Problem Statement Mr. Forsyth needs to convince Anchors board of directors for investing in high yield market.

There are many questions to be answered. For example, is the risk reward ratio proper in such case and if it proper, why very less investors have come forward. The other questions are related to volatility of return, liquidity of high yield securities in market. Now based on these factors, Mr.Forsyth needs to address how such securities fits in the portfolio of Anchor. Saving & Loan Institutions Saving & Loan Institutions also known as thrift institutions are basically in business of borrowing money from people in form of deposits and lending it to customers as housing loan. Thrift institutions are federally regulated by Federal Home Loan Bank Board(FHLBB) and they are insured by Federal Savings and Loan Insurance Corporation(FSLIC) , which insured deposits of upto $100000. S& L were heavily regulated by FHLBB and FSLIC. Issue with traditional thrift business was asset liability mismatch. Thirft generally had short term deposits by individual on their liability side while on their asset side they had long term mortgages. When in late 1970s interest rate started to rise, it created issues for thrift institutions as rates of deposits increased while long term fixed loan rates remained same. As interest rates rose in market depositors started taking out money from thrift institutions and invested money in some other assets as thrift institutions had interest rate ceil beyond which they could not pay interest on deposits. In early 1980s S&L industry was in crisis. Relaxation in government regulations was needed for survival of thrift institutions. Couple of acts was passed in 1982 to alleviate the plight of thrifts. Certain reforms in case of holding pattern and net worth level of liability were done in S&L industry. In couple of years after reform banks holding in mortgages and mortgage backed securities came down as percentage of total assets. These decreases in mortgages were invested in non traditional thrift assets. Some of the non traditional assets in which thrift institutions such as Anchor started investing in high yield bonds. Considering risks involved regulatory institutions such as FHLBB and FSLIC were considering imposing stringent diversification requirements on thrifts investments in low-grade corporate securities. In addition, members of both houses of Congress had introduced legislation prohibiting federally insured thrits from holding any security rated below investment grade. High Yield Bonds Credit rating agencies such as Moodys Investor Service and Standard & Poor provide investors with estimates of issuers ability to pay interest and principal as scheduled. Credit rating agencies rely heavily on measures of historical financial performance such as book debt to total capitalization, cash flow to debt, interest coverage ratio, etc while rating bond along with these parameters rating agencies also evaluate credit rating based

on qualitative factors such as market share, relative cost position, quality of management, etc. Below mentioned are credit ratings given by leading credit rating agencies.

As per above mentioned table, those issuers considered to have greater risk of defaulting on interest and principal are categorized under Below Investment Grade. There issuers must pay higher interest rates to attract investors to subscribe the bonds. Need of funds by Below Investment grade issuer from debt market gives rise to High Yield bonds. High Yield bonds were not issued before 1977, but at that time also some high yield bonds were present in market which were earlier issued by corporations with investment grade rating which gradually changed to junk bond rating. These junk bond did not attract investors which led to wide yield spread between high-grade and low-grade providing investors with yield premium in excess of those required to offset losses from default. Drexel Burnham Lambert in year 1977 developed techniques for analyzing the credit quality of low-grade issues. In 1977, DBL pioneered the underwriting of high yield securities for unseasoned or highly leveraged companies, which had traditionally relied on commercial band lending, private placements of debt, or equity issues for capital to finance their growth. High yield bond investment offer benefits coupled with risks. High yield bonds typically has low co-relation with investment grade bonds , which means adding high yield bond to bond portfolio will lead to diversification which in turn will decrease risk of portfolio, although investor is exposed to default risk when invested in high yield bonds. To encourage investment, high yield bonds offer higher return which will increase income of the portfolio. Capital appreciation is also high in case of high yield bonds in favorable market condition such as boom in economy or upgrade in credit rating, etc From a portfolio perspective, high yield investments fit into the space between equity and fixed income.

