Fixed income securities

Dr.Guru. Raghavan

A brief history of Euromarkets

Using the money of one currency to transact business in another is not a new one. Such off shore dealings have gone on for centuries often with the aims of avoiding taxes, regulation or confiscation. The name of euromarket was first applied to offshore deposits in 1957, when Moscow Narodny Bank decided to transfer its dollar deposits out of the United States to foreclose the possibility that the US would confiscate the Soviet assets. The Russians had their dollars transferred from New York to a French bank that had the cable address EUROBANK, and soon all dollars deposited in European banks took the name Eurodollars

Market surge This has helped create a new financial market as a

result of the Bretton Woods system of fixed exchange rates, around which the non communist world was organized after the World War II. In the 1950s US was running a persistent balance of payments deficit. US government responded with an interest equalization tax, recommended by President John Kennedy in July 1963. By claiming 15% of the interest received by Americans on stocks and bonds issued by Europeans (securities from Canada, Japan and less developed countries were exempt) this was intended to reduce capital outflows.

Back in business The tax accomplished its immediate objective, as the dollar

denominated bonds (Yankee bonds) sold by foreigners in US quickly dried up. However, the financing needs remained as European financial markets could not raise large amounts of capital. The markets responded by selling dollar denominated bonds in London. As they were not sold to American residents, they were unaffected by the US tax. When this tax was extended to bank loans in 1965, banks moved much of their dollar based international lending to London as well. As British banking regulations did not apply to foreign banks lending in foreign currencies, banks from around the world flocked to set up offices in London. By the time interest equalization tax was removed in 1974, the euromarket was a prominent part of the international financial scene

International bond market today

The international market is neither an exchange nor a particular group of products. Rather the term refers to a decentralized system in which currencies held outside their home countries are reloaned without being converted to another currency. Most euromarket dealings take the form of bank loans to customers and short term loans from one bank to another. The securities markets however account for a large and rapidly growing share of international activity. As with domestic debt instruments international instruments come in three main varieties: bonds, medium term notes and short term commercial papers.

International bond market today

The US dollar is only one of the currencies used in the euro market. A decision to issue bonds in a particular currency does not mean that the borrower requires that currency to finance investments. The larger and more sophisticated borrowers tapping the international market for financing will borrow in whichever currency offers the most attractive interest rates at a given time and then through the FX markets, obtain the desired currency. The large share of issuance occurring in US dollars therefore reflects the favourable dollar interest rates and the large pool of investors preferring to purchase dollar securities rather than the issuers’ need for dollars.

Money market instruments Bonds with maturities of upto 30 years, medium term

notes with maturities of 1-5 years, short term instruments are traded in international markets. Commercial paper sometimes referred to as euro commercial paper is a debt with a maturity of less than 270 days issued by corporate borrowers. There is also a lively international market in other short term paper, sometimes called short term euro notes. These are mainly tradable bank deposits, similar to certificates of deposit, and government securities maturing within one year

Money market instruments Historically the majority of international money

market instruments have been traded in US dollars with yen, Swiss francs, pounds sterling and Hong Kong dollars also being used significantly. Since 2002 however the euro has vied with the dollar as the main currency of issuance. In comparison with domestic money markets, trading in international money market instruments remain small

The issuers As many aspects of the international markets are

unregulated, there are no restrictions as to who may issue bonds. However, investors generally require that issuers obtain ratings from credit rating agencies, just as they do with most domestic issues of bonds and commercial paper. There is a considerable market in bonds that are rated below investment grade. This is a significant attraction for companies in countries where there is no domestic market for below investment grade bonds.

The issuers.. Typically corporations from emerging market

countries succeeded in selling bonds internationally only after the national government has obtained ratings from credit rating agencies and completed a sovereign bond issue. Both government and corporate issuers in these countries typically break into the market with bonds maturing in as little as two or three years, but they are able to issue securities with longer maturities as they become better known to investors.

The issuers.. Financial institutions are by far the largest borrowers

in the international bond markets, accounting for about 70% of all debt securities outstanding. Corporate issuers take a distant second, accounting for about one eighth of the debt traded in international markets. The role of government and state agency issuers has diminished markedly. These proportions vary greatly from country to country.

