INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

1
INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

• Lecture 11
• The International Bond Markets

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The Globalization of Capital Markets

• The globalization of financial markets has
  resulted individual markets become more
  integrated and more open to non-resident
  borrowers and investors.
• As a result, opportunities for obtaining capital
  and investing capital have widened and have
  become more sophisticated.
• Today it is commonplace for a corporation to
  consider raising capital in foreign countries and
  denominating in any one of a number of
  currencies.
• Today it is also commonplace for an investor to
  consider investing in foreign countries and doing
  so in any one of a number of currencies.

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Global Capital Markets

• The worlds capital markets represent the
  financial markets for long term funds.
• By year end 2005, the estimated value of all the
  worlds capital markets (stock markets and bond
  markets combined) was just under 100 trillion.
• Of this amount, the bond markets accounted for
  61 and the stock markets accounted for 39.
• The United States capital market was the largest
  at 42 of the total, while the EU was second at
  29
• See next slide for data.

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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

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Global Bond Markets

• By year end 2005, the estimated value of all the
  worlds bond markets was 59 trillion.
• This amount was about 1 ½ times the size of the
  worlds stock markets.
• The corporate bond market accounts for 60 of the
  bond market, with 40 accounted for by
  governments.
• The United States bond market was the largest at
  40 of the total, while the EU was second at 32
• See next slide for data.

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The Bond Markets Governments and Corporates, 2005

• Bonds Total
• Govt 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

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Global Bond Markets 2001-2005

• From 2001 to 2005, the worlds bond markets grew
  from 37 trillion to 59 billion.
• The greatest increase in this total was
  represented by the corporate bond market.
• The corporate bond markets share of the total
  bond market increased from 50 in 2001 to 61 by
  2005.
• The government bond markets share declined from
  50 in 2001 to 39 by 2005.
• See next slide for data.

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Growth in Bond Markets, 2001 - 2005

• 2001 Trillions of USD
• Total Bonds 37.2
• Government 18.5
• Corporate 18.7
• 2005 Change 2001-2005
• Total Bonds 59.0 58.6
• Government 23.1 24.9
• Corporate 35.9 92.0
• Source IMF, 2002 and 2006 Global Financial
  Stability Reports

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Rise of Corporate Debt

• As noted, corporate debt has risen substantially
  in recent years.
• Thus, both domestic and multinational
  corporations have been increasing their
  participation in global debt markets since the
  mid-1990s.
• Why?
• (1) Deregulations associated with the
  globalization process of financial markets has
  resulted in more debt markets for corporates to
  enter.

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Rise of Corporate Debt

• (2) 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.
• (3) The general decline in global interest rates
  in the last 10 years has made borrowing
  relatively more attractive.
• (4) Some governments, especially in Europe, have
  reduced their funds needs (e.g., the Growth and
  Stability Pact in the Euro-zone) thus the growth
  of government debt has slowed.

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US Interest Rates 1978 - 2006
12
Euro Area Interest Rates
13
Japanese Interest Rates
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Reason for Declining Interest Rates
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Rise of the Eurozone and Flat Japan

• Historically, the U.S. bond market has dominated
  the global bond market.
• But, since the introduction of the euro, the
  Eurozone bond market has increased in importance.
• In 2001, the U.S represented 47 of the worlds
  bond market, but by 2005, the U.S. represented
  40.
• And by 2005, the Eurozone accounted for 29 of
  global debt mark up from 21 in 2001.
• Japans share of the global bond market has
  remained relatively stable at about 17 since
  2001.

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Bond Market Growth in Europe
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Classification of the Worlds Bond Market

• The worlds bond market can be divided into two
  broad groups the domestic bond market and the
  international bond market.
• The domestic bond market is comprised of all
  securities issued in each country by government
  entities and corporates. In this case, issuers
  are domiciled (headquartered) in the country
  where those bonds are traded.
• The international bond market consists of the
  Foreign market and the Eurobond market.
• Of these two groups, the domestic and the
  international, the domestic bond market dominates
  accounting for about 80 of the total.
• See next slide for data.

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

• Foreign Bonds Bonds issued by a non-resident and
  denominated in the currency of the country in
  which it is being offered.
• Ford Corporation issuing a yen denominated bond
  in Japan
• Foreign bonds are often swapped out for another
  currency.
• Foreign bonds are subject to the regulations of
  the country in which the bond is being offered.
• Historically, the most important foreign bond
  markets are in Zurich, New York, and Tokyo.
• Foreign bonds have unusual nicknames such as
• Yankee bonds issued in the United States,
• Matador bonds in Spain,
• Rembrandt bonds in the Netherlands,
• Samurai bond in Japan,
• Bulldog bonds in the United Kingdom,
• Kiwi bonds in New Zealand.

