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					Global Bond Markets

Chapter 19
Slides by: Pamela L. Hall, Western Washington University
Francis & Ibbotson Chapter 19: Global Bond Markets

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A Brief Tour of the Global Bond Market

By the end of 1998 the aggregate value
of all outstanding bonds in the world was $25.4 trillion
– About 50% were denominated in U.S. dollars – 15% were denominated in yen – 10% denominated in Deutschemark – 26% of world’s debt originated from Euroland in 1998
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The U.S. Bond Market

U.S. Treasury is the world’s single largest borrower—also has the most liquid market—an informal OTC market.

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U.S. Government Agency Bonds
 Federal government allows governmental agencies
to borrow in the name of the agency
– The agencies’ debts do not appear as part of the federal government’s debt
• However, federal government implicitly guarantees the agencies’ debts

 Federal National Mortgage Association (FNMA—
Fannie Mae) is the second largest borrower in U.S.
– GNMA (Ginnie Mae) and FHLMC (Freddie Mac) are also large borrowers
• Subsidize home ownership by issuing low interest rate bonds guaranteed by U.S. government

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Corporate Bonds in the U.S.
Market for corporate bonds is less liquid than
market for U.S. Treasuries
– IPOs for bonds are underwritten by investment banking firms

Largest organized secondary bond market is
NYSE
– Uses matrix prices for most of the bonds listed on its Automated Bond System (ABS)
• Based on price quotes for similar bonds (in terms of coupon rate, maturity, quality rating, call provisions)
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Corporate Bonds in the U.S.
Problems with ABS
– Does not provide a liquid market free from arbitrage opportunities – Large bond orders are difficult to execute
– OTC bond quotes are not meaningful
• Again, large orders are difficult to execute at the quoted price

Most U.S. corporate bonds trade OTC

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Bond Markets in the U.S.
Debt Issuers U.S. government Underwriter U.S. Treasury Investors Governments, pensions, commercial banks, insurance companies, mutual funds, foreigners, households Governments, pensions, commercial banks, insurance companies, mutual funds, foreigners, households

Federal government agencies

Investment banks

Municipalities

Commercial and investment banks

Governments, commercial banks, insurance companies, mutual funds, foreigners, households
Pensions, commercial banks, insurance companies, mutual funds, foreigners, households

U.S. government conducts regularly scheduled auctions for Treasury securities.

Corporations

Investment banks

Home buyers, commercial real estate developers Foreign governments Foreign corporations

Mortgage banks & pool operators Investment banks Investment banks

Pensions, commercial banks, insurance companies, REITs Pensions, mutual funds, foreigners, households Pensions, commercial banks, insurance companies, mutual funds, foreigners, households

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Bond Markets in the U.S.
 Transparency in a securities market exists when accurate price
and volume information is freely available

 Internet operations help increase the market’s transparency
– TradeWeb—allows institutional investors the ability to trade U.S. Treasury securities – Broker Tec—online interdealer bond brokerage – Trading Edge—operates a trade matching system for bonds – Bond Book—allows institutional investors and dealers to anonymously trade corporate, junk and municipal bonds

– U.S. bond market is not transparent

 Bond markets are never expected to enjoy the same
transparency and liquidity as U.S. stock markets

– There are  11,000 individual U.S. stocks vs.  4.5 million bond issues

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Sectors of the Industrialized World’s Bond Markets

In almost every country, the federal
government is that country’s largest debt issuer Corporate sector for Japan, Italy and Germany is relatively small compared to their overall bond markets
– Due to custom of borrowing from a bank vs. issuing bonds
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International Bonds
Represent a rapidly growing category International bond investors face two types
of political risk
– Repatriation-of-funds risk
• A government may block payments of principal or interest

– Reflects willingness of borrowers to borrow across borders

– Sovereign risk
• A government may refuse to honor its debts
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International Bonds
Can be organized into the following
categories
– Domestic bonds
• Issued by a local borrower and denominated in local currency

– Foreign bonds
• Issued in one country and denominated in that country’s currency by a bond issuer from another country

– Eurobonds
• Any bond not issued in a domestic market regardless of its currency denomination and the issuer’s nationality
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Foreign Bonds
Categories of foreign bonds
– Yankee bonds
• Issued by non-U.S. borrowers within the U.S.

