International Bond Market Dr. Chen, Jo-Hui The structure of this topic A. Introduction B. Mechanics of Foreign Bonds C. Dynamics of Eurobonds D. Secondary Trading E. Clearing systems F. Bonds and International Portfolio Diversification A. Introduction International bond transactions have played a colorful and important role in the development of international economic and political relations. Creditor nations such as the Netherlands in the 17th century, Britain in the 18th century, and Germany and France prior to World War I had well-developed arrangements for direct loans and bonds, many of which were exchange listed and traded. Foreign lending through debt issues often helped to finance a war, and an absence of funding sometimes helped to end one. Foreign lending financed national expansion (such as America’s Louisiana purchase from France) and national economic development (such as the building of canals and railroads). A. Introduction Since the start of the 20th century, international bond markets have been confronted by wars, depressions, recessions, and crises. Over the last two decades, however, these markets have enjoyed a fairly sustained relaxation of the policy-induced barriers to the international flow of capital. Fewer restrictions on foreign capital outflows and a lower incidence of withholding taxes on interest payments to foreigners are two examples of this trend. The popularity of deficit financing among governments also has contributed to the large supply of government bonds for investors to consider. Finally, the technological and institutional changes of the last decade have greatly facilitated the development of international bond markets. A. Introduction As Figure shows, national bond markets have grown rapidly over the last decade. The total market size—measured as the market value of bonds outstanding—grew from under $4 trillion in 1981 to $22.8 trillion in 1995. 25 ● ● 20 ● Trillions of US＄ ● 15 ● ● ● ● 10 ● 39.3% ● 42.2% ● ● ● ● 40.9% ● ● ● ● 40.2% 43.3% ● 42.0% 39.2% 5 ● ● ● ● 42.7% 45.0% 50.6% 46.4% ● ● ● 40.5% ● ● ● ● 43.5% 42.0% 43.3% 0 1981 1983 1985 1987 1989 1991 1993 1995 1982 1984 1986 1988 1990 1992 1994 Year ● Global Total ● U.S. Market A. Introduction 1. Definition and Importance (a) Foreign Bonds: Issued in a domestic bond market by a nonresident borrower and are denominated in the local currency of that bond market. An American corporation may sell a Swiss franc denominated issue in the Swiss foreign bond market. These bonds will be underwritten by a primarily Swiss syndicate (investment bank), and financial institutions located in Switzerland will purchase the bonds. A. Introduction 1. Definition and Importance b) Eurobonds: The Eurobond market is the market for long-term debt instruments issued and traded in the offshore market. Issued in one or more foreign countries but currency denominations are other than that of the country or countries where the bonds are issued. Because a Eurobond issue will be distributed simultaneously in a number of countries, borrowers normally work through a large banking syndicate with multinational selling capacity. Increasing capital mobility and greater ease in telecommunications have provided the sufficient conditions, allowing the Eurobond market to flourish. A. Introduction 1. Definition and Importance b) Eurobonds: Advantage: 1) a borrower can issue Eurobonds in London with currency denomination in U.S. dollar or Japanese yen. 2) Eurobond market adds to the international mobility of capital by attracting a wider range of borrowers and investors than other internationally oriented financial markets. 