INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

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INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

• Lecture 11
• The International Bond Markets
• NOT

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Theme of this Lecture and one to Follow

• Americas post war (since the 1940s) capital
  market dominance has declined.
• While America still has the largest capital
  markets, other foreign markets have gown in
  relative importance.
• Therefore, it is critical that students be
  introduced to global capital markets.
• As investors (individual and asset managers) and
  as corporate borrowers.

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Global Capital Markets

• The worlds capital markets represent the
  financial markets for long term funds.
• By year end 2006, the estimated value of all the
  worlds capital markets (stock markets and bond
  markets combined) was just under 120 trillion.
• Of this amount, the bond markets accounted for
  57 and the stock markets accounted for 43.
• The United States capital market was the largest
  at 39 of the total (42 in 2005), while the EU
  was second at 31 (29 in 2005)
• See next slide for data.

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Size and Composition of Capital Markets, 2006

• Stock Bond
  Total Capital
• Markets Markets
  Markets
• World 50.8 (43) 68.7 (57) 119.5
  (100)
• U.S. 19.6 (39) 26.7 (39) 46.3 (39)
• EU 13.1 (26) 23.2 (34) 36.6 (31)
• Japan 4.8 ( 9) 8.7 (13) 13.5
  (11)
• Note Trillions of U.S. dollars, and () of
  total.
• Source IMF, Global Financial Stability Report,
  2007 http//www.imf.org/External/Pubs/FT/GFSR/2007
  /02/index.htm

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Size and Composition of Capital Markets, 2005

• 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 2006, the estimated value of all the
  worlds bond markets was about 69 trillion (59
  trillion in 2005).
• This amount was about 135 larger than the
  worlds stock markets.
• The United States bond market was the largest at
  39 of the total (40 in 2005), while the EU was
  second at 34 (32 in 2005)
• See previous slide for data.

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Global Bond Markets 2001-2006

• From 2001 to 2006, the worlds bond markets grew
  from 37 trillion to 69 trillion.
• This represents an increase of about 85
• The greatest increase in this total was
  represented by the corporate (private) bond
  market.
• The corporate (private) bond markets share of
  the total bond market increased from 50 in 2001
  to 63 by 2006.
• The government (public) bond markets share
  declined from 50 in 2001 to 37 by 2006.
• See next slide for data.

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Growth in Bond Markets, 2001 - 2006

• 2001 Trillions of USD
• Total Bonds 37.2
• Government 18.5
• Corporate 18.7
• 2006 Change 2001-2006
• Total Bonds 68.7 84.7
• Government 25.6 38.4
• Corporate 43.1 130.5
• Source IMF, 2002 and 2007 Global Financial
  Stability Reports

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Rise of Corporate Debt

• As noted from the previous exhibit, corporate
  debt has risen substantially in recent years.
• In effect, both domestic and multinational
  corporations have been increasing their
  participation in global debt markets since the
  mid-1990s.
• Why?
• (1) Deregulations of capital markets (associated
  with the globalization process) has expanded the
  number of debt markets which non-resident
  corporations can enter.

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Rise of Corporate Debt Continued

• (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 (coupled with a tax
  incentive in many countries).
• (4) Some governments, especially in Europe, have
  reduced their funding needs (e.g., the Growth and
  Stability Pact in the Euro-zone has limited
  European Government debt issues).

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US Interest Rates 1978 - 2007
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Euro Area Interest Rates
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Japanese Interest Rates
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Reason for Declining Interest Rates
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Rise of the Eurozone Bond Market

• Historically, the U.S. bond market has dominated
  the global bond market.
• For both U.S. companies and non-residents.
• But, since the introduction of the euro and the
  development of a true pan-European debt market,
  the Eurozone bond market has increased in
  importance.
• In 2001, the U.S represented 47 of the worlds
  bond market, but by 2006, the U.S. share had
  fallen to 39.
• By 2006, the Eurozone accounted for 34 of global
  debt mark up from 21 in 2001.

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Bond Market Growth in Europe
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Changing Nature of Corporate Bond Market
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Classification of the Worlds Bond Market

• The worlds aggregate bond market can be divided
  into two broad groups the (1) domestic bond
  market and the (2) international bond market.
• The domestic bond market is comprised of all
  securities issued by borrowers (government
  entities and corporates) domiciled (i.e.,
  headquartered) in the country where those bonds
  are traded.
• The international bond market involves
  non-resident borrowing in capital markets and
  consists of the (1) foreign bond market and the
  (2) Eurobond bond 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 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 global 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 U.S. bond market
  (these were called foreign bonds).
• However, in the early-1960s, the U.S. Government,
  in an attempt to reduce an outflow of funds from
  U.S. (i.e., a balance of payments deficit),
  imposed several controls upon both domestic and
  foreign borrowers.
• Interest Equalization Tax in 1963.
• 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 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.

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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, Nov 30 , 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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Appendix 1 Regulation of International Bonds
and Types of International 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.