– Samurai bonds
• Yen-denominated bonds issued in Japan by nonJapanese borrowers

– Shogun bonds
• Non-yen-denominated bonds issued in Japan by nonJapanese borrowers

– Bulldog bonds
• Issued by non-British borrowers in the U.K.— denominated in pounds
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Foreign Bonds
Yankee bonds are popular because
liquid markets in high quality corporate bonds are nonexistent in many countries
– Because governments encourage firms to borrow from banks rather than issuing bonds

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The Eurobond Market
Fastest growing, most diverse bond market Include the following bond types
– Fixed coupon bonds, floating rate bonds, zero coupon bonds – Renewable ordinary bonds – Ordinary bonds containing embedded options – Exchangeable floating rate notes – Convertible bonds – Bonds with warrants attached – Index-linked bonds – Dual currency bonds
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Primary and Secondary Markets for Eurobonds

Underwriting syndicates can be complex
– Management group—can have from 4 to 30 member firms – Assemble an underwriting group—ranging from 20 to 300 banks – A selling group is also created

Market’s untaxed and unregulated

• Three groups split underwriting fees—ranging from 1.25% to 2.5% of the value of issue

– Time schedule for issuing new bonds can be as short as six weeks
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Primary and Secondary Markets for Eurobonds

Eurobonds begin trading in the gray market
weeks before final offering price is set

Most Eurobonds are listed on the

– A forward market for bonds that do not yet exist

Luxembourg Stock Exchange, but they don’t actually trade there
– Most trades occur in the OTC market
• Similar to NASD but free from SEC-like regulation

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Bearer Bonds Vs. Registered Bonds

Registered bonds—send coupon
checks to registered bond owners Bearer bonds—have no list of registered owners
– Investor must submit a dated coupon to a bank to receive coupon payments
• Many Eurodollar bonds are of this type • Owner’s identity is unknown

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Eurodollar Bonds
 U.S. dollar denominated bonds
– – – – Issued as bearer bonds Underwritten by an international syndicate Issued and traded outside the jurisdiction of any single country Largest component of Eurobond market

 Who issues Eurodollar bonds?

– National governments and their agencies – Corporations
• Some countries with stringent regulations do not allow corporations to issue bonds similar to Eurodollar bonds in their country

 Investors & multinational issuers like the lack of regulation and
taxes
Francis & Ibbotson Chapter 19: Global Bond Markets

– Thus, these corporations issue Eurodollar bonds outside their country

18

Accrued Interest
Market price of bond (or its clean price) is:
Price bond  Coupon  Coupon 1 k  1 k 
1 1 2 2





Coupon 1 k 
T

T



Par 1 k 
T

T

Bonds pay coupon payments periodically When a bond is purchased on a day between
its scheduled interest payment, buyer must pay seller for accrued interest
issuer
Francis & Ibbotson Chapter 19: Global Bond Markets

Present Value of Coupon Payments

Present Value of Par

 Annually, semi-annually, quarterly, etc.

 Interest that has been earned but not yet paid by
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Accrued Interest
 Accrued interest calculation:
Accrued Interest Calculation 

 Coupon Payment 

  # of days since last coupon payment    # of days between scheduled coupon payment dates 

 Thus, the actual price for a bond is the bond’s clean
price plus the accrued interest

 U.S. newspapers quote clean prices




Known as the bond’s invoice price, full price or dirty price But buyers must pay the dirty price, which is always higher if bond is between coupon payment dates • However, difference is not substantial

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Dirty Bond Prices Experience an Ex-Coupon Price Drop-off

Some countries use different bond
invoicing methods
– Quote prices with accrued interest included (dirty prices)
• Called a cum coupon price • The quoted price will experience a drop-off in price immediately after a coupon payment is made
– Because accrued interest drops to zero

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Day Counting Conventions
The convention used in counting days
is important when calculating accrued interest
– Many countries use 360-day conventions
• Corresponds to twelve 30-day months

– U.K., Canada & Japan use 365-day convention

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Compounding Conventions
The length of time between coupon
payments impacts bonds’ yields and prices

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Yield-to-Maturity (YTM): A First Look
 A simple approximation of yield-to-maturity is:
Par - Current Price Years until maturity Non  compounded YTM  Coupon Rate  Current Price Rate of Cash Flow
Rate of price appreciation or depreciation

 Above formula does not involved compounding  Ignoring compounding will result in a YTM only a
few basis points different than the correct YTM



Used in Japan, but not in U.S.



