Global Bond Markets

1. Global Bond Markets Chapter 19 Chapter 19: Global Bond Markets

2. A Brief Tour of the Global Bond Market • By the end of 1998 the aggregate value of all outstanding bonds in the world was $25.4 trillion • About 50% were denominated in U.S. dollars • 15% were denominated in yen • 10% denominated in Deutschemark • 26% of world’s debt originated from Euroland in 1998 Chapter 19: Global Bond Markets

3. The U.S. Bond Market U.S. Treasury is the world’s single largest borrower—also has the most liquid market—an informal OTC market. Chapter 19: Global Bond Markets

4. U.S. Government Agency Bonds • Federal government allows governmental agencies to borrow in the name of the agency • The agencies’ debts do not appear as part of the federal government’s debt • However, federal government implicitly guarantees the agencies’ debts • Federal National Mortgage Association (FNMA—Fannie Mae) is the second largest borrower in U.S. • GNMA (Ginnie Mae) and FHLMC (Freddie Mac) are also large borrowers • Subsidize home ownership by issuing low interest rate bonds guaranteed by U.S. government Chapter 19: Global Bond Markets

5. Corporate Bonds in the U.S. • Market for corporate bonds is less liquid than market for U.S. Treasuries • IPOs for bonds are underwritten by investment banking firms • Largest organized secondary bond market is NYSE • Uses matrix prices for most of the bonds listed on its Automated Bond System (ABS) • Based on price quotes for similar bonds (in terms of coupon rate, maturity, quality rating, call provisions) Chapter 19: Global Bond Markets

6. Corporate Bonds in the U.S. • Problems with ABS • Does not provide a liquid market free from arbitrage opportunities • Large bond orders are difficult to execute • Most U.S. corporate bonds trade OTC • OTC bond quotes are not meaningful • Again, large orders are difficult to execute at the quoted price Chapter 19: Global Bond Markets

7. Bond Markets in the U.S. U.S. government conducts regularly scheduled auctions for Treasury securities. Chapter 19: Global Bond Markets

8. Bond Markets in the U.S. • Transparency in a securities market exists when accurate price and volume information is freely available • U.S. bond market is not transparent • Internet operations help increase the market’s transparency • TradeWeb—allows institutional investors the ability to trade U.S. Treasury securities • Broker Tec—online interdealer bond brokerage • Trading Edge—operates a trade matching system for bonds • Bond Book—allows institutional investors and dealers to anonymously trade corporate, junk and municipal bonds • Bond markets are never expected to enjoy the same transparency and liquidity as U.S. stock markets • There are  11,000 individual U.S. stocks vs.  4.5 million bond issues Chapter 19: Global Bond Markets

9. Sectors of the Industrialized World’s Bond Markets • In almost every country, the federal government is that country’s largest debt issuer • Corporate sector for Japan, Italy and Germany is relatively small compared to their overall bond markets • Due to custom of borrowing from a bank vs. issuing bonds Chapter 19: Global Bond Markets

10. International Bonds • Represent a rapidly growing category • Reflects willingness of borrowers to borrow across borders • International bond investors face two types of political risk • Repatriation-of-funds risk • A government may block payments of principal or interest • Sovereign risk • A government may refuse to honor its debts Chapter 19: Global Bond Markets

11. International Bonds • Can be organized into the following categories • Domestic bonds • Issued by a local borrower and denominated in local currency • Foreign bonds • Issued in one country and denominated in that country’s currency by a bond issuer from another country • Eurobonds • Any bond not issued in a domestic market regardless of its currency denomination and the issuer’s nationality Chapter 19: Global Bond Markets

12. Foreign Bonds • Categories of foreign bonds • Yankee bonds • Issued by non-U.S. borrowers within the U.S. • Samurai bonds • Yen-denominated bonds issued in Japan by non-Japanese borrowers • Shogun bonds • Non-yen-denominated bonds issued in Japan by non-Japanese borrowers • Bulldog bonds • Issued by non-British borrowers in the U.K.—denominated in pounds Chapter 19: Global Bond Markets