Saving & Loan Institutions Saving & Loan Institutions also known as thrift institutions are basically in business of borrowing money from people in form of deposits and lending it to customers as housing loan. Thrift institutions are federally regulated by Federal Home Loan Bank Board(FHLBB) and they are insured by Federal Savings and Loan Insurance Corporation(FSLIC) , which insured deposits of upto $100000. S& L were heavily regulated by FHLBB and FSLIC. Issue with traditional thrift business was asset liability mismatch. Thirft generally had short term deposits by individual on their liability side while on their asset side they had long term mortgages. When in late 1970s interest rate started to rise, it created issues for thrift institutions as rates of deposits increased while long term fixed loan rates remained same. As interest rates rose in market depositors started taking out money from thrift institutions and invested money in some other assets as thrift institutions had interest rate ceil beyond which they could not pay interest on deposits. In early 1980s S&L industry was in crisis. Relaxation in government regulations was needed for survival of thrift institutions. Couple of acts was passed in 1982 to alleviate the plight of thrifts. Certain reforms in case of holding pattern and net worth level of liability were done in S&L industry. In couple of years after reform banks holding in mortgages and mortgage backed securities came down as percentage of total assets. These decreases in mortgages were invested in non traditional thrift assets. Some of the non traditional assets in which thrift institutions such as Anchor started investing in high yield bonds. Considering risks involved regulatory institutions such as FHLBB and FSLIC were considering imposing stringent diversification requirements on thrifts investments in low-grade corporate securities. In addition, members of both houses of Congress had introduced legislation prohibiting federally insured thrits from holding any security rated below investment grade.

The Concept: Whats a Leveraged Buyout?

A Leveraged Buyout (LBO) is a financial set-up especially designed to enable an investor to acquire a company by financing the acquisition price by a large portion of debt. The large debt financing used under this investment structure allows the acquirer (generally a private equity fund along with the management) to put relatively little money on the table in the form of equity financing. He will then be in a position to make a significant capital gain by selling the company after a short period of time provided that the cash flows generated by this company during the LBO period are large enough to repay the initial debt.

This operation does not change the nature of the firms operating activities and only changes its capital structure by reducing the equity financing portion and increasing the debt financing portion. Case Reference: On June 21st, 1984, Metromedia was taken private by its management in a leveraged buyout transaction which was financed with $1.2 billion in bank debt, $125 million of preferred stock and $10 million of common stock. The proceeds of this financing were used to make cash payments to Metromedia shareholders and to provide working capital for operations. Metromedia would have required to sell a significant broadcasting asset by June 1985 in order to make a mandatory principal prepayment of $200 million. Thus, in October 1984, Metromedia announced that it planned to refinance its bank indebtedness by raising $1.3 billion in public offering which consisted of four securities designed by DBL. Security Zero Coupon Bonds 6 types of ZCB each maturing each year from 1988 to 1993 on December 1 Interest rate paid quarterly at a rate equal to the greatest of 1) 3month T-rate plus 375 bp 2) LIBOR plus 250bp 3) 107% of 10-year T-rate. Semi-annual payment with rate of 15 5/8% 13 1/8% of semi-annual payment till December 1, 1989, and 17% thereafter. Ranked last in the right of payment Features of Security Different yields and different investment horizon. Ranked equally with Senior indebtedness of MBC Had a embedded call option with call protection of 2 years. Until June 1, 1985, a minimum rate of 15% to be paid. Convertible to fixed rate debentures with an interest rate of 131% of 10-year T-rate. Embedded call option with call protection of 2 years. The premium on pre-redemption is 111.025% of par plus accrued interest Holders entitled to additional interest based on increases in companys participating operating cash flow, which was defined as net income before taxes and interest income, plus D&A and interest expense

Senior Exchangeable variable rate debentures

Senior-Subordinated debentures Adjustable-rate participating subordinated debenture

The following are the reasons for refinancing its bank debt 1) Metromedias cash interest expense over the succeeding four years was to equal 10.3% of the net proceeds of the offering, a reduction from 14.9% rate paid. 2) Tax deductable interest expense was to increase from a rate of 14.9% to an average of 15.4% of borrowing. 3) Defer all principal repayments, which would have totalled $290 million through 1988, until the first series of senior notes matured in 1988. 4) Release from numerous affirmative and negative covenants.

5) Metromedia would be free to borrow additional funds for its telecommunications and other activities.