NEWSWIRE - APRIL 24, 1998

Topic: Junk Bond Financing

Source: "Level 3 Sells Junk Bonds of $2 Billion," by Gregory Zuckerman, Wall Street Journal, Friday, April 24, 1998, page C1.

Synopsis of Article: Last week, a small Nebraska telecommunications firm went to market with $1.5 billion in junk bonds but quickly increased the offering to $2 billion due to strong investor interest. This is the largest non-investment grade issue in the 1990s and it indicates that junk bonds are a significant source of long term financing for small, growth oriented corporations. In fact, high-yield bond issues are being issued at nearly twice the rate of one year ago with a total of $53.7 billion sold since the beginning of the year.

Level 3 (LVLT) is modest sized telecommunications (about $9 billion market capitalization, $3 billion in assets) that develops communications networks using fiber optics and other technologies in the U.S. and Europe. The firm intends to use the proceeds of the issue to expand operations. The 10-year senior, unsecured notes were rated B by S&P and B-3 by Moody's. They sold at par with a coupon (and yield to maturity) of 9.19%. This is 3.50% higher than 10-year U.S. Treasury notes.

While these bonds are clearly speculative, it appears investors are willing to accept the risk to achieve returns well above safer securities. The article mentions that default rates among outstanding junk bond issues over the past year is at 2.2%, well under the long term rate of 3.8%. It also compares the 3.50% spread over Treasuries with an average differential of 4.50% in the 1990s.

Questions:

1. What is a "junk", or high yield bond? What is the differential, or spread between the Level 3 notes and a default-free U.S. Treasury security of the same maturity? In general, what causes this spread to narrow or widen over time?

2. What financial ratios will investors in these notes monitor most closely? How will changes in these ratios influence the value of the notes?

3. Why didn't Level 3 issue convertible bonds instead? Discuss the pros and cons of this alternative method of financing.