MauritiusIn 1992, Mauritius became the

first offshore financial center in the southern hemisphere. There are now over 1500 offshore/international companies incorporated in Mauritius.

International Financial Management: INBU 4200

Fall Semester 2004Lecture 7

The International Bond Markets

(Chapter 7)

International Capital Markets

• International Capital Markets Consist of:

• International Money Markets– Corporate short term borrowing and depositing through:

• Global commercial banks (both offshore and domestic markets)

• International Debt (Bond) Markets– Corporate and Government long term borrowing and institutional

and individual investing through:• Euro bond markets (offshore)• Foreign bond markets (domestic markets)

• Equity Markets (Stock Markets)– Corporate fund raising (IPOs) and institutional and individual

investing through:• National stock markets

Importance of These Markets

• Borrowers:– Provides them with a wide range of borrowing

possibilities (global in nature).• Offshore and foreign domestic markets

– Provides them with potential swap arrangements• Borrowing in one market and swapping out to another.• Interest rate/currency swaps.

• Investors:– Provides them with a wide range of investing

possibilities in terms of:• Returns• Types of assets,• Currencies.

International Bond Markets• Three basic segments for corporates, governments and investors:

• Foreign Bonds (external borrowers in domestic financial markets)– Issued by a non-resident and denominated in the currency of the

country in which it is being offered.• GE issuing a yen denominated bond in Japan• Republic of China issuing a dollar denominated bond in the U.S.

• Foreign Bonds (internal, domestic borrowers)– Issued by a resident and denominated in the currency of the

country in which it is being offered.• U.K. Government issuing a pound sterling bond in the U.K.• This market is potentially important to global investors seeking foreign

bonds.• Eurobond (offshore)

– Issued by a non-resident and denominated in a currency other than the currency of the country in which it is being sold.

• GE issuing a dollar denominated bond in Europe.

Characteristics of Foreign Bonds for U.S. Investors

• From a U.S. investor standpoint, a foreign bond has three distinct characteristics:– The bond is normally issued by a foreign entity

• Such as a foreign government, foreign municipality or foreign corporation.

• Exception: U.S. entity (corporation) could be the borrower in a foreign market.

– The bond is traded on a foreign financial market.• Domestic market of the foreign borrower.

– The bond is denominated in a foreign currency.• Not the U.S. dollar!• Domestic currency of the foreign borrower, or where the U.S.

entity is borrowing.

Risk with Foreign Bonds

• Foreign bonds carry two major risk elements:– Risk of default

• A primary risk of a foreign bond is that it is an unenforceable claim. An investor that owns the bonds of a borrower in his or her home country has specific legal recourse in the event of default. Foreign bonds, however, offer no such protection.

• An extremist political movement (e.g., Iran in the 1970’s) could come to power and seize or deny all foreign assets and claims.

• A country may become engaged in a military conflict and prohibit its currency from leaving its borders. After World War II, for example, U.S. investors holding bonds in Great Britain were paid interest in pounds yet were unable to convert those pounds to dollars; the money could only be reinvested in pound-denominated investments or spent within the borders of Britain or her colonies.

– Foreign exchange risk• the potential for loss due to fluctuations in exchange rates. • Currency risk can literally turn a profit on a foreign investment into a

loss or visa versa.

Foreign Government Bonds

• Foreign Government Bonds: Bonds which are a direct obligation of a foreign government.

• These bonds are of two classes: – (1) external bonds, those marketed and intended for investment

by investors in another country and payable as to both principal and interest in the currency of that country, and

– (2) internal bonds, those marketed in the home country of the government in question and payable in the currency of that country.

• A few foreign government issues are payable in several

currencies and are known as multiple currency issues.

The external bonds of foreign countries which have been marketed in the United States are also known as Yankee (dollar) bonds.

Record of Foreign Government Bonds

• The performance record of foreign government bonds sold in the United States over the last 100 years is uneven at best.– During the Great Depression of 1929–1933, many

South American governments defaulted on their bonds.

– World War II resulted in default on various European government issues.