But a few basis points can be thousands of dollars for a multi-million dollar bond transaction

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Compounded YTM
YTM defined as the discount rate
equating the present value of a bond’s future cash flows to its current market price
– For bonds paying coupon payments semiannually, the correct formula is:
Present Coupon1  2 Coupon 2  2    1 2 Value 1  YTM  2  1  YTM  2  

1  YTM  2 

Coupon 2T  2

T



Par 2T 1  YTM  2 

• The YTM is identical to IRR
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Compounded YTM
Another method for calculating YTM
– Effective YTM
• For a semi-annual coupon bond this method is:
Present Coupon1  2 Coupon 2  2    0.5 1 Value 1  EYTM  1  EYTM   Coupon T  2
2T

1  EYTM 



Par 2T 1  EYTM 

Cuts the years in half rather than the YTM.
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Example: Comparing a Bond’s Conventional and Effective YTM

Given information
– – – – Par value: $100 Coupon rate: 10% (semi-annual) Time to maturity: 10 years Purchase price: $106.59

Using the conventional YTM formula, we
calculate a YTM of 8.8973%
$106.59  $10  2
1

1  0.089873  2  1  0.089873  2 



$10  2
2





$10  2  $100

1  0.089873  2 

20

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Example: Comparing a Bond’s Conventional and Effective YTM
 Using the effective YTM (EYTM) formula, we
calculate an EYTM of 9.1892%
$106.59  $10  2

1.091892 

0.5



$10  2

1.091892 

1





$10  2  $100

1.091892 

20

 Difference is about 20 BPs  The difference between conventional YTM and
EYTM is


 

9.1892% - 8.9873% = 0.2019

(1 + EYTM) = (1+YTM/2)2 or YTM + YTM2/4 Or: 0.089873 + (0.089873)2/4 = 0.091892 or 9.1892%

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Comparing Various YTMs for a Bond
Many people think YTM is a very precise
measure
– YTM depends upon assumptions and techniques used – For example, a bond with a $100 par, a 10% coupon, a 10-year maturity and a current price of $106.59 can have several YTMs
• Conventional semi-annual: 8.9873% • Effective semi-annual: 9.1892% • Japanese semi-annual: 9.3187%

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Conditions Required to Earn a Bond’s Expected YTM

A bond’s computed YTM will only
actually be earned if:
– The bond is held to maturity – The bond issuer does not default in the timing or amount of scheduled payments – All the cash flows are immediately reinvested to earn the bond’s YTM

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Reinvestment Rate Affects A Bond’s YTM
 Different reinvestment rates impact the investor's
actual rate of return
– Example: An investor buying an 8% coupon bond at par will expect a YTM of 8%
• However, his actual return hinges on the reinvestment rate earned on the coupon income received
Reinvestment Rate 0% 5 Total Realized Yield 4.84% 6.64

6
7 8

7.07
7.53 8.00

Only if the reinvestment rate = YTM will the investor actually realize the YTM.

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A Bond’s Holding Period Return
An investor’s holding period return (r)
is:
r Price change  Cash Flow Price beginning of holding period 

 P1  P0   CF
P0

Can be positive, negative or zero
holding period

 Depends on how the price moved over the
• A bond’s price movements are determined by
fluctuations in the bond’s YTM

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Inverse Relationship Between a Bond’s Price and YTM
 The price and YTM of a bond move inversely

NOTE: Price-yield curves are convex to the origin.

