146 THE WARREN BUFFETT WAY
led buyout that was to be f inanced with high-yield bonds, announced
that it was unable to obtain f inancing. Arbitrageurs sold their UAL com-
mon stock position, and the Dow Jones Industrial Average dropped 190
points in one day.
The disappointment over the UAL deal, coupled with the losses in
Southmark and Integrated Resources, led many investors to question
the value of high-yield bonds. Portfolio managers began dumping
their junk bond positions. Without any buyers, the price for high-
yield bonds plummeted. After beginning the year with outstanding
gains, Merrill Lynch’s index of high-yield bonds returned a paltry 4.2
percent compared with the 14.2 percent returns of investment-grade
bonds. By the end of 1989, junk bonds were deeply out of favor with
the market.
A year earlier, Kohlberg Kravis & Roberts had succeeded in pur-
chasing RJR Nabisco for $25 billion f inanced principally with bank
debt and junk bonds. Although RJR Nabisco was meeting its f inancial
obligations, when the junk bond market unraveled, RJR bonds de-
clined along with other junk bonds. In 1989 and 1990, during the junk
bond bear market, Buffett began purchasing RJR bonds.
Most junk bonds continued to look unattractive during this time, but
Buffett f igured RJR Nabisco was unjustly punished. The company’s sta-
ble products were generating enough cash f low to cover its debt pay-
ments. Additionally, RJR Nabisco had been successful in selling portions
of its business at very attractive prices, thereby reducing its debt-to-
equity ratio. Buffett analyzed the risks of investing in RJR and concluded
that the company’s credit was higher than perceived by other investors
who were selling their bonds. RJR bonds were yielding 14.4 percent (a
businesslike return), and the depressed price offered the potential for cap-
ital gains.
So, between 1989 and 1990, Buffett acquired $440 million in dis-
counted RJR bonds. In the spring of 1991, RJR Nabisco announced it
was retiring most of its junk bonds by redeeming them at face value. The
RJR bonds rose 34 percent, producing a $150 million capital gain for
Berkshire Hathaway.
Level 3 Communications
In 2002, Buffett bought up large bundles of other high-yield corporate
bonds, increasing his holdings in these securities sixfold to $8.3 billion.