13. Foreign Bonds • Yankee bonds are popular because liquid markets in high quality corporate bonds are nonexistent in many countries • Because governments encourage firms to borrow from banks rather than issuing bonds Chapter 19: Global Bond Markets

14. The Eurobond Market • Fastest growing, most diverse bond market • Include the following bond types • Fixed coupon bonds, floating rate bonds, zero coupon bonds • Renewable ordinary bonds • Ordinary bonds containing embedded options • Exchangeable floating rate notes • Convertible bonds • Bonds with warrants attached • Index-linked bonds • Dual currency bonds Chapter 19: Global Bond Markets

15. Primary and Secondary Markets for Eurobonds • Underwriting syndicates can be complex • Management group—can have from 4 to 30 member firms • Assemble an underwriting group—ranging from 20 to 300 banks • A selling group is also created • Three groups split underwriting fees—ranging from 1.25% to 2.5% of the value of issue • Market’s untaxed and unregulated • Time schedule for issuing new bonds can be as short as six weeks Chapter 19: Global Bond Markets

16. Primary and Secondary Markets for Eurobonds • Eurobonds begin trading in the gray market weeks before final offering price is set • A forward market for bonds that do not yet exist • Most Eurobonds are listed on the Luxembourg Stock Exchange, but they don’t actually trade there • Most trades occur in the OTC market • Similar to NASD but free from SEC-like regulation Chapter 19: Global Bond Markets

17. Bearer Bonds Vs. Registered Bonds • Registered bonds—send coupon checks to registered bond owners • Bearer bonds—have no list of registered owners • Investor must submit a dated coupon to a bank to receive coupon payments • Many Eurodollar bonds are of this type • Owner’s identity is unknown Chapter 19: Global Bond Markets

18. Eurodollar Bonds • U.S. dollar denominated bonds • Issued as bearer bonds • Underwritten by an international syndicate • Issued and traded outside the jurisdiction of any single country • Largest component of Eurobond market • Who issues Eurodollar bonds? • National governments and their agencies • Corporations • Some countries with stringent regulations do not allow corporations to issue bonds similar to Eurodollar bonds in their country • Thus, these corporations issue Eurodollar bonds outside their country • Investors & multinational issuers like the lack of regulation and taxes Chapter 19: Global Bond Markets

19. Accrued Interest • Market price of bond (or its clean price) is: • Bonds pay coupon payments periodically • Annually, semi-annually, quarterly, etc. • When a bond is purchased on a day between its scheduled interest payment, buyer must pay seller for accrued interest • Interest that has been earned but not yet paid by issuer Chapter 19: Global Bond Markets

20. Accrued Interest • Accrued interest calculation: • Thus, the actual price for a bond is the bond’s clean price plus the accrued interest • Known as the bond’s invoice price, full price or dirty price • U.S. newspapers quote clean prices • But buyers must pay the dirty price, which is always higher if bond is between coupon payment dates • However, difference is not substantial Chapter 19: Global Bond Markets

21. Dirty Bond Prices Experience an Ex-Coupon Price Drop-off • Some countries use different bond invoicing methods • Quote prices with accrued interest included (dirty prices) • Called a cum coupon price • The quoted price will experience a drop-off in price immediately after a coupon payment is made • Because accrued interest drops to zero Chapter 19: Global Bond Markets

22. Day Counting Conventions • The convention used in counting days is important when calculating accrued interest • Many countries use 360-day conventions • Corresponds to twelve 30-day months • U.K., Canada & Japan use 365-day convention Chapter 19: Global Bond Markets

23. Compounding Conventions • The length of time between coupon payments impacts bonds’ yields and prices Chapter 19: Global Bond Markets

24. Yield-to-Maturity (YTM): A First Look • A simple approximation of yield-to-maturity is: • Above formula does not involved compounding • Used in Japan, but not in U.S. • Ignoring compounding will result in a YTM only a few basis points different than the correct YTM • But a few basis points can be thousands of dollars for a multi-million dollar bond transaction Chapter 19: Global Bond Markets

25. Compounded YTM • YTM defined as the discount rate equating the present value of a bond’s future cash flows to its current market price • For bonds paying coupon payments semi-annually, the correct formula is: • The YTM is identical to IRR Chapter 19: Global Bond Markets

