Chapter 9 Non-U S Bonds Copyright 2010

Learning Objectives After reading this chapter, you will understand Ø the reasons for the globalization of financial markets Ø the classification of global financial markets Ø what the foreign bond market is Ø what a global bond is Ø the foreign exchange risk exposure of an investor who invests in nondollar-denominated bonds Ø what a Eurobond is and the different types of Eurobond structures Ø the classification of the global bond market in terms of trading blocs Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -2

Learning Objectives (continued) After reading this chapter, you will understand Ø the euro government bond market Ø the methods of distribution of new government bonds Ø the issuance of linkers by sovereign issuers Ø the motivation for investing in nondollar bonds Ø factors considered in the rating of sovereign bonds Ø how to compare yields on U. S. bonds and Eurobonds Ø the Pfandbriefe market Ø emerging market bonds Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -3

Classification of Global Bond Markets Ø The global bond market can be classified into two markets: an internal bond market and an external bond market. Ø The internal bond market (or national bond market) can be decomposed into two parts: i. the domestic bond market is where issuers domiciled in the country issue bonds and where those bonds are subsequently traded. ii. the foreign bond market of a country is where bonds of issuers not domiciled in the country are issued and traded. Ø Exhibit 9 -1 (see Overhead 9 -5) provides a schematic presentation of the global classification system. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -4

Exhibit 9 -1 Classification of Global Financial Markets Internal Market (also called national market) Domestic Market External Market (also called international market, offshore market, and Euromarket) Foreign Market Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -5

Classification of Global Bond Markets (continued) Ø In the United States the foreign bond market is the market where bonds are issued by non-U. S. entities and then subsequently traded. Ø Bonds traded in the U. S. foreign bond market are nicknamed Yankee bonds. Ø Regulatory authorities in the country where the bond is issued impose certain rules governing the issuance of foreign bonds. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -6

Classification of Global Bond Markets (continued) Ø The external bond market, also called the international bond market, includes bonds with the following distinguishing features: i. they are underwritten by an international syndicate ii. at issuance they are offered simultaneously to investors in a number of countries iii. they are issued outside the jurisdiction of any single country iv. they are in unregistered form. Ø The external bond market is more popularly called the Eurobond market. Ø A global bond is one that is issued simultaneously in several bond markets throughout the world. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -7

Classification of Global Bond Markets (continued) Ø Another way to classify the world’s bond market is in terms of trading blocs. Ø The trading blocs used by practitioners for this classification are dollar bloc, European bloc, Japan, and emerging markets. Ø The dollar bloc includes the United States, Canada, Australia, and New Zealand. Ø The trading bloc construct is useful because each bloc has a benchmarket that greatly influences price movements in the other markets. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -8

Foreign Exchange Risk and Bond Returns Ø The return to U. S. investors from investments in non-U. S. bonds that are denominated in a foreign currency consists of two components: i. the return on the security measured in the currency in which the bond is denominated (called local currency return), which results from coupon payments, reinvestment income, and capital gains/losses ii. changes in the foreign exchange rate Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -9

Foreign Exchange Risk and Bond Returns (continue) Ø An exchange rate is the amount of one currency that can be exchanged for another currency, or the price of one currency in terms of another currency. ü Since the early 1970 s, exchange rates between currencies have been free to float, with market forces determining the relative value of a currency. ü When a currency declines in value relative to another currency, it is said to have depreciated relative to the other currency. o Alternatively, this is the same as saying that the other currency has appreciated. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -10

Foreign Exchange Risk and Bond Returns (continue) Ø If the foreign currency depreciates (declines in value) relative to the U. S. dollar, the dollar value of the cash flows will be proportionately less. ü This risk is referred to as foreign exchange risk. ü This risk can be hedged with foreign exchange spot, forwards, futures, or options instruments (although there is a cost of hedging). Ø Several reasons have been offered for why U. S. investors should allocate a portion of their fixed income portfolio to nondollar bonds. ü The party line is that diversifying bond investments across countries—particularly with the currency hedged—may provide diversification resulting in a reduction in risk. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -11