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Other Measures of Bonds’ Yields
Yield-to-call (YTC)
– A bond issuer may call a bond before its original maturity date
• Need to calculate the bond’s YTC
– Similar to YTM, except replace T as the time-tocall rather than time-to-maturity

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Example: Comparing a Callable Bond’s YTC & YTM
 Given information
– – – – – Par value: $10,000 Time to maturity: 10 years Coupon rate: 7% (3.5% semi-annually) Current price: $8,140.32 Call premium: 7% in 5 years (meaning the bond is callable at 107% of par in 5 years)
20

 Compute the YTM: $175 $10, 000 $8,140.32    1.03 1.03  Compute the YTC:
t 1 t 20

or YTM = 6% a year

$8,140.32  
t 1

10

$175 1.04686

 t

$10, 000 1.07 1.04686
10

or YTM = 9.373% a year

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Other Measures of Bond’s Yields
Floaters
– A bond with a fixed par but a fluctuating (or floating) interest rate
• Rate varies according to a specified reference rate

Current yield—every non-zero bond has a
positive current yield
Current Yield 

– LIBOR or U.S. T-bill rates are commonly used

 Investors desiring high investment cash flows are
interested in a bond’s current yield
Francis & Ibbotson Chapter 19: Global Bond Markets

Annual coupon $ interest Current price of bond

36

Brady Bonds Aid Emerging Countries
An international debt crisis occurred in late
1980s due to falling commodity prices and recessions
– Many loans were defaulting ($200 billion)
• Mostly from Latin America

Debt banks created Paris Club organization
– Also organized a secondary market for the nonperforming bank loans
• Typically priced at less than half original face value
Francis & Ibbotson Chapter 19: Global Bond Markets

– Many emerging countries vanished from international financial markets

37

Brady Bonds Aid Emerging Countries
In 1989 the U.S. Secretary of Treasury,
Nicholas Brady proposed the Brady Plan
– Provided a way to finance the defaulted loans until they could be paid off
• Emerging country must get an economic reform plan approved and obtain loans through International Monetary Fund and World Bank or elsewhere
– Development banks established repayment plans » Made the defaulted debt marketable by guaranteeing repayments » Allowed troubled banks to exchange illiquid defaulted bank loans for liquid Brady bonds
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Brady Bonds Aid Emerging Countries

No Brady bonds are 100% guaranteed Types of Brady bonds
– Most popular
• Discount bonds (AKA: principal-reduction bonds)
– Issued at a deep discount from par

• Par bond (AKA: interest-reduction bond)
– Face value equals par value of defaulted debts » Debt reduction occurs by setting coupon rate below current market rate
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Brady Bonds Aid Emerging Countries
Less popular Brady bonds
– Debt-conversion bonds (DCBs) and new-money bonds (NMBs)
• Each dollar invested in NMBs can be converted into a larger amount of more desirable DCBs

– Front-loaded interest-reduction bonds (FLIRBs)
• Pay low coupon rates during early years but coupon rate increases over time

– Past-due interest bonds (PDIs)
• Issued to pay for past omitted interest payments

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Brady Bonds Aid Emerging Countries
Outcome of the Brady Plan
– Emerging nations able to settle defaulted debt at a reduced cost – Reduced debt allowed countries to renew economic growth – Troubled countries able to regain access to capital markets – Too costly
• Developed nations finance the development banks

Critics of Brady Plan argue

– Subsidizes financial mismanagement
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International Bond Index Statistics
U.S. $ U.K. Pound Hong Kong $ German Mark

Return
Australia Belgium Canada 8.5% 11.6 9.3

SD
15.5% 17.2 10.4

Return
9.9% 13.0 10.7

SD
18.3% 14.7 19.3

Return
9.5% 12.7 10.3

SD
16.4% 16.2 13.2

Return
5.0% 8.1 5.8

SD
20.2% 8.6 17.0

France
Germany No single bond investment appears to be the most or least risky. Japan Netherlands

10.8
12.0 12.2 11.7

15.6
14.9 17.5 14.2

12.2
13.4 13.7 13.1

15.3
16.7 18.4 15.8

11.8
13.0 13.3 12.7

15.6
13.4 18.3 14.0

7.2
8.4 8.7 8.1

12.2
8.4 17.3 8.2

Switzerland
U.K. U.S.