3) No withholding tax on Eurobond interest Disadvantage: 1) shorter maturities (5~15 years) 2) higher spreads charged by multinational underwriting syndicates for Eurobonds than domestic bonds due to higher risk and currency risk. A. Introduction 1. Definition and Importance c) International Bonds: Include both foreign bonds and Eurobonds. Global bonds are defined as very large issues sold simultaneously in the world’s major capital markets in Europe, Asia, and the United States, with trading taking place both within and between these regions. These bonds are listed on one or more of the major exchanges because liquidity is the crucial feature of global bonds. A. Introduction 2. Bonds Outstanding by Market Segment Debt issued by government or government agencies accounted for 64.5 percent of the world bond market in 1995. In 15 of the 20 countries included in this sample, government debt accounted for more than half of the outstanding supply of bonds. Austria, Germany, Denmark, Sweden, and Switzerland were the exceptions. The second larges market sector is corporate bonds which represented 35.5 percent of the world market in 1995. The corporate market exceeded the government sector in Austria, Denmark, Sweden, and Switzerland. The foreign bond market accounted for only 3.7 percent of the outstanding bonds in 1995. The U.S. has been the largest center for issuing foreign bonds. Yankee dollar bonds outstanding in 1995 totaled $282 billion, or about 34 percent of all foreign bonds. The foreign bond sector in Germany has grown to roughly equal the Yankee bond market. In Switzerland, the foreign bond market is the largest sector, exceeding both the corporate and government sectors. A. Introduction 2. Bonds Outstanding by Market Segment Share of World Market 21.3% 4.9% 1.9% 1.9% 1.3% 1.1% 0.5% 0.7% 42.8% 13.3% 3.7% 2.0% 1.5% 1.2% 1.1% 0.7% 100% 80 Percentage 60 40 20 0 U.S. Germany France Canada Netherlands Switzerland Spain Austria Japan Italy U.K. Belgium Denmark Sweden Australia Others Government Corporate Foreign Other A. Introduction 3. Market Size and Importance Issues of International Bonds Eurobonds and Foreign Bonds: Volume of New Issues 1200 Eurobonds Foreign Bonds 1000 800 Bil $ 600 400 200 0 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 Year A. Introduction 3. Market Size and Importance (a) 1964~1974: Total international bond issues increased from $2.3 billion to $6.8 billion (three times) but Eurobond issues increased faster (four times). Major borrowers were multinational corporations that shifted from the United States to the European capital market due to the U.S. capital controls for the Interest Equlization Tax (IET) on American resident purchases of foreign securities. The formation of the European Community (EC) since 1958 attracted world capital suppliers with comparatively higher interest rates. A. Introduction 3. Market Size and Importance (b) 1975~1982: The increase in oil prices created a big pool of liquidity for international borrowers, especially the oil-importing countries. Since 1982 the Eurobond issues have superseded the foreign bonds due to the flexibility of Eurobonds in terms of currency, location, and maturity. The collapse of some developing country borrowers (for example, Poland, Brazil, and Mexico) in 1982 ended the monopolistic petrodollars as the principal source of funds for international lenders. A. Introduction 3. Market Size and Importance (c) 1982~1989: Japan became the largest international credit supplier due to its high domestic saving rates and continued trade surpluses. The LDC debt problem resulted in more cautious selection of international borrowers. Only high credit standing borrowers were welcomed in the global financial markets. Low credit rating borrowers had to pay higher spreads. A. Introduction 3. Market Size and Importance (d) 1990-1999 Former communist countries in Russia and Eastern Europe have adopted more market oriented economies since 1991. The People’s Republic of China also tended to pursue a more free market system. Gradually these countries have increased their borrowings in the international bond market. Many emerging market countries in Asia and Latin America increased their participation in the international bond market in order to obtain external funds for economic growth and developments. Innovations such as global bonds and derivative financial instruments stimulated demand for funds by financial institutions. A. Introduction 3. Market Size and Importance Between 1981 and 1995, world bond markets expanded more than fivefold, reaching $22.8 trillion in total bonds outstanding. Of this worldwide total—which includes government bonds, domestic corporate bonds, foreign bonds, and Eurobonds—39.2 percent were issued in the U.S. Japan and Germany are the second and third largest bond markets with 19.5 