INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

1
INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

• Lecture 11
• The International Bond Markets

2
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.

3
Capital Markets A Global View, 2004, In
Trillions of U.S. Dollars

• Stock Bonds Total
  Total
• Market Govt Private
  Bonds Market
• World 37.2 23.1 34.9 58.0
  95.2
• U.S. 16.3 5.5 17.0 22.5
  38.5
• EU 9.3 7.3 12.0 19.3
  28.5
• London 2.9 0.7 1.8
  2.5 5.4
• Japan 5.9 6.9 2.3 9.2
  15.1
• Source International Monetary Fund, Global
  Financial Stability Report, September 2005
• http//www.imf.org/external/pubs/ft/gfsr/2005/02/i
  ndex.htm

4
Capital Markets A Global View, 2004, In Percents

• Stock Bonds Total
  Total
• Market Govt Private
  Bonds Market
• World 39.0 22.1 36.7 61.0
  100.00
• of Individual Markets and of Total Market
• U.S. 47.8 23.8 48.7 38.8
  40.4
• EU 25.0 31.6 34.4 33.3 29.9
• London 7.8 3.0 5.5
  4.3 5.7
• Japan 15.9 29.9 6.6 15.9
  15.9

5
Initial Statistics Bonds

• Year end 2004, the worlds total bond market was
  estimated at 58.0 trillion.
• This was larger than the worlds equity markets
  by 56
• Historically, the U.S. bond market has dominated
  this global total
• In 2001, the U.S represented 47 of the worlds
  bond market.
• But, U.S. dominance is declining
• By 2004, the U.S. represented 39.
• And by 2004
• The Eurozone accounted for 33 of global debt
  market
• Up from 21 in 2001.
• Japan accounted for nearly 16
• Percent unchanged since 2001.

6
Growth in Bond Markets, 2001 - 2004

• 2001 Trillions of USD
• Total Bonds 37.2
• Government 18.5
• Private 18.7
• 2004 Change 2001-2004
• Total Bonds 58.0 55.9
• Government 23.1 24.9
• Private 34.9 86.6
• Source IMF, 2002 and 2005 Global Financial
  Stability Reports

7
Composition of Global Debt Markets

• Government debts share of the global bond has
  declined in recent years especially since the
  mid-90s.
• By 2001, Government debt was about 50 of the
  total global bond market.
• By 2004, Government debt was about 40 of the
  total global bond market.

8
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
• 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.
• Japanese Government debt has risen from 4.4
  trillion in 2001 to 7.3 in 2004.
• The globalization of financial markets has
  resulted in more debt markets for corporates to
  enter especially in emerging markets.
• Recently, the advent of the euro and the single
  market process in the eurozone has encouraged the
  growth of global corporate issuance within this
  area (see next slide)
• The decline in global interest rates in the last
  10 years has made borrowing more attractive (see
  3 slides following next)

9
Corporate Bond Activity in Europe
10
Yields on Corporate and T-Bonds, U.S., 1978 -2005
11
10-Year Bond Rates, 1995- 2004

• In the Worlds major financial markets, interest
  rates trended down from 1995 to 2004.
• Why?

12
2005 and 2006 Interest Rate Trends

• U.S. corporate rates still low, but moving up?

13
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 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 3 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?

14
10-Year Govt Bond Spreads, April 18, 2006
Source http//news.ft.com/markets/bondspread
15
10-Year Govt Bond Spreads, March 8, 2004

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

16
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).

17
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.

18
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.

19
Amounts of Domestic and International Bonds
Outstanding As of Year-End 2004 in U.S. Billions
20
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. dollars share of international bonds
  fell from 50.7 to 40.5
• The euros 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 pounds share remained stable at
  around 7.
• The yens share fell from 6 to 4.4
• See next slide

21
Amounts of Domestic and International Bonds
Outstanding As of Year-End 2002 in U.S. Billions
22
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.

23
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.
• Foreign Exchange Risk for Borrowers
• Adverse changes in the exchange rate can increase
  the home currency equivalent interest rate.
• 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.
• 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.

24
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.

25
Eurobonds

• In any given year, about 80 of the worlds
  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.

26
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.

27
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 bonds
  indenture.

28
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.

29
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!

30
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.

31
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)!

32
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.

33
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
• ATT 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.