– The late 70’s and 80’s were characterized by many government debt defaults (throughout the emerging world).

• Third World Debt Crisis in response to global slowdown and rising price of oil

Governments in the Foreign Bond Market

• Why do Governments borrow in foreign bond markets?– Foreign market may be larger and thus offer

opportunities for larger borrowings and at better borrowing terms (interest rates).

• Many countries bypass their smaller domestic markets to issue in larger foreign markets, especially the U.S. market.

– Interest rates in domestic markets may be relatively high due to internal economic factors:

• Inflation, business cycle, central bank policies.– Foreign markets may be more transparent then

domestic markets, and thus offer better protection for investors.

• More transparency means potentially less risk and thus a lower required return (i.e., lower borrowing costs).

• Especially true with the world’s major capital markets such as the United States.

Government Bond Markets: 10-year Bond Yields and Spreads

October 21, 2004

Corporates in the Foreign Bond Market

• Corporates are also attracted to the foreign bond markets:– Domestic markets may be fairly developed but small

and thus result in higher borrowing costs.• Many markets in Europe prior to the single market.• Smaller markets in emerging Asian nations today.

– Domestic markets may be underdeveloped and small and result in less favorable borrowing terms.

• China today.• These countries are attempting to “enhance” their domestic

markets.– Vietnam (Postal savings scheme similar to Japanese model).

– Domestic markets may be less transparent resulting in less investor protection.

• Requiring higher required returns (i.e., borrowing costs).

Postal Savings Systems

• Japan: Essentially a government run banking system based on the post office.– Japan has 24,000 post offices, and each has a bank inside. – System was created in 1875 and modeled after a British system

established in 1861. • The United States created one in 1910, attracting mostly urban

immigrants who distrusted private banks. It never gained the popular appeal that the Japanese version has and was dismantled in 1967.

– It is the largest financial institution in the world, with about $2.4 trillion (250 trillion yen) on deposit.

– Many government corporations have financed projects with loans from the postal savings system.

– Now going through a process of privatization!

Examples of International Bonds: Issued October 21, 2004 by Currency, Amount, Yield, and “Book-Runners”

• In U.S. Dollars– Republic of China, $500M, 3.8%, Merrill/JPMorgan

• In Euros– BNG (Benetton Group, Italian company) 1.5B 3.3%,

Citi/JPMorgan (through London)• In British Pounds

– KBC Bank (Belgium Bank) 175m 5.8%, HSBC/Lehman

• In Canadian Dollars– Toyota Credit of Canada100m 4.2%,TD Securities

SEC Requirements

• U.S. Federal securities laws are designed to provide disclosure of financial information about borrowers:– seeking an initial public stock offering (IPO) or issuing bonds,

and/or – those already publicly held.

• The Securities Act of 1933 requires that a borrower, before offering securities to the public, must file a report detailing several categories of information specified by the Securities and Exchange Commission (SEC).

• The Securities Exchange Act of 1934 deals mainly with securities already publicly held. Issuers of such securities must publish periodic reports outlining current material information.

Registering Bonds in the U.S.

• All bonds being offered to the investing public in the United States must be registered with the Securities & Exchange Commission. – U.S. government, federal agency and municipal

bonds are exempt from the registration rule.• Registration requires that specific information be

disclosed, such as: – include financial data about the borrower, – how the money will be spent, – how the borrower intends to repay.– the terms of the bond itself.

• Included in the bond’s indenture.

Regulation S Bonds

• As noted, qualified bonds issued in the United States must be registered with the Securities and Exchange Commission.

• However, Regulation S permits a US dollar bond offered outside America without registration under the US Securities Act of 1933. These bonds cannot be sold to Americans.– Telekom (Malaysian telecommunications; Moody’s A3), $500M,

5.3% yield, offered September 15, 2004. Book runners: Deutsche Bank and UBS.

– Sold to 183 investors representing a mix of pension funds, asset managers, banking/financial institutions, and private banks; all sales outside of the United States: 61% in Asia and 39% in Europe.