percent and 12.1 percent shares, respectively. Eurobonds comprise 8.6 percent of all outstanding bonds. The Euro returned as an important currency in the Eurobond market in 1998. With the start of EMU in 1999, the Euro’s share expanded to 39% as the DM, FFr, Italian lire and other legacy currencies fell out of use. Overall, almost 95% of all Eurobonds issued in 1999 were denominated in either US$, Euro or UK£. B. Mechanics of Foreign Bonds 1. Maturity and Interest Coupon Foreign bonds are usually issued with relatively long maturities, normally 20-30 years. The interest coupon will be marginally above what the U.S. Treasury must pay in the same market to borrow funds. Corporate borrowers are spread across a broad range of credit ratings, depending on their financial status as well as on the perceived country risk that affects their international credit worthiness. B. Mechanics of Foreign Bonds 2. Interest Rates on Foreign Bonds Foreign bonds are issued in separate national capital markets. Therefore the interest rates on foreign bond issues are basically determined by the level of rates prevailing in each respective market. The general rule applies that stronger currencies carry lower interest rates, and softer currencies carry higher interest rates. 1) 1970s: The interest rate levels in bond markets were set by domestic demand and supply. Foreign borrowers were price takers. 2) 1980s: Foreign investor fund flows became a more important factor in shaping the interest rate levels. For example, in the first half of 1987 American authorities became concerned that a falling dollar would discourage foreign investor inflows to purchase U.S. Treasury securities. In turn, this decline would lead to a higher interest rate level in the U.S. bond market, with the spillover effects being greater difficulties for debtor countries trying to maintain interest payments on external debt. B. Mechanics of Foreign Bonds 3. Access to Foreign Bond Markets Foreign bond market Top Tier (New York, Switzerland, Very Difficult Access Frankfurt, London, Tokyo) Second Tier Eurobond Market Somewhat Difficult Access Third Tier Syndicated Euroloan Market Moderately Easy Access Fourth Tier Short-Term Bank Loans Easiest Access Access to the foreign bond markets is for the most part limited to the higher rated international credits. Developing country borrowers have only limited access to these markets. The United States, Switzerland, and Japan accounted for about 80% of the total foreign bond issues in 1995 largely because of stable currency rates for favorable variable long-term interest rates, availability of funds, and good underwriting facilities in these countries. C. Dynamics of Eurobonds C. Marketing of Eurobonds is a multi-country project. Given location flexibility, this market remains largely unregulated. The Eurobond market is multi-currency, with borrowers being able to designate any one of several currencies to denominated the issue. Because bearer bonds are not registered, they are attractive investment assets for investors who wish to remain anonymous. C. Dynamics of Eurobonds 1. Interest rates and Maturities Eurobond yields often can be lower than in the respective domestic capital market due to greater efficiency in the market. The shorter maturities common for Eurobonds reflect the special role of the market, the interests of investors, and the need to keep risks under control. C. Dynamics of Eurobonds 2. Reasons for Market Growth 1) Steadily growing demand for funds by multinational corporations, governments, and international organizations; 2) Development of new sources of funds seeking investment outlets, including the oil surpluses of OPEC countries; 3) Efficient market 4) High degree of flexibility afforded by the market, whereby borrowers and investors can select from several possible currencies of denomination. 