Assignment

On
International bond market

Submitted to: -
Submitted:-
Dr. S.N Malik
Sunil Kumar kushwaha
HSB (GJUS&T, Hisar)
Roll No- 09101263
International Bond Market
This constitutes the long-term debt market in the international scene. Many coun
tries have very active bond markets available to domestic and foreign investors.
The US market in the mid 1980s was attractive for the foreign investors given t
he relative political and economic stability; high real rates of interest and go
vernment’s desire to finance it finance its budget deficit with borrowings. The in
ternational bond markets refers both to the sets of broker-dealer over the-count
er debt capital markets, trading bonds issued by government, Municipalities or c
orporate organisations and the various fast growing electronic bond trading plat
forms resulting from either single initiatives or more frequently from a consort
ium of banks and dealers like Trade Web, Broker Tec, Euro MTS, WebET, eSpeed, Bo
ndBook, BondDesk and many more. In the bond market, one usually also separates t
he primary market, corresponding to the issue of new bonds from the secondary ma
rket, trading existing bonds. The international Bond Market can be broadly class
ified into two categories:
1. Foreign Bonds
2. Euro Bonds
Foreign Bonds- It issue is one offered by a foreign borrower to the investor in
a national capital market and denominated in that nation’s currency.
Euro Bonds- It issue is one denominated in a particular currency but sold to inv
estor in a national capital market other than the country that issued the denomi
nated currency.
Bearer Bonds- Bearer bonds are bonds with no registered owner. They offer anonym
ity but they also offer the same risk of loss as currency.
Registered Bonds-the owner’s name is registered with the issuer. U.S. security law
s require Yankee bonds sold to U.S. citizens to be registered.

On January 1, 1999, the euro was formally introduced in 11 countries of the Euro
pean Union. At that date, the European Central Bank (ECB) received control over
monetary policy in the Euro area. Only the United Kingdom, Denmark and Sweden vo
luntarily opted out, for the moment, while Greece was deemed not ready for entry
. Obviously, the introduction of the euro will have significant consequences for
international investors’ demands for assets denominated in different currencies.
Portes and Rey (1998), for instance, predict that international investors will i
ncrease the demand for euro assets when European markets get deeper and more liq
uid with lower transaction costs. When relative asset supplies react slower than
demands, Portes and Rey predict sizable exchange-rate effects as well. Portes a
nd Rey (1998), McCauley and White (1997) and McCauley (1997) all stress the key
role of European bond markets compared to the U.S. bond market. Internationally,
trading in bonds substantially dominates trading in equity or real trade flows.
McCauley (1997) explicitly distinguishes between asset managers and liability m
anagers in this respect. In his view, issuers of debt currently prefer the U.S.
market because of lower transactions costs and higher liquidity. However, with i
ncreasing size and integration of the European bond markets, debt issues might b
e increasingly denominated in Euros. For managers of a diversified asset portfol
io, an additional argument plays a role. Not only liquidity and transactions cos
t, but also the correlation structure between bond returns of different currency
denomination and between bond and exchange-rate returns is of crucial importanc
e. If a new euro bond market would offer diversification opportunities not yet a
vailable in the current constituent bond markets, a substantial increase in dema
nd for euro assets might occur.
Types of Instruments
Straight Fixed Rate Debt
Euro-medium term notes
Floating-Rate Notes
Equity-Related Bonds
Zero Coupon Bonds
Dual-Currency Bonds
Straight fixed-rate- Straight fixed-rate bond issues have a designated maturity
date at which the principal of the bond issue is promised to be repaid. During
the life of the bond, fixed coupon payments that are some percentage rate of the
face value are paid as interest to the bondholders. This is the major internat
ional bond type. Straight fixed-rate Eurobonds are typically bearer bonds and p
ay coupon interest annually.
Euro-Medium-Term Notes (Euro MTNs)
1 to 10 year notes (medium term) fixed coupon rate. Issued on a continual basis
(not all at once like bonds) as MNC needs credit.€ It is Very popular for issuers
due to flexibility

