Saturday, November 15, 2008

The Warren Buffett Way: Chp 6 Part 2: Fixed-Income Marketable Securities

RJR Nabisco Bonds:

High-yield bonds were introduced as a financial product innovation in the 1980's. Buffett makes an important distinction between "fallen angel" bonds and high-yield "junk" bonds. According to Buffett, "fallen angel bonds are investment grade bonds that have fallen on bad times whereas the new high-yield bonds, were junk before they were issued".

Wall Street salespeople were able to sell the new high-yield bonds based on historical research that showed that higher bond yields compensated investors for the accepting the higher investment risk. Buffett warned investors that the yield history that salespersons were quoting was for fallen angel bonds and is an entirely different situation than what is being inferred for the junk bonds.

There was a lot of junk bonds being sold in the 1980's. Buffett observed that "mountains of junk bonds were being sold by those who didn't care to those who didn't think". Problems started cropping up in the later 1980's with firms that were financed using junk bonds. Companies started defaulting on their bonds and by 1989, junk bonds were largely out of favor in the market.

As the junk bond market unravelled, Buffett noticed that RJR Nabisco's bonds were declining with others in the market. Unlike many other companies that had issued high yield bonds at the time, RJR Nabisco was meeting its financial obligations. Buffett thought that RJR's bonds were being overly punished in the markets. RJR was selling parts of its business and was successfully lowering its debt-to-capital ratio, thereby reducing its financial risk.

Berkshire bought $440 million worth of discounted RJR bonds in 1989 to 1990. In early 1991, RJR Nabisco announced it was retiring its high-yield bonds and Berkshire turned a profit of $150 million on the investment.

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