26. Cuts the years in half rather than the YTM. Compounded YTM • Another method for calculating YTM • Effective YTM • For a semi-annual coupon bond this method is: Chapter 19: Global Bond Markets

27. Example: Comparing a Bond’s Conventional and Effective YTM • Given information • Par value: $100 • Coupon rate: 10% (semi-annual) • Time to maturity: 10 years • Purchase price: $106.59 • Using the conventional YTM formula, we calculate a YTM of 8.8973% Chapter 19: Global Bond Markets

28. Example: Comparing a Bond’s Conventional and Effective YTM • Using the effective YTM (EYTM) formula, we calculate an EYTM of 9.1892% • Difference is about 20 BPs • 9.1892% - 8.9873% = 0.2019 • The difference between conventional YTM and EYTM is • (1 + EYTM) = (1+YTM/2)2 or YTM + YTM2/4 • Or: 0.089873 + (0.089873)2/4 = 0.091892 or 9.1892% Chapter 19: Global Bond Markets

29. Comparing Various YTMs for a Bond • Many people think YTM is a very precise measure • YTM depends upon assumptions and techniques used • For example, a bond with a $100 par, a 10% coupon, a 10-year maturity and a current price of $106.59 can have several YTMs • Conventional semi-annual: 8.9873% • Effective semi-annual: 9.1892% • Japanese semi-annual: 9.3187% Chapter 19: Global Bond Markets

30. Conditions Required to Earn a Bond’s Expected YTM • A bond’s computed YTM will only actually be earned if: • The bond is held to maturity • The bond issuer does not default in the timing or amount of scheduled payments • All the cash flows are immediately reinvested to earn the bond’s YTM Chapter 19: Global Bond Markets

31. Reinvestment Rate Affects A Bond’s YTM • Different reinvestment rates impact the investor's actual rate of return • Example: An investor buying an 8% coupon bond at par will expect a YTM of 8% • However, his actual return hinges on the reinvestment rate earned on the coupon income received Only if the reinvestment rate = YTM will the investor actually realize the YTM. Chapter 19: Global Bond Markets

32. A Bond’s Holding Period Return • An investor’s holding period return (r) is: • Can be positive, negative or zero • Depends on how the price moved over the holding period • A bond’s price movements are determined by fluctuations in the bond’s YTM Chapter 19: Global Bond Markets

33. Inverse Relationship Between a Bond’s Price and YTM • The price and YTM of a bond move inversely NOTE: Price-yield curves are convex to the origin. Chapter 19: Global Bond Markets

34. Other Measures of Bonds’ Yields • Yield-to-call (YTC) • A bond issuer may call a bond before its original maturity date • Need to calculate the bond’s YTC • Similar to YTM, except replace T as the time-to-call rather than time-to-maturity Chapter 19: Global Bond Markets

35. Example: Comparing a Callable Bond’s YTC & YTM • Compute the YTC: • Given information • Par value: $10,000 • Time to maturity: 10 years • Coupon rate: 7% (3.5% semi-annually) • Current price: $8,140.32 • Call premium: 7% in 5 years (meaning the bond is callable at 107% of par in 5 years) • Compute the YTM: Chapter 19: Global Bond Markets

36. Other Measures of Bond’s Yields • Floaters • A bond with a fixed par but a fluctuating (or floating) interest rate • Rate varies according to a specified reference rate • LIBOR or U.S. T-bill rates are commonly used • Current yield—every non-zero bond has a positive current yield • Investors desiring high investment cash flows are interested in a bond’s current yield Chapter 19: Global Bond Markets

37. Brady Bonds Aid Emerging Countries • An international debt crisis occurred in late 1980s due to falling commodity prices and recessions • Many loans were defaulting ($200 billion) • Mostly from Latin America • Many emerging countries vanished from international financial markets • Debt banks created Paris Club organization • Also organized a secondary market for the non-performing bank loans • Typically priced at less than half original face value Chapter 19: Global Bond Markets

