FNCE 3020 Financial Markets and Institutions

1
FNCE 3020Financial Markets and Institutions

• Lecture 9
• The Capital Markets
• An Overview of The Bond Markets

2
Capital Markets Overview

• Capital Markets Defined Financial markets
  involving financial assets with maturities of
  greater than one year.
• Best known capital market securities include
• Stocks and bonds
• Mortgages
• Primary issuers of these securities
• Federal government and local governments
• Corporations (U.S. and foreign)
• Individuals
• Largest purchasers of capital market securities.
• Individuals and Financial Instructions.
• Pension funds, mutual funds.

3
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)
• Euro 8.4 (17) 18.8 (27)
  27.2 (23)
• U.K. 3.8 ( 8) 3.3 ( 5)
  7.1 ( 6)
• 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

4
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)
• Euro 6.0 (16) 15.2 (26)
  21.2 (22)
• U.K. 3.1 ( 8) 3 3 (
  6) 6.4 ( 7)
• 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

5
Global Capital Markets Summary

• By year end 2006, the estimated value of all the
  worlds capital markets was 115.5 trillion (this
  was an increase of 24 over 2005).
• In 2006, stock markets grew by 37 and the bond
  markets by 16
• Bond markets are the larger of the two capital
  markets (57 versus 43 in 2006 but down from 61
  and 39 in 2005).
• The United States capital market is the largest
  at 39 of the total (but down from 42 in 2005),
  while the EU is second at 31 (up from 29 in
  2005).
• Japans share of the worlds capital markets fell
  from 17 in 2005 to 11 in 2006.

6
Global Bond Markets Summary

• By year end 2006, the estimated value of all the
  worlds bond markets was about 69 trillion
  (compared to 59 trillion in 2005).
• 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).
• Japans share of the global bond market slipped
  from 15 to 13.

7
Size and Composition of Developed and Emerging
Capital Markets, 2006

• Stock Bond
  Total Capital
• Markets Markets
  Markets
• World 50.8 (43) 68.7 (57) 119.5 (100)
• Developed 39.2 (77) 62.1 (90) 101.3
  (85)
• Emerging 11.6 (23) 6.1 (10) 17.7
  (15)
• Asia 6.9 (13) 3.5 (
  5) 10.4 ( 9)
• Latin Amer 1.5 1.6
  3.1
• Europe 1.9 .7
  2.6
• Africa .9
  .1 1.0
• 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

8
Size and Composition of Developed and Emerging
Capital Markets, 2005

• Stock Bond
  Total Capital
• Markets Markets
  Markets
• World 37.2 (39) 59.0 (61) 96.2 (100)
• Developed 30.6 (82) 54.5 (92) 85.1
  (89)
• Emerging 6.6 (18) 4.5 ( 8) 11.1
  (11)
• Asia 4.4 (12) 2.4 (
  4) 6.8 ( 7)
• Latin Amer 1.2 1.3
  2.5
• Europe .3 .7
  1.0
• Africa .6
  .1 0.7
• 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

9
Developed and Emerging Capital Markets Summary

• Developed country capital markets dominate the
  worlds total capital markets.
• But their share is declining (89 in 2005 to 85
  in 2007)
• The increase in emerging capital markets is
  occurring in Asia, and especially in their equity
  markets.
• Emerging market equity markets increased from 18
  of total world equity markets in 2005 to 23 in
  2006.
• By 2006, emerging Asia equity markets represented
  13 of the worlds total equity markets.

10
The Bond Markets Governments and Corporates, 2006

• Bonds Total
• Government Corporate Bonds
• World 25.6 (37) 43.1 (63) 68.7(100)
  
• U.S. 6.2 (24) 20.5 (48) 26.7 (39)
• EU 7.7 (30) 15.5 (36) 23.2 (34)
• Euro 6.6 (26) 12.2 (28)
  18.8 (27)
• UK .8 ( 3) 2.5 ( 6)
  3.3 ( 5)
• Japan 6.7 (26) 2.0 ( 5) 8.7
  (13)
• Emerging 3.8 (15) 2.2 ( 5)
  6.0 ( 9)
• Note Trillions of U.S. dollars, and () of
  total.
• Source IMF, Global Financial Stability Report,
  2007

11
Composition of Global Debt Markets

• Government debts share of the global bond market
  has declined in recent years especially since the
  mid-90s.
• In the early 1990s, Government debt was over 60
  of the total global bond market.
• By 2006, Government debt was less than 40 of the
  total global bond market.

12
Government and Corporate Bond Markets Summary

• 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 (i.e., private) bond
  market.
• The corporate (private) bond markets share of
  the total bond market increased from 50 in 2001
  to 63 by 2006.
• With the exception of Japan, in the United States
  and in the EU, the corporate bond markets are now
  larger than the government bond markets.
• In the emerging countries as a group, the
  government bond markets dominate the corporate
  bond markets.

