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IBUS 302: International Finance

Topic 13-International Bonds

Lawrence Schrenk, Instructor.

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Learning Objectives

1. Describe the general characteristics of international bond markets.▪

2. Explain the classification of international bonds.

3. Explain the types of instruments available in the international bond market.▪

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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.

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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)

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• Domestic Bond Market

• Foreign Bond Market

• Global Bond Market

• EuroBond Market

International

Internal

External / Offshore

Classification

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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)

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Domestic Bonds: Review Key Variables

Principal, Par Value, Face Value Coupon, Coupon Rate Maturity (t) Discount Rate (r) Periods (per year), (m)

tmtm

mr

ParValue

mr

mr

CouponPV

11

11

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Domestic Bonds: Review

Premium versus Discount Bonds Features

Callable Bonds Convertible Bonds Sinking Funds

Debt Covenant Financial Ratios Technical Default

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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.

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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

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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 $)

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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.

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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

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Bond Return of Foreign Currency Bonds

RETURN

= local currency return

+ foreign exchange return

= YTM + %change in spot exchange rate

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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).

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Summary of Features Affecting Eurobond Yields

Yield impact Eurobond Feature

– Tax Free Interest

+ Registration and Regulation

+ Annual Coupons

– Quality of Issuer

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Types of Instruments

Straight Fixed Rate Debt Floating-Rate Notes Zero Coupon Bonds Equity-Related Bonds Dual-Currency Bonds

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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.

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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

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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%

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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.

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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’

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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.

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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