38. Brady Bonds Aid Emerging Countries • In 1989 the U.S. Secretary of Treasury, Nicholas Brady proposed the Brady Plan • Provided a way to finance the defaulted loans until they could be paid off • Emerging country must get an economic reform plan approved and obtain loans through International Monetary Fund and World Bank or elsewhere • Development banks established repayment plans • Made the defaulted debt marketable by guaranteeing repayments • Allowed troubled banks to exchange illiquid defaulted bank loans for liquid Brady bonds Chapter 19: Global Bond Markets

39. Brady Bonds Aid Emerging Countries • No Brady bonds are 100% guaranteed • Types of Brady bonds • Most popular • Discount bonds (AKA: principal-reduction bonds) • Issued at a deep discount from par • Par bond (AKA: interest-reduction bond) • Face value equals par value of defaulted debts • Debt reduction occurs by setting coupon rate below current market rate Chapter 19: Global Bond Markets

40. Brady Bonds Aid Emerging Countries • Less popular Brady bonds • Debt-conversion bonds (DCBs) and new-money bonds (NMBs) • Each dollar invested in NMBs can be converted into a larger amount of more desirable DCBs • Front-loaded interest-reduction bonds (FLIRBs) • Pay low coupon rates during early years but coupon rate increases over time • Past-due interest bonds (PDIs) • Issued to pay for past omitted interest payments Chapter 19: Global Bond Markets

41. Brady Bonds Aid Emerging Countries • Outcome of the Brady Plan • Emerging nations able to settle defaulted debt at a reduced cost • Reduced debt allowed countries to renew economic growth • Troubled countries able to regain access to capital markets • Critics of Brady Plan argue • Too costly • Developed nations finance the development banks • Subsidizes financial mismanagement Chapter 19: Global Bond Markets

42. International Bond Index Statistics No single bond investment appears to be the most or least risky. Chapter 19: Global Bond Markets

43. Components of International Bond Returns Returns are from the standpoint of a U.S. investor. Results suggest investor needs to analyze all three components. Chapter 19: Global Bond Markets

44. Correlations of International Bond Returns • High correlations result from: • Bilateral trade agreements • Policies to align currencies • Cultural similarities Chapter 19: Global Bond Markets

45. Correlations of International Bond Returns • What’s important is the fact that there are some relatively low correlations among international bond returns resulting from • Dynamics of business cycles within countries • Different monetary policies • Different government financing practices • Differing inflation levels • Social trends, foreign policies ad political forces • Correlations are unstable over time Chapter 19: Global Bond Markets

46. Markowitz Analysis of International Bond Portfolio • Caveats: • Based on historical data—no guarantee future will be the same • Ignores commissions and other expenses U.S. investor can achieve a dominant position by investing 40% of portfolio in non-U.S. bonds. Chapter 19: Global Bond Markets

47. Actively Managing International Bond Investments • Active international bond investors can use different approaches: • Political analysts begin with a top-down approach and analyze sovereign risks, etc. • Macro-economists study macro factors (income, employment, etc.) to determine which nations are economically strong • Monetary economists forecast a nation’s level and structure of market interest rates by analyzing central bank and their policies, etc. • Industry analysts analyze financial data from different industries • Security analysts have a bottom-up approach—focus on bond issuer’s financial conditions, protective provisions, etc. Chapter 19: Global Bond Markets

48. The Bottom Line • Governments are the largest borrowers in the world • Most rapid growth occurring in Eurobond market • Unregulated and untaxed • Some countries publish clean bond prices while others publish dirty prices which includes accrued interest • Day counting conventions differ across countries • YTM calculations methods also differ across countries Chapter 19: Global Bond Markets

49. The Bottom Line • If a bond’s cash flows are not invested at the bond’s YTM the investor will not earn the YTM • Other yield measures exist • Holding period return • Current yield • Yield to call Chapter 19: Global Bond Markets

50. The Bottom Line • Brady Plan generated an array of packages of defaulted bank loans from emerging countries • Investors need to analyze capital appreciation, coupon interest return and foreign exchange return when considering investments in international bonds • Markowitz portfolio analysis is applicable for international bond investing Chapter 19: Global Bond Markets