Investments & Securities Chapter 9 International Bonds Summary This Covers International Bond Markets From

CHAPTER 9

INTERNATIONAL BONDS

CHAPTER SUMMARY

This chapter covers international bond markets from the perspective of U.S. investors. U.S.

investors have become increasingly aware of non-U.S. interest-rate movements and their

relationship to U.S. interest rates. Foreign countries have liberalized their bond markets, making

CLASSIFICATION OF GLOBAL BOND MARKETS

From the perspective of a given country, the global bond market can be classified into two

markets: an internal bond market and an external bond market. The internal bond market is

The foreign bond market of a country is where bonds of issuers not domiciled in the country

are issued and traded. Bonds traded in the U.S. foreign bond market are nicknamed Yankee

bonds.

The external bond market is commonly referred to as the offshore bond market, or, more

popularly, the Eurobond market. Another way to classify the world’s bond market is in terms

of trading blocs. The trading blocs used by practitioners for this classification are dollar bloc,

European bloc, Japan, and emerging markets.

NON-U.S. BOND ISSUERS AND BOND STRUCTURES

In this section, we describe the various non-U.S. issuers of international bonds, the type of bond

structures, and the currencies in which international bonds are issued.

Non-U.S. Bond Issuers

Non-U.S. issuers of international bonds include sovereign governments, subsovereign

governments, supranational agencies, financial institutions, and corporations.

Organizations that collect data on international debt issuance use different definitions for

categorizing the nationality of issuers.

FOREIGN EXCHANGE RISK AND BOND RETURNS

The key factor that impacts the price and the yield of a bond is the currency denomination. In

contrast, when a portfolio includes non-dollar denominated issues by non-U.S. entities, there are

two additional factors to consider beyond the analysis of the issuer’s credit. The first is the

If the foreign currency depreciates (i.e., declines in value) relative to the U.S. dollar, the dollar

The return on a portfolio that includes non-dollar denominated bonds consists of three components:

(1) income, (2) capital gain/loss in the local currency, and (3) foreign currency gain/loss.

BONDS ISSUED BY NON-U.S. ENTITIES

Bonds issued by non-U.S. entities include: Yankee bonds, Regulation 144a private placements,

Eurobonds, Euro medium term notes, Global bonds, Non-U.S. domestic bonds, emerging market

bonds. Below we describe each.

Yankee bonds

Yankee bonds are bonds issued by non-U.S. entities that are registered with the U.S. Securities

Regulation 144a Private Placements

SEC Rule 144A allows the trading of privately placed securities among qualified institutional

Eurobonds

The Eurobond market is divided into sectors depending on the currency in which the issue is

denominated. For example, when Eurobonds are denominated in U.S. dollars, they are referred to

as Eurodollar bonds. The Eurodollar bond market is the largest sector within the Eurobond

market.

Corporate Bonds and Covenants

In the Eurobond market, there is a debate regarding the relatively weak protection afforded by

covenants. The chief reason for this is that investors in corporate Eurobonds are geographically

diverse.

Securities Issued in the Eurobond Market

The Eurobond market has been characterized by new and innovative bond structures to

accommodate particular needs of issuers and investors. There are the “plain vanilla,” fixed-rate

coupon bonds, referred to as Euro straights. Coupon payments are made annually, rather than

semiannually, because of the higher cost of distributing interest to geographically dispersed

bondholders. There are also zero-coupon bond issues and deferred-coupon issues.

currency. Such issues are called dual-currency issues. One type of the latter offers to the

investor or the issuer the choice of currency. These bonds are commonly referred to as option

currency bonds.

Convertible Bonds and Bonds with Warrants

A convertible Eurobond is one that can be converted into another asset. Bonds with attached

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issuer at the same price and yield as the host bond. A currency warrant permits the warrant

owner to exchange one currency for another at a set price (i.e., a fixed exchange rate).

Comparing Yields on U.S. Bonds and Eurodollar Bonds

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 fixed-rate bond. Given the yield to maturity on a Eurodollar fixed-rate bond, its

bond-equivalent yield is computed as follows:

bond-equivalent yield of Eurodollar bond = 2[(1 + yield to maturity on Eurodollar bond)1/2 – 1].

To convert the bond-equivalent yield of a U.S. bond issue to an annual-pay basis so that it can be

and can be issued in any currency. The three characteristics of a global bond are as follows:

(i) they are issued and sold simultaneously in multiple bond markets at the same offering price;

(ii) they are traded in these markets without restrictions with settlement that is similar to a trade

of domestic bonds; and, (iii) the issuance size is large, allowing for multiple tranches by

maturity.

according to different methods in various countries, and these differences will affect the

interpretation of yield spreads. Withholding and transfer tax practices also affect global

investment strategies.

