INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

Lecture 10

The International Bond Markets

Capital Markets: A Global View, 2005, In Trillions of U.S. Dollars Stock Bond Total Capital Markets Markets Markets World $37.2 (39%) $59.0 (61%) $96.2 (100%)

U.S. $17.0 (46%) $23.8 (40%) $40.8 (42%) EU $ 9.6 (26%) $18.7 (32%) $28.3 (29%) Japan $ 7.5 (20%) $ 8.7 (15%) $16.2 (17%)

Note: Trillions of U.S. dollars, and (%) of total. Source: IMF, Global Financial Stability Report, 2006

http://www.imf.org/External/Pubs/FT/GFSR/2006/02/index.htm

The Bond Markets: Governments and Corporates, 2005 Bonds Total

Gov’t Corporate Bonds

World $23.1 (40%) $35.9 (60%) $59.0 (100%)

U.S. $ 5.9 (26%) $17.9 (50%) $23.8 (40%) EU $ 6.7 (29%) $12.0 (33%) $18.7 (32%) Japan $ 6.6 (29%) $ 2.0 ( 6%) $ 8.6 (15%)

Note: Trillions of U.S. dollars, and (%) of total. Source: IMF, Global Financial Stability Report, 2006

http://www.imf.org/External/Pubs/FT/GFSR/2006/02/index.htm

Growth in Bond Markets, 2001 - 2005 2001 Trillions of USD

Total Bonds: $37.2 Government: $18.5 Private: $18.7

2005 % Change 2001-2005 Total Bonds: $59.0 58.6% Government: $23.1 24.9% Private: $35.9 92.0%

Source: IMF, 2002 and 2006 Global Financial Stability Reports

Summary of Bond Market Statistics Year end 2005, the world’s total bond market was estimated at $59.0 trillion. This was larger than the world’s equity markets by 59% Historically, the U.S. bond market has dominated this total.

In 2001, the U.S represented 47% of the world’s bond market, but, U.S. dominance is declining: By 2005, the U.S. represented 40%.

And the Eurozone’s importance is increasing. By 2005, The Eurozone accounted for 29% of global debt mark; this was up from

21% in 2001. Japan’s share has remained stable at nearly 17% since 2001.

Finally, the corporate bond market currently dominates the government bond market. In the early 1990s, corporate debt represented about 40% of

the bond market, by 2005 it was up to 60%.

Corporate Debt in the Global Debt Markets Domestic and multinational corporations have been

increasing their relative participation in global debt markets since the mid-1990s. Why?

The globalization of financial markets has resulted in more debt markets for corporates to enter..

Since January 1999, the advent of the euro and the single market process in the eurozone has encouraged the growth of global corporate issuance within this area.

The general decline in global interest rates in the last 10 years has made borrowing more attractive.

At the same time, some governments, especially in Europe, have reduced their funds needs (Growth and Stability Pact in the Euro-zone); thus the growth of government debt has slowed.

Japan is an exception to this trend where government debt has increased

Composition of Global Debt Markets Government debt’s share of the global bond market has declined

in recent years especially since the mid-90s. In the early 1990s, Government debt was about 60% of the total

global bond market. By 2005, Government debt was about 40% of the total global

bond market.

Bond Market Growth in Europe

10-Year Bond Rates, 1995- 2004 In the World’s major

financial markets, interest rates trended down from 1995 to 2004.

Why?

Bond Markets Bond markets are part of the “capital” markets.

Capital markets consists of long term debt and equity. Bonds represent long term debt instruments

Why are they important for borrowers? Means for raising long term capital.

Avoids the refinancing risk associated with shorter term borrowing.

Why are they important for investors? Means for committing funds for long investment horizons.

Avoids the reinvestment risk associated with shorter term financial assets.

The Spread Between Local Debt Interest Rates and Major Market Issues Of importance to global borrowers, is the relative cost of

borrowing in different markets. Global companies can select from a wide range of markets,

including the many local debt markets in which they are operating and the major capital markets of the world (especially the United States and now the Euro-zone).