Eurobond Market Ø The Eurobond market is divided into sectors depending on the currency in which the issue is denominated. ü For example, when Eurobonds are denominated in U. S. dollars, they are referred to as Eurodollar bonds. ü Eurobonds denominated in Japanese yen are called Euroyen bonds. Ø Although Eurobonds are typically registered on a national stock exchange, the most common being the Luxembourg, London, or Zurich exchanges, the bulk of all trading is in the over-the-counter market. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -12

Eurobond Market (continued) Ø Issuers of foreign bonds include national governments and their subdivisions, corporations (financial and nonfinancial), and supranationals. Ø A supranational is an entity that is formed by two or more central governments through international treaties. ü The purpose for creating a supranational is to promote economic development for the member countries. Ø In the Eurobond market, indications for trades are initially expressed on a spread basis. Ø In the U. S. market, the spread is relative to the U. S. Treasury yield curve. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -13

Eurobond Market (continued) Ø Corporate Bonds and Covenants ü In the Eurobond market, there is a debate regarding the relatively weak protection afforded by covenants. o The chief reason for this is that investors in corporate Eurobonds are geographically diverse. o As a result, it makes it difficult for potential bond investors to agree on what form of covenants offer true protection. ü For investment-grade corporate issues in the Eurobond market, documentation is somewhat standardized. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -14

Eurobond Market (continued) Ø Corporate Bonds and Covenants ü There is a wide variety of floating-rate Eurobond notes. ü The coupon rate on a floating-rate note is some stated margin over the London interbank offered rate (LIBOR), the bid on LIBOR (referred to as LIBID), or the arithmetic average of LIBOR and LIBID (referred to as LIMEAN). ü The size of the spread reflects the perceived credit risk of the issuer, margins available in the syndicated loan market, and the liquidity of the issue. ü Typical reset periods for the coupon rate are either every six months or every quarter, with the rate tied to six-month or threemonth LIBOR, respectively; that is, the length of the reset period and the maturity of the index used to establish the rate for the period are matched. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -15

Eurobond Market (continued) Ø Securities Issued in the Eurobond Market ü The Eurobond market has been characterized by new and innovative bond structures to accommodate particular needs of issuers and investors. o There is the “plain vanilla, ” fixed-rate coupon bonds, referred to as Euro straights. o Because these are issued on an unsecured basis, they are usually issued by high-quality entities. ü Coupon payments are made annually, rather than semiannually, because of the higher cost of distributing interest to geographically dispersed bondholders. o There also zero-coupon bond issues and deferred-coupon issues. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -16

Eurobond Market (continued) Ø Securities Issued in the Eurobond Market ü A floating-rate note issue will either have a stated maturity date or it may be a perpetual issue (i. e. , with no stated maturity date). ü There are issues that pay coupon interest in one currency but pay the principal in a different currency. o Such issues are called dual-currency issues. ü There is a wide array of bonds with warrants: equity warrants, debt warrants, and currency warrants. i. An equity warrant permits the warrant owner to buy the common stock of the issuer at a specified price. ii. A debt warrant entitles the warrant owner to buy additional bonds from the issuer at the same price and yield as the host bond. iii. A currency warrant allows the warrant owner to exchange one currency for another at a set price (i. e. , a fixed exchange rate). Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -17

Eurobond Market (continued) Ø Comparing Yields on U. S. Bonds and Eurodollar Bonds ü Because Eurodollar bonds pay annually rather than semiannually, an adjustment is required to make a direct comparison between the yield to maturity on a U. S. fixed rate bond and that on a Eurodollar fixedrate bond. ü Given the yield to maturity on a Eurodollar fixed-rate bond, its bondequivalent yield is computed as follows: bond-equivalent yield of Eurodollar bond = 2[(1 + yield to maturity on Eurodollar bond)1/2 – 1]. ü To convert the bond-equivalent yield of a U. S. bond issue to an annualpay basis so that it can be compared to the yield to maturity of a Eurodollar bond, the following formula can be used: The yield to maturity on an annual-pay basis would be: [1 + (yield to maturity on bond-equivalent basis / 2)]2 – 1. ü The yield to maturity on an annual basis is always greater than the yield to maturity on a bond-equivalent basis. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -18