13
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.

14
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).
• Japan is the exception (see next slide).

15
Government Debt as a of GDP
16
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 in 1999
  and the resulting 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 and the Eurozone countries
  represented 21.
• But by 2006, the U.S. share had fallen to 39 and
  the Eurozone share had grown to 27.

17
Bond Market Growth in Europe
18
Growth in Corporate Bonds in the Eurozone,
1998-2005 (Billions of Euros)
19
U.S. Interest Rates 1990 - 2008
20
Eurozone 10-year Government Bond Rates, 1990-2008
21
Japan 10-Year Government Bond Rates, 1990 - 2008
22
Australia 10-Year Government Bond Rates,
1990-2008
23
The Worlds Bond Markets

• The worlds bond market can be divided into two
  broad groups (1) the domestic bond market and
  (2) the international bond market.
• (1) The domestic bond market is comprised of all
  securities issued in each country by domestic
  government entities and corporates.
• In this case, issuers are domiciled (i.e.,
  headquartered) in the country where those bonds
  are traded.
• (2) The international bond market is comprised of
  non-residents borrowing in another countrys bond
  markets
• The international bond market consists of two
  groups Foreign Bonds of and Eurobonds.
• The domestic market dominates the global bond
  market, accounting for about 80 of the total.
• See next slide

24
Amounts of Domestic and International Bonds
Outstanding, Year-End 2004 in U.S. Billions
25
Foreign Bonds

• Foreign Bonds Bonds issued by a non-resident and
  denominated in the currency of the country in
  which it is being placed.
• Example Ford Motor Corporation issuing a yen
  denominated bond in Japan
• Foreign bonds are subject to the regulations of
  the country in which the bond is being offered.
• The SEC regulates foreign bond offerings in the
  U.S.
• Historically, the most important foreign bond
  markets have been in Zurich, New York, and Tokyo.
• Foreign bonds are often issued because of
  interest rate considerations (see next slide) and
  then swapped out for another currency.

26
Bond Spreads, April 8, 2008
27
Names for Foreign Bonds

• The financial markets have come up with unusual
  nicknames for foreign bonds. These include
• Yankee bonds
• Issued in the United States,
• Matador bonds
• Issued in Spain,
• Rembrandt bonds
• Issued in the Netherlands,
• Samurai bonds
• Issued in Japan,
• Bulldog bonds
• Issued in the United Kingdom,
• Kiwi bonds
• Issued in New Zealand.
• Kangaroo bonds
• Issued in Australia.
• Maple bonds
• Issued in Canada.

28
Eurobonds

• Eurobonds Bonds issued and sold simultaneously
  in more than one market, and all 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 borrow from individual and
  institutional investors all around the world.
• Thus the advantage of a large global capital
  market.
• Issuers include national governments, AAA
  corporations and global banks.
• Issue size can range from 50 million to 1
  billion and over.
• U.S. dollar is the dominant currency of
  denomination for Eurobonds.

29
The Main Features of a Eurobond

• Denominated in an offshore currency.
• Therefore, investors in eurobonds take both
  credit and foreign exchange risks.
• Sold to a wide range of individual and
  institutional investors through a multinational
  syndicate of underwriting firms and banks.
• Generally bearer instruments to ensure the
  anonymity of the ultimate investors.
• Some publically offered eurobonds trade on stock
  exchanges, normally in London or Luxembourg.
  Others are placed directly with institutional
  investors without a listing (private placement).

30
History of the Euro-Bond Market

• Until the early 1960s, foreign borrowers
  generally raised money by issuing securities
  denominated in U.S. dollars in the U.S. bond
  market (referred to as 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.
• Voluntary Credit Restraint Program in 1965.
• As a result, many US and foreign borrowers turned
  to the euro-bond markets (offshore).
• First euro-bond was issued in July of 1963 by the
  Italian highway authority, Autostrad, a 15
  million U.S. dollar denominated bond issued to
  investors in the UK, Belgium, Germany and the
  Netherlands and was listed on the London Stock
  Exchange.

31
Eurobond Market Surpasses U.S. Bond Market in 2005
32
Risk to Holders of Foreign Bonds

• A holder of a foreign currency denominated bond
  assumes the following types of risk
• Default Risk (Credit Risk)
• Price Risk
• Foreign Exchange Risk
• The latter is unique to holders of foreign
  currency denominated bonds.
• Essentially, the risk that the foreign currency
  you will be receiving in the future (interest and
  principal repayment) will weaken relative to your
  home currency.

33
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.

34
Appendix 1 Regulation of International Bonds
35
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.

36
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.

37
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.

38
Appendix 2 Types of International Bonds
39
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!

40
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.

41
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)!

42
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.