W
hen businesses need to raise money, they can do so in two ways (assuming that raising money through profits is not possible).They can sell off equity (for instance, in an IPO or a secondary offering, or a PIPE transaction), or they can borrow money by selling bonds. The interest rate on the bond is determined by a variety of factors, the most important two being what the federally imposed discount rate is and what rating the ratings agencies such as Moody’s and Standard &
Poor’s have assigned the company.
The discount rate is important for the following reason: If I can get a yield of, say, five percent from treasuries and I know this is risk-free unless the government defaults, then a corporation with presumably more risk than the U.S. government better be paying me substantially more than five percent for me to take on that risk.
The rating from the ratings agencies is also fairly important. Moody’s and Standard & Poor’s, in general, do enough due diligence on every com- pany in order to determine the relative safety between the bonds of differ- ent corporations. If a company is rated AAA (for example, Berkshire Hathaway), then I have a high degree of comfort that I will be paid back if I loan them money. (Hence, when Berkshire Hathaway issued its SQUARZ bonds in May 2002, it actually had a negative yield. The yield was a func- tion of the historic lows on federal interest rates, the extreme safety of
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Berkshire as determined by the ratings agencies, and the fact that the bond was actually a convertible, so it had extra features other than the yield. This bond is the first, and at the time of this writing, the only, example of a bond with a negative yield). If a company is rated in junk territory, B−or below, then the interest rate needs to be high enough to compensate the bond- holder for that additional risk.
Although bonds are rated by the agencies, once they are issued, the mar- ket sets the price and yield. As with any other securities, the twin forces of greed and fear in the bond market will often send prices to one extreme or other. In 2002, for instance, after the bankruptcy of Enron, many of its bonds went straight to zero. As a result, many investors had no idea what shoe would drop next and ended up selling the corporate bonds of many energy companies en masse, even somewhat stable ones. Similarly, when the prices of Internet stocks were falling up to 99 percent, the bonds also were in a freefall and some corporate debt was yielding up to 20 percent or more.
When Buffett analyzes junk bonds, he doesn’t care as much if the com- pany has a stable and consistent ROE or earnings. All he wants to know is, Can the company generate enough cash to pay him back?
In the 2002 annual Berkshire Hathaway letter, Buffett comments:
[Junk bonds] are not, we should emphasize, suitable investments for the general public, because too often these securities live up to their name. We have neverpurchased a newly issued junk bond, which is the only kind most investors are urged to buy. When losses occur in this field, furthermore, they are often disastrous: Many issues end up a small fraction of their original offering price and some become entirely worthless.
There are a couple of interesting points in these four sentences. First,
“often these securities live up to their name.” In other words, the market is usually efficient. If the market is telling us that these bonds are junk, then chances are they are junk. This is not to say that they will not pay their exorbitant yields, but the risk is commensurate with the payoff and there is no additional margin of safety.
Furthermore, the fact that Buffett has never purchased a newly issued junk bond is telling. Many people do purchase such issues. In fact, Wall Street would almost cease to exist if people stopped purchasing such issues. But Buffett has determined there is essentially zero edge to buying
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into an issue that Wall Street right from the start is labeling as “distressed”
enough to be paying a junk rate yet in demand enough that many investors are clamoring to pay those rates. Chances are, he figures, the rates are not high enough at the moment of issuance and he would prefer to wait.
However, Buffett goes on to say in the same annual letter: “Despite these dangers, we periodically find a few—a veryfew—junk securities that are interesting to us. And, so far, our 50-year experience in distressed debt has proven rewarding.” There is an important reason why it is only the
“very few” that appeal to Buffett. A bond, unlike a growing company, has a maximum value it can return to the investor: the face value plus all of the coupons of the bond. A business, on the other hand, can keep growing forever—there is no cap on the maximum return of a business. Neverthe- less, in extreme cases, the returns of a bond can exceed the hoped-for returns, in the short-term, of even the best businesses.
For instance, in 1983, the Washington Public Power Supply System (WPPSS) was involved in five building projects. Two of these, Projects 4 and 5, were building nuclear reactors. It was these projects that turned into a $2.25 billion default for WPPSS when it had to abandon the projects after a state ruling that threw into question who would pay for the energy that is produced if it is no longer needed. However, although Projects 1, 2, and 3 had “material differences in the obligors, promises, and properties underlying the two categories of bonds, the problems of Projects 4 and 5 have cast a major cloud over Projects 1, 2, and 3” (from the Berkshire Hath- away 1984 annual letter). This cloud sent the bonds issued to pay for these projects down to 40 cents on the dollar and yielding an average of 16 per- cent. Buffett bought $139 million of the bonds.
The question was: Is the potential reward worth the risk inherent in buying $139 million of the bonds? Buffett knew that there is a ceiling to the amount he could get back: the coupons plus the initial face value of the bonds. Buffett also realized that these bonds might be worth zero if he did not analyze the risks of the defaults on Projects 4 and 5 carefully enough.