Non-U. S. Government Bond Markets Ø The institutional settings for government bond markets throughout the world vary considerably, and these variations may affect liquidity and the tactics of investment strategies. ü For example, in the government bond market different primary market issuance practices may affect the liquidity and the price behavior of specific government bonds in a country. Ø The two largest non-U. S. government bond markets are those in Japan and Germany. ü Japanese government securities, referred to as JGBs, include medium-term bonds and long-dated bonds. ü The German government issues bonds (called Bunds) with maturities from 8 -30 years and notes, Bundesobligationen (Bobls), which have a maturity of five years. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -19

Non-U. S. Government Bond Markets (continued) Ø In January 1999, the structure of the market changed with the start of the European Monetary Union (EMU). Ø The EMU, combined with the decline in the U. S. Treasury issuance of securities, has resulted in the Euro government bond market becoming the largest government bond market in the world in terms of size and number of issues. Ø Within the Euro bond market, the government bond sector represents half of the market of Euro-denominated bonds, followed by the German Pfandbriefe market. Ø While many Euro government bonds can be stripped, the stripped securities are not as liquid as that of U. S. Treasury strips. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -20

Non-U. S. Government Bond Markets (continued) Ø Methods of Distribution of New Government Securities ü There are four methods that have been used in distributing new securities of central governments: i. iii. iv. the regular calendar auction/Dutch style system the regular calendar auction/minimum-price offering the ad hoc auction system the tap system ü In the regular calendar auction/Dutch style auction system, there is a regular calendar auction and winning bidders are allocated securities at the yield (price) they bid. ü This is a multiple-price auction and the U. S. Department of the Treasury currently uses this method when issuing all U. S. Treasury securities except the two-year and five-year notes. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -21

Non-U. S. Government Bond Markets (continued) Ø Methods of Distribution of New Government Securities ü In the regular calendar auction/minimum-price offering system, there is a regular calendar of offering. ü The price (yield) at which winning bidders are awarded the securities is different from the Dutch style auction. ü Rather than awarding a winning bidder at the yield (price) they bid, all winning bidders are awarded securities at the highest yield accepted by the government (i. e. , the stop-out yield). Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -22

Non-U. S. Government Bond Markets (continued) Ø Methods of Distribution of New Government Securities ü In the ad hoc auction system, governments announce auctions when prevailing market conditions appear favorable. ü A regular calendar auction introduces greater market volatility than an ad hoc auction does because yields tend to rise as the announced auction date approaches and then fall afterward. ü In a tap system additional bonds of a previously outstanding bond issue are auctioned. ü The government announces periodically that it is adding this new supply. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 9 -23

Non-U. S. Government Bond Markets (continued) Ø Sovereign Bond Ratings ü Sovereign debt is the obligation of a country’s central government. ü Whereas U. S. government debt is not rated by any nationally recognized statistical rating organization, the debt of other national governments is rated. ü The two general categories used by Standard & Poor’s in deriving their ratings are economic risk and political risk. o Economic risk is an assessment of the ability of a government to satisfy its obligations. o Political risk is an assessment of the willingness of a government to satisfy its obligations. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -24

Non-U. S. Government Bond Markets (continued) Ø Sovereign Bond Ratings ü There are two sovereign debt ratings assigned by rating agencies: a local currency debt rating and a foreign currency debt rating. ü The reason for distinguishing between local debt ratings and foreign currency debt ratings is that historically, the default frequency differs by the currency denomination of the debt. ü Specifically, defaults have been greater on foreign currencydenominated debt. ü The reason for the difference in default rates for local currency debt and foreign currency debt is that if a government is willing to raise taxes and control its domestic financial system, it can generate sufficient local currency to meet its local currency debt obligation. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -25