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Eurobond Market

• Eurobonds bonds issued and sold simultaneously
  in more than one market, and in a jurisdiction
  outside the country of the currency of
  denomination.
• Coca Cola issuing a U.S. dollar denominated bond
  in Europe and Asia.
• The advantage of the Eurobond market is that
  issuers can tap investors and investing
  institutions from around the world.
• Issuers include governments, AAA corporations
  and banks.
• Issue size can range from 50 million to 1
  billion and over.

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Birth of the Euro-Bond Market

• Until the early 1960s, foreign borrowers
  generally raised money by issuing securities
  denominated in US dollars in the US bond market
  (these were called foreign bonds).
• However, the US Government, in order to reduce
  the flow of funds out of the US and, thereby, to
  redress its balance of payments deficit, imposed
  several controls in the early-1960s upon both
  domestic and foreign borrowers.
• As a result, many US and foreign borrowers turned
  to the euro-markets (offshore).
• This shift led to the creation of the
  euro-securities market, and specifically the
  eurobond market.

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Euro-Bond Market

• The first euro-bond was issued in July of 1963 by
  the Italian highway authority, Autostrada.
• The bond was a 15 million US dollar denominated
  bond issued to investors in the UK, Belgium,
  Germany and the Netherlands.
• The bond was listed on the London Stock Exchange.
• The Euro-Bond market took off in 1968 when
  Euroclear, the computerized settlement and
  deposit system for the delivery and payment of
  eurobonds bonds, came on line.

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The Main Features of a Eurobond

• Denominated in an offshore currency. Therefore,
  investors in eurobonds take both credit and
  foreign exchange risks
• Issued and marketed internationally
• Sold to a wide range of investors through a
  multinational syndicate of underwriting firms and
  banks
• Generally bearer instruments to ensure the
  anonymity of the ultimate investors
• Either issued with the benefit of a stock
  exchange listing, normally in London or
  Luxembourg (although still placed with investors
  in various countries) and, therefore, called a
  "public offering", or placed with institutional
  investors without a listing (private placement).

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Eurobond Versus Foreign Bond Market

• Since the early 1980s, the volume of business in
  the Eurobond market has exceeded of the Foreign
  bond market by a growing margin.
• Today Eurobonds represent about 80 of
  international bonds with foreign bonds accounting
  for about 20.
• The reason for this growth lie in the fact that
  the Eurobond market is offshore and is not
  subject to the restrictive regulatory
  constrains of those in the domestic markets.

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Borrowing Spreads

• Since 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), of
  importance to global borrowers is the relative
  cost of borrowing in different markets.
• One way to assess the extent to which local
  markets differ from the worlds 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.

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10-Year Govt Bond Spreads, March 8, 2004

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

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10-Year Govt Bond Spreads, April 4, 2007
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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., an operational
  hedge).
• Why not use a forward contract?
• 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.

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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.
• Why not hedge with a forward contract?
• Again, if the Interest Rate Parity holds,
  protecting with a forward contact will negate the
  interest rate differential and offset the
  measured advantage of investing overseas in a
  high interest rate country.
• Perhaps an investor can protect himself/herself
  with a put option (in case the currency weakens).

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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.

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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, however, 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.
• 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.

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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 as well.
• 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 bonds
  indenture.

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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 Moodys
  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.

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Types of International Bonds Straight

• Straight Fixed Rate International Bond
• Most international bonds are of this type and are
  characterized by
• Designated maturity date,
• Fixed coupon payments ( of par value),
• Eurobond interest is typically paid annually
• Why? Less costly for borrowers to do so.
• No options (e.g., convertibility into stock)
  attached
• Entire issue brought to market at one time.
• Sometimes referred to as plain vanilla bonds!

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International Bonds Equity Related

• Equity Related Bonds
• (1) either fixed income convertible issues,
  which
• Allow 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.
• (2) or fixed income bonds with equity warrants,
  which
• Have a 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.

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International Bond Zeros

• Zero Coupon Bonds have the following
  characteristics
• Sold at a discount from face (par) value,
• Do not pay any coupon interest payments.
• At maturity, holder receives full face (par)
  value.
• Return is represented by the difference between
  price and face value.
• These zero coupon bonds are especially attractive
  to Japanese investors
• Why? Their tax laws treat the return on zero
  coupon bonds as a tax free capital gain (where in
  Japan coupon payments are taxable)!

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International Bonds Dual Currency

• Dual-Currency Bonds
• Fixed rate bond that pays interest in one
  currency, and
• Upon maturity, repays the principal 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.
• Example of a strategy in using a dual currency
  bond
• Used by Japanese companies wanting to establish
  or expand U.S. based subsidiaries.
• 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.