One way to assess whether “local” markets differ from the world’s major capital markets is to examine interest rate spreads. A reasonable “proxy” measure of this spread is provided daily by the

Financial Times with their 10-year Government bond spreads. The next two slides present this data over the last 2 years.

Note the changing “attractiveness” of the euro market (i.e., the “Bund”) over the U.S. market (i.e., “T-bonds”) since 2004. What is the reason for this?

10-Year Gov’t Bond Spreads, Nov 24, 2006

Source: http://news.ft.com/markets/bondspread

10-Year Gov’t Bond Spreads, March 8, 2004

Source: http://news.ft.com/markets/bondspread

Why the Difference in Borrowing Rates Across Border? Differences in “credit conditions” from one country to another will

be reflected in financial market differentials. Some local financial markets may be fairly developed but small

and this will result in higher borrowing costs. Many markets in Europe prior to the single market. True of many smaller markets in emerging Asian nations

today. Some local financial markets may be both underdeveloped and

small and this will 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).

Local markets are likely to be less transparent, resulting in less investor protection.

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

International Bond Markets Two basic types of international bonds:

Foreign Bonds 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.

Eurobond Issued by a non-resident and denominated in a currency

other than the “legal tender” currency of the country in which it is being sold. Coca Cola issuing a U.S. dollar denominated bond in Europe. Honda issuing a euro denominated bond in the U.S. British Petroleum issuing a yen denominated bond in

Singapore.

International Bond Markets: 2004 As of 2004, 78.4% of the global bond market was

represented by domestic bonds. These are bonds issued by residents of the country in which they

are being issued. Coca Cola issuing a (dollar) bond in the United States. Honda issuing a (yen) bond in Japan. British Petroleum issuing a (pound) bond in the United Kingdom.

The largest domestic bond market was the United States, representing 45.5% of the domestic market The euro and yen domestic market each represented about 20%

The remainder, 21.6% of the global bond market was represented by the international bond markets (both foreign and offshore bonds). The largest international bond market was represented by

euro denominated debt, with 43.5% of total international bonds.

See next slide.

Amounts of Domestic and International Bonds Outstanding As of Year-End 2004 in U.S. $Billions

Currency Domestic Percent International Percent Total Percent

U.S. dollar $17,930.7 45.5% $4,492.5 40.5% $22,423.2 43.7%

Euro $8,436.4 20.9% $4,834.5 43.5% $13,270.9 25.8%

Pound $1,274.6 3.2% $778.7 7.0% $2,053.3 4.0%

Yen $8,145.0 20.2% $488.6 4.4% $8,633.6 16.8%

Other $4,506.6 11.2% $508.2 4.6% $5,014.8 9.8%

Total (and % of Total Global) $40,293.3 78.4% $11,102.5 21.6% $51,395.8 100.0%

Chart: Dollar Amounts of Domestic and International Bonds Outstanding

(As of Year-End 2004 in U.S. $Billions)

Chart: Percent of Total, Domestic and International Bonds Outstanding

(As of Year-End 2004 in U.S. $Billions)

Data on the International Bond Markets: 2002 to 2004 From 2002 to 2004, international bonds as a percent

of total global bonds grew from 18.3 to 21.6%. The U.S. dollar’s share of international bonds fell from 50.7%

to 40.5% The euro’s share of international bonds rose from 31.7% to

43.5%. By 2004 the euro had replaced the U.S. dollar as the largest

international bond currency. How do you think interest rates affected this?

The British pound’s share remained stable at around 7%. The yen’s share fell from 6% to 4.4%

See next slide for 2002 data.

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 (and % of Total Global) $30,488.9 81.7% $6,839.1 18.3% $37,328.0 100.0%

Foreign Bonds Recall that there are two basic types of international

bonds: foreign bonds and euro-bonds. Foreign bonds represent approximately 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

These foreign bonds are usually issued because of attractive interest rates and then swapped out the foreign currency into some “home currency.

