International Bond Market ppt Introduction Currency Risk by mikeholy

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									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
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.

     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%
                             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%





                      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
                       Foreign Bonds

Bil $
































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
   Innovations such as global bonds and derivative financial
    instruments stimulated demand for funds by financial
A. Introduction

        3. Market Size and Importance
  Between 1981 and 1995, world bond markets expanded more than
   fivefold, reaching $22.8 trillion in total bonds outstanding. Of this
   worldwide total—which includes government bonds, domestic
   corporate bonds, foreign bonds, and Eurobonds—39.2 percent were
   issued in the U.S. Japan and Germany are the second and third
   largest bond markets with 19.5 percent and 12.1 percent shares,
   respectively. Eurobonds comprise 8.6 percent of all outstanding
  The Euro returned as an important currency in the Eurobond
   market in 1998. With the start of EMU in 1999, the Euro’s share
   expanded to 39% as the DM, FFr, Italian lire and other legacy
   currencies fell out of use. Overall, almost 95% of all Eurobonds
   issued in 1999 were denominated in either US$, 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
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

   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
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
   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
   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
 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
     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

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:
 2) The payment for the bond net of accrued interest is:
 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

      Percent per year



                                  1970s 1980s          1970s 1980s           1970s 1980s
                                      Japan               Britain              Germany
F. Bonds and International Portfolio Diversification

           Figure 18-10

                                30   Globally efficient frontier
                                         including bonds
           (percent per year)

                                                              Globally efficient frontier

                                20                                excluding bonds
                                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.

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