Global Bond Data• Year end 2002, the face value of bonds outstanding in the world was

estimated at $37.3 trillion.– Domestic bonds represented the largest share of this amount, or about

82% ($30.5 trillion).• This measures borrowing by residents in their own markets.• The U.S. market dominates, with about 59% of this total.

– International bonds (foreign and euro bonds) only represent about 18% ($6.8 trillion)

• By currency of denomination (total bond market):– 50% denominated in U.S. dollars, – 20% in euros, and– 17% in yen.

• By currency of denomination (International bond market)– 51% in U.S. dollars– 32% in euros– 7% in pounds, and – 6% in yen

Amounts of Domestic and International Bonds Outstanding

As of Year-End 2002 in U.S. $Billions

Currency Domestic Percent International Percent Total Percent

U.S. dollar $15,377.0 50.4% $3,465.6 50.7% $18,842.6 50.5%

Euro $5,226.1 17.1% $2,170.2 31.7% $7,396.3 19.8%

Pound $920.8 3.0% $505.3 7.4% $1,426.1 3.8%

Yen $5,846.8 19.2% $409.1 6.0% $6,255.9 16.8%

Other $3,118.2 10.2% $288.9 4.2% $3,407.1 9.1%

Total $30,488.9 100.0% $6,839.1 100.0% $37,328.0 100.0%

International Bonds: Eurobonds

• In any given year, about 80% of the world’s international bonds are likely to be euro bonds (as opposed to foreign bonds).– Offshore issues.– They are noted by the name of the currency in which

they are denominated:• Eurodollar bonds, • euroyen bonds, • euroeuro bonds

– They may or may not be available to home currency investors.

International Bonds: Foreign Bonds

• Foreign bonds represent about 20% of the new international bond offerings in any year.– They are noted by the country where they are issued

and have taken on rather “unique” names:• Yankee bonds (issued in the U.S.)• Samurai bonds (issued in Japan)• Bulldogs (issued in the United Kingdom)• Matadors (issued in Spain)• Kiwi bonds (issued in New Zealand)

• They are usually issued because of attractive interest rates and then swapped out the issuing currency into a “home currency.”– Especially true with regard to Samurai bonds today.

Who Issues International Bonds?

• Distribution (2002) of International Bond Offerings by Nationality

• U.S. borrowers represent about 32% of total.

• Germany, 13%• U.K., 8%

Nationality U.S. $ Billions

Australia 99.8Canada 208.3France 366.7Germany 889.4Italy 259.3Japan 245.6Sweden 293.9U.K. 571.5United States 2,170.3

Total $6,839.1

What Type of Borrower is Involved in the International Bond Markets?

• Financial institutions are the major borrowers with 59%

• Governments at 21%• Corporates at 15%

Type of Issuer U.S. $ Billions

FinancialInstitutions

4,030.3

Governments 1,416.5

Corporates 1,014.6

International Organizations

377.7

Total $6,839.1

Bearer Versus Registered Bonds

• Bearer Bonds:– Possession is evidence of ownership.

• Issuers does not keep ownership records.• Offer privacy and anonymity to holders.

– Thus, carry a lower interest rate than registered bonds.

• Eurobonds are bearer bonds.

• Registered bonds:– Owners name is recorded by issuer.

• Yankee bonds and U.S. corporate bonds must be registered.

Regulations of International Bonds

• Foreign bonds must meet the registration and listing regulations of the country in which they are issued.– Yankee bonds must comply with 1933 Securities Act requiring

full financial disclosure and the offering of a prospectus to potential public buyers.

• Eurobonds are not required to meet registration requirements– For example, not required of euro-dollar bond offerings outside

of the United States (Reg S).• Issue of time and expense in bring a foreign bond to

market has resulted in a general preference for eurobond offerings by global borrowers.– Response of U.S. to timing and disclosure issue:

• U.S. shelf registration, or pre-registration, (rule 145) since 1982 has reduced the time issue.

• Private placements (rule 144A) since 1990 do not have to meet the full disclosure requirements of the 1933 Act.