Non-U. S. Government Bond Markets (continued) Ø Sovereign Bond Ratings ü In assessing the credit quality of local currency debt, for example, S&P emphasizes domestic government policies that foster or impede timely debt service. ü The key factors looked at by S&P are: i. stability of political institutions and degree of popular participation in the political process ii. economic system and structure iii. living standards and degree of social and economic cohesion iv. fiscal policy and budgetary flexibility v. public debt burden and debt service track record; and, monetary policy and inflation pressures. ü However, the single most important leading indicator according to S&P is the rate of inflation. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -26

Non-U. S. Government Bond Markets (continued) Ø Sovereign Bond Ratings ü For foreign currency debt, credit analysis by S&P focuses on the interaction of domestic and foreign government policies. ü S&P analyzes a country’s balance of payments and the structure of its external balance sheet. ü The areas of analysis with respect to its external balance sheet are the net public debt, total net external debt, and net external liabilities. ü Exhibit 9 -3 shows how ratings for a country can change during a time of financial crisis. (See truncated version of Exhibit 9 -3 in Overhead 9 -28. ) Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -27

Exhibit 9 -3 Ratings for Indonesia, Thailand, and South Korea During the Asian Financial Crisis (Information for Thailand South Korean not show on overhead. ) Indonesia Moody’s Date Rating 25/6/97 Standard Change Date Rating Baa 3 — 25/6/97 BBB — 27/12/97 Bal -1 10/10/97 BBB- -1 9/1/98 B 2 -5 31/12/97 9/1/98 27/1/98 BB+ BB B -2 -3 -6 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Change 9 -28

The European Covered Bond Market Ø One of the largest sectors of the European market is the covered bonds market. Ø Covered bonds are issued by banks. Ø The collateral for covered bonds can be one of the below loans: i. residential mortgage loans ii. commercial mortgage loans iii. public sector loans. Ø They are referred to as “covered bonds” because the pool of loans that is the collateral is referred to as the “cover pool. ” Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -29

The European Covered Bond Market (continued) Ø Investors in covered bonds have two claims. i. The first is a claim on the cover pool. ü At issuance, there is no legal separation of the cover pool from the assets of the issuing bank. ii. The second claim is against the issuing bank. Ø Because the covered pool includes high-quality mortgage loans and is issued by strong banks, covered bonds are viewed as highly secure bonds, typically receiving a triple A or double A credit rating. Ø Covered bonds can be issued in any currency. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -30

The European Covered Bond Market (continued) Ø The difference between these securities created from a securitization is fourfold. i. At issuance, the bank that originated the loans will sell a pool of loans to a special purpose vehicle (SPV). ii. Investors in RMBS/CMBS/ABS do not have recourse to the bank that sold the pool of loans to the SPV. iii. For RMBS/CMBS/ABS backed by residential and commercial mortgage loans, the group of loans, once assembled, does not change, whereas covered bonds are not static. iv. Covered bonds typically have a single maturity date (i. e. , they are bullet bonds), whereas RMBS/CMBS/ABS typically have time tranched bond classes. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -31

The Pfandbriefe Market Ø The German mortgage-bond market, called the Pfandbriefe market, is the largest covered bonds market. Ø In fact, it is about one-third of the German bond market and the largest asset in the European bond market. Ø The bonds in this market, Pfandbriefe, are issued by German mortgage banks. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -32

Emerging Market Bonds Ø The financial markets of Latin America, Asia (with the exception of Japan), and Eastern Europe are viewed as emerging markets. Ø Investing in the government bonds of emerging market countries entails considerably more credit risk than investing in the government bonds of major industrialized countries. Ø Standard & Poor’s and Moody’s rate emerging market sovereign debt. Ø Although there are exceptions, the securities issued by governments of emerging market countries are denominated in U. S. dollars. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -33

Emerging Market Bonds (continued) Ø A good amount of secondary trading of government debt of emerging markets is in Brady bonds. ü Basically, these bonds represent a restructuring of nonperforming bank loans of governments into marketable securities. ü Countries that issue Brady bonds are referred to as “Brady countries. ” ü There are two types of Brady bonds. i. The first type covers the interest due on these loans (“past-due interest bonds”). ii. The second type covers the principal amount owed on the bank loans (“principal bonds”). Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -34

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9 -35