Floating-rate notes (FRNs)- Floating-rate notes (FRNs) are typically medium-term

bonds with their coupon payments indexed to some reference rate. Common refere
nce rates are either three-month or six-month U.S. dollar LIBOR. Coupon payment
s on FRNs are usually quarterly or semi-annual, and in a accord with the referen
ce rate.
convertible bond -A convertible bond issue allows the investor to exchange the b
ond for a pre-determined number of equity shares of the issuer. The floor value
of a convertible bond is its straight fixed-rate bond value. Convertibles usua
lly sell at a premium above the larger of their straight debt value and their co
nversion value. Additionally, investors are usually willing to accept a lower c
oupon rate of interest than the comparable straight fixed coupon bond rate becau
se they find the call feature attractive. Bonds with equity warrants can be vie
wed as a straight fixed-rate bond with the addition of a call option (or warrant
) feature. The warrant entitles the bondholder to purchase a certain number of
equity shares in the issuer at a pre-stated price over a pre-determined period o
f time.
Zero coupon bonds- Zero coupon bonds are sold at a discount from face value and
do not pay any coupon interest over their life. At maturity the investor receiv
es the full face value. Another form of zero coupon bonds are stripped bonds.
A stripped bond is a zero coupon bond that results from stripping the coupons an
d principal from a coupon bond. The result is a series of zero coupon bonds rep
resented by the individual coupon and principal payments.
Dual-currency bond- A dual-currency bond is a straight fixed-rate bond which is
issued in one currency and pays coupon interest in that same currency. At matur
ity, the principal is repaid in a second currency. Coupon interest is frequentl
y at a higher rate than comparable straight fixed-rate bonds. The amount of the
dollar principal repayment at maturity is set at inception; frequently, the amo
unt allows for some appreciation in the exchange rate of the stronger currency.
From the investor’s perspective, a dual currency bond includes a long-term forwar
d contract.
International Bond Market Credit Ratings- International credit ratings
Standard & Poor s and Moody s evaluate an international firm s or a country s c
redit worthiness based on the same criteria as for domestic issues.€ No considerat
ion is given to ex-rate risk, just default risk.€ Moody s has 19 categories (9 gen
eral and 3 specific, e.g. A1, A2, A3) and S&P has 20 categories (using + and - f
or AA to CCC) from AAA (almost no chance of default) to D (bond is in default -
late, partial or no coupon payments) based on the question: How likely is it tha
t this company will default on its debt?€
The top four categories (AAA, AA, A, BBB) are Investment Grade, the other catego
ries are Speculative Grade/High-Yield/Junk bonds.€ The Intl Bond market is mostly
an investment grade market - very large MNCs with excellent credit, brand name r
ecognition, etc.€ €
S&P and Moody s also do intl. ratings for foreign countries, cities, utilities,
etc.€ Govt. borrowing (central banks, local and national govts.) is about 10% of i
ntl. bond market, see Exhibit 12.5 page 300.€ Creditworthiness of foreign govts is
based on Political and Economic Risk of default.€ See Exhibit 12.7 page 304 for s
pecific criteria.€ The rating a foreign govt. receives is important because it usu
ally establishes the benchmark, highest rating (ceiling) for any entity in that
country.€ Example: If the Mexican national govt. gets a rating of A (third highest
rating), that would be the highest rating that any other entity in Mexico (city
, state, company, utility) could qualify for.€ Reason?€ Treasuries?€€
€
EUROBOND MARKET STRUCTURE
Primary Market - Borrower (MNC) wants to raise funds by issuing Eurobonds.€ They h
ire an investment bank to be the main underwriter or Lead Manager of the issue.€ T
he lead bank will set up a underwriting syndicate, group of investment banks, ea
ch with their own clients, contacts, and salespeople, to jointly sell the bonds.€
Example: Investment banks buy the bonds at 2% discount from the Price, guarantee
s the money to the issuer, and resells to public for a profit, i.e. investment b
anks pay $980 for $1000 face value bonds, make 2% ($20) per bond.€ Lead manager ba