International Bonds: “Global Bond”

• Refers to a large international bond simultaneously offered in different financial markets (first appeared in 1989).– May be issued in different currencies

• Deutsche Telekom $14.6 billion (2000 offering) multicurrency (dollar, euro, pound, yen) issue

– Or same currency:• AT&T $8 billion (1999) U.S. dollar global offering (throughout the

world).

• Usually sold throughout North America, Europe, and Asia!

• Usually sold to institutional investors.– Pension funds, insurance companies, private banks, asset

managers.

Types of International Bonds

• Straight Fixed Rate Bond– Most international bonds are of this type– Designed maturity date, – Fixed coupon payments (% of par value),– Eurobond interest is typically paid annually:

• Less costly for borrowers

– No options (e.g., convertibility) attached– Entire issue brought to market at one time.– U.S. dollar bonds the most popular– Sometimes referred to as “plain vanilla” bonds!

International Bonds: Types

• Euro-Medium Term Notes (Euro MTNs)– Similar to straight fixed rate bonds in that they

have a fixed maturity and carry a fixed coupon rate.

– Unlike a straight fixed rate bond, they are sold on a “continuous basis” through some prearranged period (called an issuance facility).

• Allows issuers to raise money as needed

– Generally carry maturities from less than 1 year out to 10 years.

International Bonds: Types

• Floating Rate Notes (FRNs)– Coupon rate is indexed to some reference

rate.• Usually LIBOR!

– Coupon reset at time of interest payment for the next period.

• Coupon payments generally reset every 3 or 6 months.

– U.S. dollar and euro denomination dominate this market.

International Bonds: Types

• Equity Related Bonds– Convertible issues

• Fixed income bond which,• Allows the holder to exchange the bond for a predetermined

number of share of common stock.• Carry lower interest rates than a straight only bond.

– Bonds with Equity Warrants• Fixed income bond with,• Call option (or warrant) feature which allows the holder to

purchase a certain number of equity shares at a pre-stated price over a predetermined period of time.

International Bond Types

• Zero Coupon Bonds– Sold at a discount from face (par) value,– Do not pay any coupon interest– At maturity, holder receives full face (par) value.– Return is represented by the difference between price

and face value.– Most popular currencies have been the U.S. dollar

and Swiss franc.– Especially attractive to Japanese investors

• Their tax laws treat the return as a tax free capital gain (where coupon payments are taxable)!

International Bonds: Types

• Dual-Currency Bonds– Fixed rate bond that pays interest in one currency,

and– Upon maturity, pays principal value in another

currency.• Very popular among Japanese firms:• Coupon payments in yen; principal repayment in dollars.

– Used by Japanese companies wanting to establish or expand U.S. based subsidiaries.

– Japanese subsidiaries anticipate generating U.S. dollars needed to pay off the principal from their activities in the United States.

Instrument

Straight Fixed-Rate

Floating Rate Note

Convertible Bond Annual Fixed Currency of issue or conversion to equity shares.

Straight fixed rate with equity warrants

Annual Fixed Currency of issue plus conversion to equity shares.

Zero None Zero Currency of issue

Dual Currency Bond

Annual Fixed Dual currency

Frequency of Payment

Annual

Size of Coupon

Payoff at Maturity

Review: Characteristics of International Bond Market Instruments

Currency of issueFixed

Every 3 or 6 months Variable Currency of issue

Placing Eurobonds

• Lead Manager(s) (“Book-runner”)– Primary investment banking firm(s)

• Lead manager of underwriting syndicate.• Negotiate terms with the issuer, ascertain market conditions and

timing.• Put together the underwriting syndicate!

• Underwriting Syndicate– Group of investment banks, merchant banks, and commercial

banks that will bring the issue to market.– Syndicate members commit their own capital to buy the issue

from the issuer (at a discount) and then resell this issue.• Underwriting spread is typically 2 to 2.5%!

• Selling Group:– Includes the underwriting syndicate plus other institutions.– Sell the bonds to the public and receive commission for doing so.