bankruptcy on record. They represented 56% of the total liability defaulting in 1986.
According to Ma, Rao, and Peterson, this circumstance caused a brief six-month modification in the market’s contingency for default. This was as echoed by the risk-premium return on junk bonds and junk bond refinancing.
The market rebounded afterward, and this effect was transitory. According to the study by Ma, Rao, and Peterson, the junk bond market was resilient at the time. It was more than capable of withstanding the shock of a major default.
However, things weren’t over yet. There was more to come.
Financing Failures of 1989
If the junk bond market was resilient enough to withstand the bankruptcy of the LTV, it would later be put to another test.
The junk bond market was shocked once again, This was caused by the financing failures of 1989. The lack of success of other junk bond issuers was precisely related to exaggerated and overleveraged deals.
For instance, offerings by issuers swelled the market with increased supplies. Campeau Corporation was one of the largest issuers at the time.
In the first few months of 89, there was around $20 billion valuations of junk bonds presented. The same period the year before, there was only $9.2 billion offerings in junk bond refinancing.
Why did this happen? Well, issuers had to offer larger and larger rates to attract investors. This was the only way to get investors to buy risky securities.
The junk bond offering by Campeau Corporation was poorly received in 1988. Despite the fact that the offer provided 16% voucher premiums on 12-year bonds. They also offered a 17.75% voucher on 16-year bonds. This was managed by the First Boston Corporation. It was an investment bank.
However, in October that same year, the investment bank had to withdraw a $1.15 billion junk-bond offering. This was because investors demanded that the debt-laden concern’s guarantee failed to appear.
The bank’s response was to offer a $750 million that brought higher returns. Despite this large sum of money, however, the demand was still weak.
Now, more than ever, it was challenging to bid new high return bonds at the time. This was because of the absense of a capable, respectable secondary market.
More Contributing Factors
That was another assisting factor in the unraveling of the financing for the acquisition of the United Airlines in October of 1989. The market continued to refuse to respond even when reputable issuers presented 15% interest rates for an expected $475 million release in 1989. This event would later be famous as the “burning mattress”
The Default of Integrated Resources
In June of 1989, Integrated Resources defaulted. The company was built on junk bond refinancing. It was known as the most distinguished consumer of junk bonds amongst all insurance companies. In early 1990, the company submitted a filing for bankruptcy.
This event has sent shockwaves through a lot of institutional investors who had helped the junk bond market grow.
The Bankruptcy of Drexel Burnham Lambert
Now, let’s talk about the bankruptcy of the famous Drexel Burnham Lambert. In 1986, the investment bank reported an annual profit of $1 billion pre-tax.
However, in late 1988, no more than 2 years later, the bank pleaded guilty to criminal charges. They have compensated more than $40 million in levy.
A year later, the investment bank showed a loss of $40 million. They filed for bankruptcy because there was a liquidity crisis. This crisis was caused by the firm’s failure to pay short-term credit. They were also unable to pay for commercial paper funding that was overdue.
Usually, securities firms rely on short-term financing to bankroll their securities holdings. And Drexel Burnham Lambert was one of the major issuers. They were the primary issuer of more than $700 million in commercial paper.
In 1989, the commercial paper market declined. This has compelled Drexel to disburse more than $575 million. This money could not be refinanced through the issues of new monetary paper.
Later on, the commercial paper market closed. And because of this, Drexel’s liquidity was effectively wiped out.
Drexel wasn’t able to seek long-term junk bond refinancing. This was due to the fact that the junk bond market collapsed prior to the bank’s bankruptcy. Their only course of action was to file for Chapter 11 protection.
Hopefully this piece has helped you learn about junk bond refinancing and bridge loans. As well as the collapse and fall of the junk bond market. In the next article, we will discuss the post of junk bond analysis in the growth of the market in the fourth wave.
© Image credits to Julie Aagaard