IBUS 302: International Finance

1. IBUS 302: International Finance Topic 13-International Bonds Lawrence Schrenk, Instructor .

2. Learning Objectives • Describe the general characteristics of international bond markets.▪ • Explain the classification of international bonds. • Explain the types of instruments available in the international bond market.▪

3. International Bond Markets • International bond markets are NOT unified into a single market (like FX and Eurocurrency market). • International Bonds are viewed as substitutes to Domestic bonds.

4. Market Demographics • Bond Market Segments: Domestic Bonds, Foreign Bonds, Eurobond • Total market value of the world’s bond markets are about 50% larger than the world’s equity markets. • Denominations: 1. U.S. $ = 47% (46% of international) 2. Euro = 18% (23% of international) 3. Yen = 19% (4.0% of international)

5. Classification • Domestic Bond Market • Foreign Bond Market • Global Bond Market • EuroBond Market Internal International External / Offshore

6. Domestic Bonds • Issued by domestic entity • Denominated in that country’s currency • Corporate • IBM issues $ denominated bonds in USA • Governments: • Treasury Bonds (USA) • Gilts (UK) • Bunds (Germany)

7. Domestic Bonds: Review • Key Variables • Principal, Par Value, Face Value • Coupon, Coupon Rate • Maturity (t) • Discount Rate (r) • Periods (per year), (m)

8. Domestic Bonds: Review • Premium versus Discount Bonds • Features • Callable Bonds • Convertible Bonds • Sinking Funds • Debt Covenant • Financial Ratios • Technical Default

9. Foreign Bonds–Type I • Issued by foreign entity • Outside the country where the entity resides • Denominated IN THE currency of the country where issued • Example: • Toyota issues $ denominated bonds in USA.

10. Foreign Bonds–Type II • Issued by foreign entity • Outside the country where the entity resides • Denominated in currency OTHER THAN THAT of the country where issued • Example: • Toyota issues Yen denominated bonds in USA

11. Foreign Bonds–Type II • Who are the potential investors for such a bond? • Toyota issues Yen denominated bonds in USA • Hedger: • Your Firm imports from Japan and has Yen A/P • Yen bond interest you receive is used to pay Yen A/P on your imports. Like a forward contract • Speculator: • Speculate that Yen will appreciate (buy more $)

12. Global Bonds • Similar to Foreign bonds, but • Simultaneously issued in many different countries. • Denominated in 1 or many currencies. • Registered in each market where issued.

13. EuroBonds • Issued outside the country in bond is denominated (same as second type of foreign bond) • OR, issued in same country, but only to ‘non-residents’ • Not Registered, i.e., Bearer Bonds • Example: • Toyota issues Yen-denominated bonds in “offshore” market. • EUROYEN Bond

14. Bond Return of Foreign Currency Bonds • RETURN = local currency return + foreign exchange return = YTM + %change in spot exchange rate

15. Comparing Yields on US Bonds and Eurodollar Bonds • U.S. Bonds pay semiannual coupons • Eurobonds pay annual coupons • Bond Equivalent Yield (BEY) of Eurobond = 2[(1 + YTM on eurobond)1/2 - 1] • Example: YTM on Eurobond = 10%. BEY = 2[(1.1).5 -1] = 0.09762 = 9.762% • Thus, Eurobonds must offer higher yields (all else is equal).

16. Summary of Features Affecting Eurobond Yields

17. Types of Instruments • Straight Fixed Rate Debt • Floating-Rate Notes • Zero Coupon Bonds • Equity-Related Bonds • Dual-Currency Bonds

18. Straight Fixed Rate Debt • ‘Plain Vanilla’ Bonds • Typically have annual coupons. • Since most Eurobonds are bearer bonds, coupon dates tend to be annual rather than semi-annual, less costly for issuer. • The vast majority (71% in 2002) of new international bond offerings are straight fixed-rate issues.

19. Floating-Rate Notes • Coupon rate reset every 6 or 12 months • Eurobonds commonly use LIBOR as reference rates LIBOR = London Interbank Offer Rate • Usually pay quarterly or semiannual coupons

20. Zero Coupon Bonds • No Explicit Interest Paid • Issued in one of two ways: • At a discount to face value • Issued as a zero at a 50% discount to $100 face value in 4 years • Yield = 18.9% • At face value, but pay a premium at maturity • Issue at $100 (Face Value), Pay $200 in 4 years • yield = 18.9%

21. Equity-Related Bonds • Convertibles • Allow the holder to convert bond in exchange for a specified number of shares in the firm of the issuer (or for some other specified commodity). • Bonds with Equity Warrants • Allow the holder to keep his bond but still buy a specified number of shares in the firm of the issuer at a specified price.

22. Dual-Currency Bonds • Fixed-rate bond • Price and interest in one currency. • Principal in another currency. • Japanese firms have been big issuers with coupons in yen and principal in dollars. • Good option for a MNC financing a foreign subsidiary. • Straight Bond + Forward Contract on ‘FV’

23. Credit Ratings • Corporate Debt • Fitch IBCA, Moody’s and Standard & Poor’s sell credit rating analysis. • Focus on default risk, not exchange rate risk. • Sovereign Debt • Assessing sovereign debt focuses on political risk and economic risk. • Sovereign debt is the obligation of a country’s central government.

24. International Bond Market Indices • There are several international bond market indices. • J.P. Morgan and Company • Domestic Bond Indices • International Government bond index for 18 countries. • Widely referenced and often used as a benchmark. • Appears daily in The Wall Street Journal