10.2
10.2 9.3

17.1
22.3 12.2

11.6
11.6 10.6

16.8
17.2 21.3

11.2
11.6 10.3

16.0
17.2 14.7

6.7
11.3 5.8

9.8
23.4 16.8

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Components of International Bond Returns
Capital Appreciation Australia
Belgium Canada

Income Return 10.4%
9.1 9.6

Currency Return -1.3%
1.6 -0.9

Total Return (US$) 8.5%
11.6 9.3
Returns are from the standpoint of a U.S. investor.
Results suggest investor needs to analyze all three components.

-1.2%
0.3 0.1

France Germany
Italy Japan

0.3 0.5
0.1 1.0

9.7 7.6
12.2 6.4

0.3 3.2
-3.3 4.1

10.8 12.0
9.5 12.2

Netherlands Switzerland
UK US
Francis & Ibbotson

0.3 0.4
0.2 0.4

8.0 5.0
11.0 8.4

2.7 4.2
-1.3 N/A

11.7 10.2
10.2 9.3

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Correlations of International Bond Returns
Aus’l A’str Belg Can Fra Ger Ire Ita Jap Net NZ Safr Swi UK US

Australia

1.00

Austria
Belgium Canada France Germany Ireland Italy Japan Netherlands

0.22
0.20 0.28 0.20 0.20 0.24 0.17 0.19 0.21

1.00
0.86 0.22 0.82 0.91 0.59 0.50 0.59 0.88 1.00 0.25 0.82 0.86 0.60 0.47 0.59 0.83 1.00 0.25 0.28 0.27 0.22 0.26 0.30 1.00 0.82 0.59 0.52 0.57 0.83 1.00 0.61 0.47 0.59 0.93

High correlations result from: •Bilateral trade agreements •Policies to align currencies •Cultural similarities

1.00 0.46 0.45 0.57 1.00 0.33 0.47 1.00 0.59 1.00

New Zealand
South Africa

0.32
0.21

0.26
0.39

0.27
0.35

0.07
0.06

0.24
0.34

0.23
0.37

0.24
0.29

0.21
0.26

0.23
0.25

0.26
0.34

1.00
0.14 1.00

Switzerland
UK US

0.18
0.23 0.16

0.82
0.43 0.18

0.77
0.46 0.22

0.24
0.30 0.67

0.75
0.45 0.24

0.83
0.47 0.26

0.56
0.74 0.23

0.39
0.34 0.18

0.61
0.40 0.21

0.82
0.46 0.29

0.18
0.23
-0.05

0.31
0.23 0.05

1.00
0.42 0.24 1.00 0.21 1.00

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Correlations of International Bond Returns

What’s important is the fact that there are
some relatively low correlations among international bond returns resulting from
– – – – – Dynamics of business cycles within countries Different monetary policies Different government financing practices Differing inflation levels Social trends, foreign policies ad political forces

Correlations are unstable over time
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Markowitz Analysis of International Bond Portfolio

U.S. investor can achieve a dominant position by investing 40% of portfolio in non-U.S. bonds.

Caveats: • Based on historical data—no guarantee future will be the same • Ignores commissions and other expenses

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Actively Managing International Bond Investments
 Active international bond investors can use different
approaches:
– Political analysts begin with a top-down approach and analyze sovereign risks, etc. – Macro-economists study macro factors (income, employment, etc.) to determine which nations are economically strong – Monetary economists forecast a nation’s level and structure of market interest rates by analyzing central bank and their policies, etc. – Industry analysts analyze financial data from different industries – Security analysts have a bottom-up approach—focus on bond issuer’s financial conditions, protective provisions, etc.
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The Bottom Line
 Governments are the largest borrowers in the world  Most rapid growth occurring in Eurobond market  Some countries publish clean bond prices while
others publish dirty prices which includes accrued interest  Day counting conventions differ across countries  YTM calculations methods also differ across countries
– Unregulated and untaxed

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The Bottom Line
If a bond’s cash flows are not invested
at the bond’s YTM the investor will not earn the YTM Other yield measures exist
– Holding period return – Current yield – Yield to call

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The Bottom Line
Brady Plan generated an array of packages of
defaulted bank loans from emerging countries Investors need to analyze capital appreciation, coupon interest return and foreign exchange return when considering investments in international bonds Markowitz portfolio analysis is applicable for international bond investing
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