Investments & Securities Chapter 9 The Strongest Argument For Investing Nondollar Bonds That There Are Diversification Benefits

3. “The strongest argument for investing in nondollar bonds is that there are diversification

benefits.” Explain why you agree or disagree with this statement.

There are mixed empirical findings for agreeing with the statement that diversification is the

strongest argument for investing in nondollar bonds. The details are supplied below.

Several reasons have been offered for why U.S. investors should allocate a portion of their fixed

4. “The strongest argument for investing in nondollar bonds is that it reduces risk.”

Explain why you agree or disagree with this statement.

One would tend to agree with the statement as diversification is the strongest argument for

investing in nondollar bonds.

Several reasons have been offered for why U.S. investors should allocate a portion of their fixed

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opportunities to find value that multiple markets provide.” However, it is hard to quantify such a

benefit because it depends on the investor’s talents. That is, nondollar bond investments—with

the currency hedged—permits investment strategies based on interest rate changes in various

countries. This provides additional dimensions to the actual investment decision or a broader

range of investment choices. A final reason given for nondollar bond investing is that the

decision not to hedge the currency component can then be regarded as an active currency play.

6. “Yen-denominated bonds issued and traded only in Japan by non-Japanese entities

could be foreign bonds or Euroyen bonds.” Explain why you agree or disagree with this

statement.

One would disagree with the statement, and the bonds are classified as foreign bonds but not

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

7. What is the debate regarding covenants in corporate bonds in the Eurobond market?

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

8. Explain the step-up and step-down structure used in the Eurobond market.

The coupon rate of certain securities can either increase or “step up” over time or decrease or

9. Suppose that the yield to maturity on a Eurodollar bond is 6.1%.What is the bond

equivalent yield?

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:

The yield to maturity on an annual-pay basis would be:

10. This excerpt, which discusses dual currency bonds, is taken from the International

Capital Market, published in 1989 by the European Investment Bank:

“The generic name of dual-currency bonds hides many different variations which are

difficult to characterize in detail. These variations on the same basic concept have given

The first category covers bond issues denominated in one currency but for which coupon

and repayment of the principal are made in another designated currency at an exchange

Within this category, one finds the forex-linked bonds, foreign currency bonds and

heaven and hell bonds. A final category includes bonds which offer to issuers or the

(a) Why do all currency bonds “expose the issuers and the holders to some form of foreign

exchange risk” regardless of the category of bond?

Foreign exchange risk refers to the risk associated with receiving cash flows in another country’s

currency. From the perspective of the holder of a currency bond (the investor), the cash flows

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payments into a specific currency is specified at the time the bond is issued. A second type

differs from the first in that the applicable exchange rate is the rate that prevails at the time

a cash flow is made (i.e., at the spot exchange rate at the time a payment is made). A third type is

one that offers to either the investor or the issuer the choice of currency. These bonds are

commonly referred to as option currency bonds.

(b) Do you agree that the pricing of all dual-currency bonds is an application of option

pricing?

An option gives the holder the right to future claims conditioned upon contingent outcomes. To

be an application of option pricing, an option must be present or embedded in the asset (in this

case a dual-currency bond). As discussed in part (a), there are three types of dual-currency

(c) Why should the price of the option component be “equal to the difference between the

dual currency bond price and its bond component”?

In a perfect capital market environment (with no transaction costs and other frictions), the value

11. Answer the below questions.

(a) Why do rating agencies assign a different rating to the debt of a sovereign entity based

on whether the debt is denominated in a local currency or a foreign currency?

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. Specifically,

defaults have been greater on foreign currency-denominated debt. For example, an S&P survey

(b) What are the two general categories of risk analyzed by rating agencies in assigning

a sovereign rating?

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

governments is rated by the rating agencies. There are two sovereign debt ratings assigned by

rating agencies: a local currency debt rating and a foreign currency debt rating. Standard

12. What are the different methods for the issuance of government securities?

There are four methods that have been used in distributing new securities of central

governments: the regular calendar auction /Dutch style system, the regular calendar

auction/minimum-price offering, the ad hoc auction system, and the tap system.