Outside of the United States, the largest government issuer of inflation-linked bonds is the

United Kingdom, followed by France. These bonds, popularly referred to as linkers in Europe,

conditions appear favorable. It is only at the time of the auction that the amount to be auctioned

and the maturity of the security to be offered are announced. In a tap system, additional bonds of

a previously outstanding bond issue are auctioned.

Sovereign debt is the obligation of a country’s central government. The debt of national

governments is rated by the rating agencies. For the reasons discussed subsequently, there are

impair a national government’s ability to satisfy such obligation.

In assessing the credit quality of local currency debt, S&P emphasizes domestic government

policies that foster or impede timely debt service. For foreign currency debt, credit analysis by

S&P focuses on the interaction of domestic and foreign government policies. S&P analyzes

a country’s balance of payments and the structure of its external balance sheet.

compared to residential mortgage-backed securities (RMBS), commercial mortgage-backed

securities (CMBS), and other asset-backed securities (ABS). Four differences results from this

securitization process. First, the bank that originated the loans will issue and sell a pool of loans

to a special purpose vehicle (SPV). Second, investors do not have recourse to the bank that sold

the pool of loans to the SPV. Third, for RMBS/CMBS/ABS backed by residential and

public-sector entities. When the bonds are fully collateralized by residential and commercial

mortgages, they are called HypothekenPfandbriefe.

The Pfandbriefe market is further divided into Traditional Pfandbriefe and JumboPfandbriefe.

The former represents the market for issues of smaller size. The tap method was used for issuing

Traditional Pfandbriefe. The sector of the Pfandbriefe market that has received the greatest

retired their outstanding Brady bonds.

At one time, the securities issued by governments of emerging market countries were exclusively

denominated in U.S. dollars or other major currencies. Today, emerging market local debt issues

are denominated in local currency as well in major currencies. The development of the local

market has been fostered by both the growth of local pension funds and foreign investor interest.

Credit Risk

Investing in the government bonds of emerging market countries entails considerably more credit

risk than investing in the government bonds of major industrialized countries. Standard & Poor’s

Refinancing risk =

Short-term debt Interest Amortization on medium & long-term debt

Reserves

++







external service ratio, and public sector borrowing requirement. These four solvency

measures are given below:

( )

1 Expected 3 year domestic credit growth Domestic credit

+ − 



GDP





Debt service ratio=

Interest payments Amortization on medium & long-term debt

Exports of goods and services Income receipts

+





+



Primary fiscal balance Interest payments

+



Factors that fall into the structural category involve an assessment of the country’s long-run

health and provide guidance as to the likely development of economic problems when there are

KEY POINTS

• The global bond market can be classified into two markets: the internal or national bond

market, which consists of a domestic bond market and a foreign bond market, and the external

or international bond market (or Eurobond market).

• Although it is often stated that the primary motivation to investing in non-U.S. bondsis that it

provides diversification benefits, such benefits may not be significant. Rather,investing in

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• The return on a portfolio that includes non-dollar denominated bonds consists of three

components: (1) income, (2) capital gain/loss in the local currency, and (3) foreign currency

gain/loss.

• Bonds issued by non-U.S. entities include Yankee bonds, Regulation 144a private placements,

Eurobonds, Euro medium term notes, global bonds, non-U.S. domestic bonds, and emerging

market bonds.

• Domestic bond markets throughout the world offer U.S. investors the opportunity to buy

bonds of non-U.S. entities. The largest sector of domestic bond markets throughout the world

is the government sector.

• Sovereign debt is the obligation of a country’s central government. Ratings are assigned

separately for local currency denominated debt and foreign currency denominated debt. The

ANSWERS TO QUESTIONS FOR CHAPTER 9

(Questions are in bold print followed by answers.)

1. What are the four trading blocs that are used in classifying the world’s bonds markets.

The trading blocs used by practitioners to classify the world’s bond market in terms of trading

bloc include the four classifications. They are: (i) the dollar bloc, (ii) the European bloc, (iii) the

Japan bloc, and (iv) the emerging markets bloc. The trading bloc construct is useful because each

2. What risk is faced by a U.S. life insurance company that buys British government bonds?

From the perspective of a U.S. life insurance company investing in British government bonds,

the cash flows of assets denominated in a foreign currency expose the investor to uncertainty as

to the cash flow in U.S. dollars. The actual U.S. dollars that the investor gets depend on the