Types of instruments

Fixed rate bonds Floating rate bonds Equity linked bonds

Fixed rate bonds These are the most widely traded instrument,

accounting for approximately three quarters of all bonds and notes outstanding in the euromarket. In recent years there have been some extremely large fixed rate issues

Floating rate bonds Almost all issued by the financial institutions. These

accounted for 26% of the total amount of bonds outstanding as at Dec 2004

Equity linked bonds These constitute less than 5% of the paper traded in

the euromarket. Almost all of them are convertible, meaning that they can be exchanged for the issuer’s shares at a predetermined time and price. Equity linked bonds are issued almost exclusively by non financial corporations

The swaps market

Neither the type nor the currency of an international bond issue provides a clear indication of the obligations the borrower has taken on. This is because the international bond markets are tightly linked to the swaps market. Swaps are derivative instruments that permit the user to exchange one set of payment obligations for another. Often an issuer will sell bonds of whatever type and currency offers the most attractive interest rate at the time of issue and simultaneously enter a swap so that it can make payments in the form desired.

The swaps market

Swaps can make financial reports misleading. For example, an industrial firm that entered the international markets to issue Stg 100 mio fixed rate ten year bonds with a 6% coupon might be assumed to face a Stg 6 mio annual interest payment, when in reality it swapped the payments for floating rate US Dollar payments, the size of which will depend upon US interest rates. If US interest rates were to rise suddenly the firm could thus find itself in financial distress even though it has no dollar denominated borrowings

The swaps marketThe most common transactions are fixed for floating swaps in the same currency. In such deals, the issuer exchanges payment obligations with a counterparty usually a bank. An issuer of fixed rate bonds would exchange its fixed payment obligation for the obligations to pay a floating interest rate on a similar amount of principal. Conversely an issuer of floating rate bonds might trade its payment obligation for a fixed rate payment. The desirability of such a transaction depends on swap spreads, the premiums banks demand for agreeing to take on fixed rate payments (which are usually higher but stable) and to cede floating rate payments (which are usually lower but variable). There is a lively market in swaps, and market participants can easily obtain current swap spreads from financial information providers

The swaps market In the case of long term bonds, swaps lasting until

the bonds’ maturity may be difficult to obtain in the market. In such a case, an issuer might arrange a fixed for floating swap for five to ten years, after which it would reassume the obligation to make fixed payments, or perhaps arrange another swap transaction.

The volume of new interest rate swaps is obviously much larger than the volume of new international bond issues, as most swaps are related to domestic bond issues or other types of obligations. The swaps market was almost entirely a telephone market upto 2002. But an electronic trading system sponsored by major banks began in 2002.

Global bonds A global bond is an issue that is marketed simultaneously

in the international markets and in the domestic market. The first global bond a $1.5 billion issue by the World Bank in 1989 was sold simultaneously as a domestic security in the US and as an international security in the Euromarket, with the issuer dedicating separate portions or tranches to each market. Until 1999 the number of global issues was quite small as a large issue is needed to make the procedure worthwhile. However a general increase in investor demand for large (and hence more liquid) issues has resulted in several huge global issues.

Bond issuance The method for issuing securities in the international

markets is significantly different from that in most domestic markets. The requirement for registration or regulatory approval depends on where the issue will occur and whether the issuer wishes the bonds to trade on an exchange after the issue. In general disclosures about the issuer’s financial condition and other matters may be substantially less than would accompany a domestic issue in many countries of the European Union, Canada or the United States.

Bond issuance Most international bond issues are sold by a syndicate or

selling group of investment dealers formed for the purpose. The principal investment bank, the syndicate manager, determines the price at which the issue will be sold and allocates the bonds to the other dealers in the syndicate. Syndicate members handle the bonds on a fixed price re offer basis, meaning that they agree to sell the bonds to customers only at the established price as long as the bonds are still in syndicate. Once the issue is sold, the syndicate breaks and the bonds can trade in the secondary market at prices determined by the demand and supply

Bond issuance In certain cases, the issuer and its lead bank will

agree on a bought deal. This means that one bank or a syndicate purchases the entire issue and seeks to resell it in the market, taking the risk that it will lose money if it is unable to sell the bonds for more than it has paid the issuer. In other cases, the bonds will be sold on a best efforts basis, reverting to the issuer in the event that the members of the syndicate are unable to sell them.

