CP

176 CHAPTER 4 Bonds and Their Valuation

flexibility, and improved financial profile.”^17 However, S&P also reported that Xerox

Corporation’s senior unsecured debt had been downgraded from a BBBto a BB

due to expectations of lower operating income in 2001 and 2002.

Junk Bonds

Prior to the 1980s, fixed-income investors such as pension funds and insurance com-

panies were generally unwilling to buy risky bonds, so it was almost impossible for

risky companies to raise capital in the public bond markets. Then, in the late 1970s,

Michael Milken of the investment banking firm Drexel Burnham Lambert, relying on

historical studies that showed that risky bonds yielded more than enough to compen-

sate for their risk, began to convince institutional investors of the merits of purchasing

risky debt. Thus was born the “junk bond,” a high-risk, high-yield bond issued to fi-

nance a leveraged buyout, a merger, or a troubled company.^18 For example, Public

FIGURE 4-5 Relationship between Bond Ratings and Bond Yields, 1963 and 2001

Long-Term Risk Premiums

Government

Bonds AAA Corporate BBB Corporate

(Default-Free) Bonds Bonds AAA BBB

(1) (2) (3) (4) 
(2) (1) (5) 
(3) (1)

June 1963 4.0% 4.2% 4.8% 0.2% 0.8%

August 2001 5.5 7.0 8.0 1.5 2.5

RPAAA
risk premium on AAA bonds.

RPBBB
risk premium on BBB bonds.

Source:Federal Reserve Bulletin,December 1963, and Federal Reserve Statistical Release, Selected Interest Rates, Historical Data, August, 2001:

http://www.federalreserve.gov/releases.

U.S. AAA BBB

Treasury

Bonds

Bond Ratings

Rate of Return

(%)

1963

4.0

6.0

5.0

7.0

8.0

RPBBB= 2.5%

RPAAA= 1.5%

2001

RPAAA= 0.2%

RPBBB= 0.8%

9.0

(^17) See the Standard & Poor’s web site for this and other changes in ratings:
http://www.standardandpoors.com/RatingsActions/RatingsNews/CorporateFinance/index.html.
(^18) Another type of junk bond is one that was highly rated when it was issued but whose rating has fallen be-
cause the issuing corporation has fallen on hard times. Such bonds are called “fallen angels.”

172 Bonds and Their Valuation