FX Risk with Foreign Bonds Foreign Exchange Risk for Borrowers:

Adverse changes in the exchange rate can increase the “home currency” equivalent interest rate (cost).

Especially important if the global firm anticipates repaying the international bond with home currency. One possible hedge is to use foreign currency cash

flows associated with overseas operations to fund these liabilities (i.e., Operational hedge).

If the Interest Rate Parity holds, hedging with a forward contract will negate the interest rate differential and offset the measured advantage of borrowing overseas in a low interest rate country.

FX Risk with Foreign Bonds Foreign Exchange Risk for Investors:

The potential for loss (or a lower rate than on home investments) due to fluctuations in exchange rates.

Currency risk impacts can turn an anticipated profit on a foreign investment into a loss. Perhaps an investor can “protect” himself/herself with a put

option (in case the currency weakens). If the Interest Rate Parity holds, protecting with a forward

contact will negate the interest rate differential and offset the measured advantage of borrowing overseas in a low interest rate country.

Impact of FX Changes on Bond Returns, 2005

In 2005, The U.S. dollar strengthened against most currencies. Or, put another way, most

foreign currencies weakened against the dollar.

Thus resulted in a reduction of the returns U.S. investors achieved on their foreign bond holdings. As the chart shows, most

foreign bonds produced negative exchange rate adjusted returns for U.S. investors.

The one major exception was Canadian bonds.

Eurobonds In any given year, about 80% of the world’s

international bonds are likely to be euro bonds. These are “offshore” issues.

Denominated in a currency other than the “legal” tender of the market in which they are being issued.

They are noted by the name of the currency in which they are denominated: Eurodollar bonds, euroyen bonds, euroeuro bonds

The two most popular currencies of denomination are the U.S. dollar and the euro.

Eurobonds may or may not be available to home currency investors.

Regulations of International Bonds Foreign bonds must meet the registration and listing

regulations of the country in which they are issued. Thus, Yankee bonds being offered to potential public buyers

(i.e., public placements) must comply with 1933 Securities Act requiring full financial disclosure and the offering of a prospectus. Private placements do NOT have to be registered with the SEC. See next slide for U.S. requirements

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

States (“Reg S Bonds”) do not require SEC registration. See second slide for Reg S Bond information.

Note: Issue of time and expense in bring a foreign bond to market has resulted in a general preference for eurobond offerings by global borrowers.

Registering Bonds in the U.S. All bonds being offered to the investing public in the

United States (with the exception of U.S. government, federal agency and municipal bonds) must be registered with the Securities & Exchange Commission. This requirement applies to Yankee bonds.

Registration requires that specific information be disclosed to the public, such as: financial data about the borrower, how the money will be spent, how the borrower intends to repay. the terms of the bond itself.

This information is included in the bond’s indenture.

Regulation S Bonds Yankee bonds issued in the United States to the general

public must be registered with the Securities and Exchange Commission.

However, Regulation S exempts a US dollar bond offered outside the United States by a non-resident from having to register.

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.

Types of International Bonds: Straight 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:

Why? 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: Equity Related 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 because of

the conversion option. 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: Zeros

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

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

International Bonds: Dual Currency Dual-Currency Bonds

Fixed rate bond that pays interest in one currency, and Upon maturity, pays principal value in another currency.

Good option for a MNE financing a foreign subsidiary. 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.

Example of a strategy in using a dual currency bond: Japanese company with US subsidiary, needing money up-

front for U.S. operations. Japanese company has a more recognized name in Japan so

they raise money initially in Japan. Eventually the subsidiary will realize profits in the U.S. and at

that time they will pay the principal on the debt in US$.

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 directly to institutional investors.

Pension funds, insurance companies, private banks, asset managers.

Represents a way for global firms to tap a “larger” market.