A Bond By Any Other Name
Whether you call them "high-yield," "low-rated," or just plain "junk" bonds, a lot of companies are finding there is nothing shoddy about public market debt.
In the spring of 1982, us bank interest rates hovered at around 17%, Kevork Hovnanian, a New Jersey-based real estate developer, began searching for long-term financing that would let his company plan future projects without having to beg banks for more and more short-term loans. Hovnanian Enterprises Inc., the $70-million, private company he had founded in the late 1960s, was borrowing some $30 million from commercial banks -- about three times its current equity. The money was being used to finance construction of more than 1,000 condominium units in southern New Jersey and Florida. But there was hardly any breathing room in the way the financing worked. For each dollar Hovnanian Enterprises borrowed, bankers asked it to pledge specific real estate and property as collateral. And Hovnanian himself, as the owner, was required to sign personal guarantees for every loan. All of the debts had to be paid back in two years or less.
The millions of dollars of secured bank debt had met the company's financial needs for years. But the requirements of the growth-minded developer were changing dramatically. "We had reached a where we wanted to be able to do the engineering and approval work for several prospective projects at once," Hovnanian notes. Ground breaking for future condo developments is sometimes a year or two after the project begins, "but we needed to be able to expand our operations and cover all those planning expenses," he says. "We needed long-term money, but we had almost no security to offer a lender. Everything we owned was committed to the banks as collateral for current projects."
While an obvious financing option might have been to sell a piece of the company's equity in an initial public offering, the depressed stock market of early 1982 had made that strategy both difficult and unappealing. "I wasn't prepared to give away part of the company," Hovnanian says. "The price would have been too low." Selling long-term debt privately to a large insurance company -- another possible route -- had similar drawbacks. With no assets to secure, "an institution would have wanted some equity. And I didn't want a partner," he explains.
The long-term financing option Hovnanian ended up choosing, however, didn't require him to give up any equity at all. Nor would it require him to put up any specific collateral or limit its ability to do other types of financings in the future. Instead, Hovnanian Enterprises opted to make its public-market debut in an unusual way. Hovnanian elected to raise $25 million of long-term capital by selling his company's bonds in the public market. Hovnanian Enterprises would remain a closely held business controlled by its founder, although it would have to report financial data to the public (see sidebar, page 78). But its 12-year bonds -- subordinated to all other debt -- would be sold to mutual funds and other diversified portfolio managers. In particular, the targeted buyers would be specialists that had lately been demonstrating a voracious appetite for the higher yields paid by smaller and lower-rated companies. In the jargon of the investment world Hovnanian Enterprises would be selling "junk bonds."
By issuing its bonds to the public, the company would have little chance of appealing to investors that insisted upon the sterling credit strength of an IBM or an AT&T -- corporations that held the highest AAA ratings of Moody's and Standard & Poor's, the established rating agencies. But it really wouldn't matter. In the diverse financial marketplace, an increasing number of other buyers had surfaced that were willing to assume higher levels of risk on their investments in exchange for the chance to earn returns of three to five percentage points higher than they usually would. At a time when many high-quality issues were being snubbed, junk-bond investors were snapping up the bonds of lowrated companies just as unknown as, and sometimes even smaller than, Hovnanian Enterprises. What is more, Kevork Hovnanian had learned from Drexel Burnham Lambert Inc., his investment banker, that not every company selling long-term debt had publicly traded stock. "We wanted the long-term money," he recalls. "And it seemed like an idea worth pursuing."
As intriguing as the approach had sounded, it also brought results. In May 1982, Hovnanian accompanied his investment bankers on a six-city tour to meet some of the nation's leading institutional buyers of junk bonds. At meetings in Los Angeles, Kansas City, Chicago, Boston, Philadelphia, and New York, the Iraq-born condominium developer described his company's niche at the moderate end of the New Jersey and Florida housing markets. "We showed off our numbers," Hovnanian recalls. "And we talked about how we keep our inventory lower than most everybody in our industry."
Evidently, the investors liked what they heard. Within a few days, Hovnanian Enterprises had raised its $25 million at an interest rate of 16 7/8%, about 4 percentage points less than it was paying on its shortterm bank loans. To qualify for its comparatively low cost of borrowing, the highly leveraged company offered bond buyers a sweetener of 3% of its pretax earnings, over and above the established interest rate. But to achieve maximum flexibility to pursue long-range expansion, Hovnanian Enterprises wasn't required to make any principal payments on the new debt for several years. Moreover, because the new debt was to be subordinate to the company's existing short-term loans, it provided a welcome layer of comfort to the banks that was almost like a new shot of equity. With the proceeds, in fact, Hovnanian Enterprises was able to pay off a lot of its bank loans. "It placed us in a much stronger financial position," Hovnanian, who is now 60, asserts. "It was a major milestone in the growth of the company."