Trading The market for international bonds is largely an over

the counter market. Although many bonds are listed on the Luxembourg Stock Exchange, and bonds are traded on other bourses as well, primarily in London, most dealing occurs over the telephone rather than at exchanges. Several banks are attempting to create electronic trading systems, but these remain in their infancy

Trading.. The lack of market information has contributed to

illiquidity, which is perhaps the most severe problem confronting the international markets. Many international bonds disappear into investors’ portfolios and are then held to maturity, which keeps trading volume rather small.

Trading.. Trading in international bonds is also restricted by

national regulations. Some countries allow dealers to sell bonds only to large sophisticated investors, known in legal terminology as qualified institutional buyers – called QIBS – (pronounced quibs). The American authorities prohibit the sale of international bonds to American residents for 40 days after issue, and require that such bonds be seasoned by being sold first to other investors before Americans buy them.

Towards international standards

International Capital Markets Association – ICMA – has been created by the dealers to establish standard practices. Based in Switzerland, the ICMA is now recognized as a self regulatory organisation by the British authorities, and all major dealers adhere to its rules. Among other things, the ICMA has established procedures for clearing transactions, including a reporting system so firms can identify and reconcile errors that may have occurred in writing down the name and quantity of a security that has been bought or sold. The ICMA has also agreed on settlement procedures, so that for all international bond trades among its members, money and securities change hands on the third business day after the transaction

Obtaining price information There is no central source for price and volume

information concerning the international markets. Most issues trade infrequently, if at all. In any case, most transactions are conducted between a customer and a bond dealer, which has no obligation to inform the public about the details of any transaction. Thus the reported price of a bond may be imputed from the prices of other, similar bonds, rather than the price at which a transaction actually occurred. Nonetheless financial information services do seek to report the prices of international bonds and price tables appear in some newspapers.

Looking ahead The international bond markets developed largely as

a response to taxation and regulation in domestic bond markets. It allowed issuers to borrow money in the currency of their choice without being bound by the regulations of the country whose currency they used. Because the bonds were issued in bearer form, without being registered in the buyer’s name, they allowed investors to protect their anonymity and in some cases avoid taxation

Looking ahead.. Over the years, many of the distinctive features of

the international market have been eroded as national governments have liberalized the rules and eased restrictions on cross border capital flows. Thus advantages of Euromarket have ceased to loom large. Global bond issues and the creation of cross border issues within the EU have blurred the distinction between Eurobonds and other international bond issues. Some securities traditionally considered to be domestic, such as Pfandbrief mortgage bonds issued in Germany, are now promoted heavily to foreign investors and are considered international instruments

Looking ahead.. These changes have blurred the difference between

Eurobonds and foreign bonds. The term international bonds are now applied to both, and the Euromarkets label has largely been made redundant. But although the Euromarkets may have faded into history, the international bond markets are flourishing and are likely to grow rapidly

Risk management In the fixed income markets, an investor is exposed

to several kinds of risks. These risks may arise due to any factor that influences the potential stream of returns from holding a fixed income security. There are three sources of income from a fixed income security – coupon or interest payments, capital gains/losses and reinvestment income, which is income from the intermediate cash flows that are reinvested

Risk management An investor faces considerable risk from an adverse

movement of interest rates. There exists an inverse relationship between interest rates and the price of the bond. In situations of rise in interest rates, the price of the bond declines, posing the risk of capital loss to an investor who wants to sell off his security prior to maturity

Risk management The risk arising out of variations in interest rates

could be hedged by use of interest rates derivatives. The commonly used interest rate derivatives are forwards, futures, swaps and options. Of these, interest rate swaps and forward rate agreements are the most popular derivative instruments and account for the largest share of turnover in interest rate derivatives all over the world.