Would it be better, for instance, for him to buy a business for $139 million?
However, he states:
In the case of WPPSS, the “business” contractually earns $22.7 mil- lion after tax (via the interest paid on the bonds), and those earnings are available to us currently in cash. We are unable to buy operating
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businesses with economics close to these. Only a relatively few busi- nesses earn the 16.3 percent after tax on unleveraged capital that our WPPSS investment does and those businesses, when available for purchase, sell at large premiums to that capital.
Viewing the investment in the context of “Should I buy a bond or an operating business?” allows the investor to avoid many mistakes that bond investors have made in the past. Buffett points out the example of AAA tax- exempt bonds in 1946:
In effect, the buyer of those bonds at that time bought a ‘business’ that earned about one percent on “book value” (and that, moreover, could never earn a dime more than one percent on book), and paid 100 cents on the dollar for that abominable business. This was during a period of substantial post-war growth when businesses were earning up to 15 percent on their book value.
Additionally, in that 1984 letter to Berkshire shareholders, Buffett stated another interesting factor in his decision on the WPPSS bonds. He noted that these bonds were not long-term, and the risk of runaway infla- tion in the future makes him hesitant to ever purchase a long-term bond.
This theme remained with Buffett until the present day, when the fear of inflation has even compelled him to make, for the first time ever, substan- tial investments in foreign currencies.
There is a similarity between the WPPSS bonds and the next junk bonds that Buffett mentions in his annual letters: The RJR Nabisco bonds.
In both cases, the sell-off on the bonds was not directly related to faltering economics in the business.
RJR Nabisco was the target in the famous takeover engineered by leveraged-buyout shop KKR and made famous in the book and subsequent movie, “Barbarians at the Gates.” In order to pay for the takeover, KKR had to issue junk bonds backed up by RJR’s cash flow. If KKR had made a mis- take in how they valued the cash flows prior to the takeover, or the busi- ness faltered for whatever reason, then the potential for full payment on those junk bonds could become suspect.
However, RJR was performing fine as a business. The real issue was the blowup in general of the high-yield market. With the demise of Michael
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Milken and Drexel, the credibility of all high-yield bonds came into ques- tion. And for good reason. As Buffett noted in the 1990 letter to Berkshire Hathaway shareholders:
In some cases, so much debt was issued that even highly favorable business results could not produce the funds to service it. One par- ticularly egregious “kill-’em-at-birth” case a few years back involved the purchase of a mature television station in Tampa, bought with so much debt that the interest on it exceeded the station’s gross rev- enues. Even if you assume that all labor, programs, and services were donated rather than purchased, this capital structure required revenues to explode—or else the station was doomed to go broke.
With issuances like that, which were being quickly bought up and devoured by savings and loans institutions that would soon be bankrupt, it is no wonder that investors decided to throw out the baby with the bathwa- ter and sell off all high-yield instruments they could find in their portfolios.
This explains the sell-off in RJR bonds. Buffett, having dealt with KKR before (see the Arcata example in Chapter 5 on merger arbitrage), deter- mined that the cash flows on RJR were sufficient to pay off the bonds and bought up to $440 million of the bonds during late 1989. In 1991 RJR announced that it was retiring the bonds and paid off the full face value of the bonds, rendering Berkshire a healthy profit of $150 million.
As seen in Chapter 7, Buffett’s interest in high yield extended to not only purchasing discounted bonds on the open market, but buying them in the form of convertible preferreds directly from the company. This gave him the added one-two punch of getting not only the benefits of the high yield, but removing the problem of having the ceiling on his potential return by allowing him to convert into equity at a later date.
In the tech and energy company sell-off of 2001 and 2002, Buffett again dipped into the high-yield market on several occasions.
For instance, in late 2002, Buffett began buying up debt in telecom company Nextel. Nextel’s stock had fallen 95 percent from its peak in 2000 to its low in 2002; in 2002, it was even flirting with possible bankruptcy. In response, it used cash flow to retire up to $3.2 billion in debt and slashed 5,300 jobs in an attempt to cut costs. For 2002, Nextel posted a $1.4 billion profit, its first profit in 15 years. However, the combination of the recession
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and Nextel’s prior problems still had the rating agencies ranking the com- pany’s debt as junk. In this environment, when interest rates were also being cut down to 50-year lows, Buffett was able to buy up $500 million of Nextel’s bonds.
In early 2003, the markets were reeling in anticipation of the war in Iraq and the uncertainty that would come with it. At the same time, Buffett was coolly buying $100 million worth of Amazon.com bonds yielding 10 percent in anticipation that they would be called back by the company within a month—with the $1.3 billion in cash and marketable securities that the company had on hand. The company did redeem the bonds, giving Buffett a 22 percent annualized return for his efforts at relatively low risk.
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149 C H A P T E R 9