nk gets full spread, others get less.€ Takes 5-6 weeks for the borrower to receive
funds after starting the process.
Secondary market - After issue, bonds then trade (prior to maturity) in the seco
ndary Eurobond market, based on bid-ask spread (commission) in an electronic mar
ket (OTC).€ Market makers carry an inventory of bonds, and help “make a market” by sta
nding ready to either buy or sell bonds. Dealers buy bonds at the bid price (low
) and sell at the ask price (high). As bond investors, we would buy bonds from
the dealer at the ask price (high), and sell bonds to the dealer at the bid pric
e (low). See Exhibits 12.10 and 12.11 page 308-309, government bonds in seconda
ry market.€ Notice: Discount and premium bonds.€ €
Clearing Procedures - Euroclear and Clearstream International are companies that
provide clearinghouse services for the Eurobond market, including physically st
oring the bond certificates, transferring ownership for trades in secondary mark
et, distributing new bond issues, coupon payment distribution.€ Part of the infra
structure of the international bond market.€
€
PORTFOLIO OPTIMIZATION
In the analysis, I assume that a representative investor in the United States op
timizes an international bond portfolio, consisting of domestic (US), Japanese (
JP), British (UK), German (GE), Italian (IT) and French (FR) bonds, with corresp
onding currency denomination. The investor maximizes a quadratic utility functio
n of the following form: [1]
(1) MaxU = E([R.sub.p])-1/2Var([R.sub.p]),
where E(.) is the expectations operator, Var(.) is the variance and [R.sub.p] is
the portfolio return in U.S. dollars, which is defined as:
(2) [R.sub.p] = [[sigma].sub.i][[alpha].sub.i]([R.sub.i] - [e.sub.i]), i = FR, G
E, IT, UK, JP, US,
where [R.sub.i] represents the percentage return on the country i bond expressed
in country i s currency, and [e.sub.i] is the percentage change in the exchange
rate between currency i and the U.S. dollar. The exchange rate is defined here
as the amount of foreign currency per U.S. dollar, so that a rise indicates an a
ppreciation of the dollar and a capital loss on foreign investments. [2] The ter
m in parentheses ([R.sub.i] - [e.sub.i]) thus represents the return on country i
s bond expressed in U.S dollars. [3]
The U.S. investor maximizes equation 1 with respect to portfolio weights [[alpha
].sub.i] subject to the constraints that
(3) [[sigma].sub.i][[alpha].sub.i] = 1, and [[alpha].sub.i] [greater than or equ
al to] 0, i = FR, GE, IT, UK, JP, US.
The first restriction ensures that the portfolio shares sum to one. The inequali
ty restrictions require positive portfolio shares and essentially are non-borrow
ing constraints. That is, a country s investors are unable (in net terms) to bor
row in one currency (issue bonds in that denomination) and invest the proceeds i
n bonds with a different currency denomination.
Representative investors in each of the other five countries are assumed to perf
orm a similar optimization procedure. Investors in all countries share the same
quadratic utility function. However, each takes a different perspective due to t
he preferred currency denomination. While a U.S. investor optimizes a dollar-den
ominated portfolio, a German investor optimizes a German mark-denominated portfo
lio (after 1998, a euro-denominated portfolio). Since expected returns and the c
ovariance structure of bond returns and exchange-rate returns depend on the curr
ency of denomination, investors from different countries with correspondingly di
fferent benchmark currencies will obtain different optimal portfolios.
Obviously, this deviates from the standard result in international capital asset
pricing models (CAPM). Under the extreme assumptions of homogeneous preferences
of investors--irrespective of their country of residence and perfect validity o
f purchasing power parity (PPP)--such models lead to the conclusion that investo
rs choose a common global portfolio (Adler and Dumas, 1983). In practice, countr
y-specific factors appear to remain quite important in investment decisions, as
witnessed by the well-known "home-bias" in asset portfolios (Lewis, 1995, 1999),
and the importance of country-factors in asset pricing (Heston and Rouwenhorst,
1994, and de Menil, 1999). Also, deviations from PPP abound and are strongly pe
rsistent (Mussa, 1986, Abuaf and Jorion, 1990, and Frankel and Rose, 1996).