In a tap system, additional bonds of a previously outstanding bond issue are auctioned. The

government announces periodically that it is adding this new supply.

13. Answer the below questions.

(a) What are covered bonds?

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are issued by banks. The collateral for covered bonds can be either (1) residential mortgage

loans, (2) commercial mortgage loans, or (3) public sector loans. They are referred to as

“covered bonds” because the pool of loans that is the collateral is referred to as the “cover pool.”

The cover pool is not static over the life of a covered bond. That is, the composition of the cover

pool changes over time.

(b) How do covered bonds differ from residential mortgage-backed securities, commercial

mortgage-backed securities, and asset-backed securities.

Covered bonds work as follows. Investors in covered bonds have two claims. The first is a claim

on the cover pool. At issuance, there is no legal separation of the cover pool from the assets of

the issuing bank. However, if subsequently the issuing bank becomes insolvent, then at that time,

(c) What is the Pfandbriefe market?

The German mortgage-bond market, called the Pfandbriefe market, is the largest covered

bonds market. In fact, it is about one-third of the German bond market and the largest asset in the

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The former represents the market for issues of smaller size. Historically, it has been an illiquid

and fragmented market and, as a result, has not attracted much interest from non-German

investors.

14. In the analysis of emerging market sovereign bonds, what is meant by structural

factors?

In the analysis of emerging market sovereign bonds, factors structural factors involve an

assessment of the country’s long-run health. Although not directly associated with the default of

15. In the analysis of emerging market sovereign bonds, why is geopolitical significance

important?

Traditionally, the term has applied primarily to the impact of geography on politics, but its usage

has evolved over the past century to encompass wider connotations. The Free Dictionary defines

geopolitics as “The study of the relationship among politics and geography, demography, and

16. What can one consider alleged corruption in a presidential election in an emerging

market country or the change in finance minister in an emerging market country headline

risk? (Headline risk was described in a prior chapter.)

Headline risk refers to the possibility that a news story will adversely affect a stock’s price. This

type of risk can also impact the performance of the stock market as a whole. With respect to

elections in an emerging market country, corruption factors to consider include the fairness of

elections and the political opposition programs. An example of the immediate impact of these

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Garcia, former president of Peru. During his administration, he pushed Peru into a debt crisis in

1987. Because of the uncertainty associated with his possible election to president, the spread on

Peruvian bonds once again increased by 200 basis points relative to the same emerging bond

market index.

17. On January 9, Reuters announced a US$2.6 billion bond offering by the Australia and

New Zealand Banking Group. The following is reproduced from the announcement:

Issue: US$2.6 bln 144a reg S 2, 3-year

The offer comprised US$1.9 bln 3-year at 100bp/swapand US$700 mln 2-yr at

70bp/Libor.

companies rely when accessing the U.S. capital markets.

It can be further noted that Regulation S is a “safe harbor” that defines when an offering of

securities is deemed to be executed in another country and therefore not be subject to the

registration requirement under section 5 of the 1933 Act. The regulation includes two safe harbor

provisions: an issuer safe harbor and a resale safe harbor. In each case, the regulation demands

Treasury bill rate. This difference between the borrowing and lending rates (the spread) leads to

interest-rate risk. By entering into a basis rate swap, where they exchange the T-bill rate for the

LIBOR rate, they eliminate this interest-rate risk.

According to the Reutersannouncement, there were initially 45 investors involves in the offer

(later the number of investors increased). The offering consists of two tranches. All the tranches

18. On January 9, Reuters announced a US$3.075 billion bond offering by the Commonwealth

Bank of Australia. The following is reproduced from the announcement:

Issue: US$3.075 bln of 144a reg S bonds priced on Jan. 9.

The offer included US$2.5 bln 3-yr bonds at 78bp/swap and US$575 mln 5-yr

19. Which of the following are Eurodollar Bonds and which are not?

a. U.S. dollar bonds are issued and traded in Germany

b. Bonds denominated in Japanese yen are issued and traded in the United States

U.S. dollar bonds are issued and traded in the United States

A Eurobond is a bond issued outside the country in whose currency it is denominated. When

Eurobonds are denominated in U.S. dollars, they are referred to as Eurodollar bonds. Thus, only