5) Worldwide distribution of Eurobonds by multinational underwriting syndicate facilitates international capital flows; 6) Efficient secondary markets help liquidity settlements between buyers and sellers of Eurobonds. C. Dynamics of Eurobonds 3. The Currency Factor To be eligible as a currency of denomination there must be a fairly wide acceptance of the currency as a standard of value and a unit of account in which deferred payments can safely be denominated. The four most preferred currencies of denomination are indicated for each of the nine countries that are important borrowers in the international bond markets. C. Dynamics of Eurobonds Rank Importance of Currencies of Denomination of International 3. The Currency Factor Bonds, By Country Borrower (1994-1996) Country Borrower US$ SF Yen DM Sterling Other Australia 2 3 4 1(1) Canada 1 3 4 2(2) France 2 4 4 3 1(3) Germany 2 3 1 4(1) Italy 2 1 4 3(4) Japan 1 3 2 4 Sweden 1 3 2 4 United Kingdom 2 4 3 1 United States 1 4 3 2(4) Summary Cd EAu ECU FF n Rank 1 4 － 1 1 1 1 － 1 － Rank 2 5 2 － － － 1 － 1 Rank 3 － 3 4 1 － 1 － － Rank 4 － 3 1 4 1 1 1 － － C. Dynamics of Eurobonds 3. The Currency Factor 1) The dollar stands out as the first ranked in four cases, and second ranked in five cases. The Swiss franc and yen run close as second and third ranked currencies in overall preference, but German mark was increasingly important in 1995-1996. 2) Between 1981-1991 the European Currency Unit (ECU) was a more important currency of denomination for Eurobond issues. a) The importance of ECU denominated bonds has declined since the European monetary crisis in Oct. 1991. b) The uncertainty of the European Monetary union (EMU) in 1999 is another problem. c) Some international borrowers still issue ECU bonds because these bonds provide relatively high yields, coupled with low currency risk. C. Dynamics of Eurobonds 4. Major Instruments of The Eurobond Market 1991 1992 1993 1994 1995 Type and Currency Structure of International Bonds 309 334 481 427 467 International Bond (in $billion) Issues (A) By Major Instruments (in percent) Straights 78.6 79.5 76.7 67.8 75.6 Floating rate 5.9 13.1 14.5 22.5 16.9 Convertibles 3.3 1.6 3.8 5.1 2.6 Equity Warrants 10.2 4.7 4.3 2.3 1.2 Zero Coupons 1.2 1.0 0.4 1.3 1.8 Other 0.7 0.2 0.3 1.0 1.8 Total 100.0 100.0 100.0 100.0 100.0 C. Dynamics of Eurobonds 4. Major Instruments of The Eurobond Market 1991 1992 1993 1994 1995 Type and Currency International Bonds 309 334 481 427 467 Structure of International Bond By Major Currencies Issues (B) (in percent) U.S Dollar 29.7 36.9 35.9 37.5 39.5 Deutsche Mark 7.1 10.4 11.8 7.8 15.5 Yen 12.6 11.2 9.6 13.3 12.6 Sterling 8.8 7.6 10.8 8.8 5.9 Swiss Franc 7.1 5.8 6.1 4.8 5.6 Italian Lira 3.2 2.5 3.1 5.5 3.8 Dutch Guilder 1.1 2.0 2.6 3.0 3.2 Canadian Dollar 7.2 4.7 6.4 3.6 0.7 French Franc 6.1 7.5 8.7 7.0 2.8 Other 17.1 11.4 5.0 8.7 10.7 Total 100.0 100.0 100.0 100.0 100.0 C. Dynamics of Eurobonds 4. Major Instruments of The Eurobond Market 1) Straight Fixed rate bond issues represent more than 60% of new offerings. 2) Bonds with equity warrants increased in importance over the short period 1987-1989 when the Tokyo stock exchange showed rising stock prices, but these issues declined in the period 1991-1995 due to excess value of Japanese stocks. 3) Floating rate notes (FRNs) occupy an important niche in the Eurobond market. The FRN is a relatively short-term note that is automatically rolled over twice a year. The rollover rate is usually based on LIBOR plus a premium. The size of the premium depends on the quality of the bond or note issue. FRNs generally have a minimum rate. As a rule, the coupon interest does not fall below this minimum. 4) The convertible Eurobond can be viewed as a straight bond with an option. In this case the option to convert the bond into stock of the same company has a potential value. 5) Zero coupon bonds make up a small share of international bond issues. C. Dynamics of Eurobonds 5. Categories of Borrowers International Bond Offerings by Category of Issuer 1991 1992 1993 1994 1995 Governments 44.4 64.0 106.3 90.5 75.9 Public Enterprises 48.3 51.2 64.9 52.1 56.7 Banks 55.9 67.6 110.2 133.5 154.0 Private Corporations 123.7 109.6 151.7 123.7 145.0 International Organizations 36.4 41.3 47.9 28.8 35.7 Total 308.7 33.7 481.0 428.6 467.3 Memorandum Item: Issues by Governments As a Percentage of Total 14.1 19.2 22.1 21.1 16.2 $Billion C. Dynamics of Eurobonds 5. Categories of Borrowers Government share of all international bond offerings continued to decline in 1994-1995 while borrowings from public enterprises were relatively stable. Banks, especially German banks, needed funds to finance international credit expansion, particularly to finance the global wave of mergers and acquisitions. Private corporations stepped up borrowings in the international bond market to finance their worldwide investments, especially in the prosperous Asian countries. C. Dynamics of Eurobonds 6. Taxation Eurobonds are usually free of most taxes. (1) From a legal standpoint syndicate managers take great care in preparing the issue to assure nonapplicability of withholding taxes. Because a substantial part of the investors are individuals, applicability of estate and gift taxes is minimized. (2) Many corporate borrowers issue Eurobonds through a finance subsidiary incorporated in a tax heaven. In this way the issue is not subject to income taxes or capital gains taxation. (3) International tax treaties can play a role in broadening the potential market for Eurobond issues. Such tax treaties reciprocally lower or remove the tax burden imposed on foreign source interest income of international investors. D. Secondary Trading 1. Eurobond prices are quoted as a percent of face value. A bid/ask quote of 92-92.5 indicates a bid price of $920 and an asked price of $925 for a bond with face value of $1000. 2. The spread on Eurobonds is 0.5%, but a range of spreads can exists depending on conditions in the market. 3. Settlement date is approximately a week. 4. The standard-size Eurobond transaction is 100 bonds (with $100,000 of face value). 5. The buyer pays the seller the agreed price, plus interest that has accumulated since the last coupon interest payment. D. Secondary Trading For example: On 15 October 1996 a bond trader buys 200 Eurobonds with a face value of $1000 each. The bonds have a 9% coupon, and the bond trader pays a price of 96. The bonds pay annual coupon on March 15. What is the bond trader’s total cost? 1) The bond transaction is settled on October 22. There are 217 days (15 March 1996 to 22 October 1996), calculated on a 30/360 basis. The accrued interest is: 200*$1,000*0.09*217/360=$10,850 2) The payment for the bond net of accrued interest is: 200*$1,000*0.96=$192,000 3) Total payment is $192,000+$10,850=$202,850 E. Clearing systems 1. Euroclear: An international clearing system located in Brussels created by Morgan Guaranty Trust Company in 1968. 2. Cedel: An international clearing system located in Luxembourg created by a group of European banks in 1970. F. Bonds and International Portfolio Diversification Comparison of Figure 18-9 with the comparable figure for stocks, Figure 18-5 shows that the contribution of exchange rates to the riskiness of bonds is much larger than it is for stocks. 1) In the case of stocks, inflation increases prices, including those of assets, but causes a depreciation. In such a situation the effect of inflation in the local-currency asset price is offset by the depreciation when the asset price is measured in terms of U.S. dollars. 2) In the case of bonds, currency depreciation could lead to government action to increase interest rates in an attempt to prop up the currency. Higher interest rates reduce bond prices in local currency, so that depreciation of the currency is associated with a decline in the local- currency value of bonds. a positive correlation between the local-currency asset value and the exchange rate add to volatility. F. Bonds and International Portfolio Diversification Figure 18-9 Local-Market versus Exchange-Rate Components of Volatility of Dollar Values of Non-U.S. Bonds, 1970s and 1980s Percent variation per year in local-currency bond value Percent variation in dollar values of foreign-currency bonds from exchange-rate variations 20 15 Percent per year 10 5 0 1970s 1980s 1970s 1980s 1970s 1980s Japan Britain Germany F. Bonds and International Portfolio Diversification Figure 18-10 35 30 Globally efficient frontier including bonds (percent per year) 25 Globally efficient frontier Return 20 excluding bonds 15 10 U.S. stocks Risk, σ 5 (percent per year) 5 10 15 20 25 30 35 a) efficiency frontiers for optimally internationally diversified portfolio of stocks only b) efficiency frontiers for stocks plus bonds. the portfolio shows reduced risk for given returns.