2. Introduction
īIn this chapter we look at:
īĄ Bond market statistics
īĄ Major differences among bond markets
īĄ The Eurobond market
īĄ A recap of bond valuation
īĄ Multicurrency bond portfolio bond management
īĄ Exotic bonds (from FRNS to structured notes found on
the Eurobond market)
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3. World Market Size
īThe world market capitalization is higher than that
of equity.
īThe relative share of each currency market depends
not only on new issues and repaid bonds, but also on
exchange rate movements.
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5. The Global Bond Market
īDomestic bonds:
īĄ Issued locally by a domestic borrower and are usually
denominated in the local currency
īĄ Usually make up the bulk of the national bond market
īĄ Issuers include government, semi-government and corporate
agencies
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6. The Global Bond Market
īForeign bond market
īĄ Issued on a local market by a foreign borrower and are
usually denominated in the local currency.
īĄ Foreign bond issues and trading are under the
supervision of local market authorities.
īĄ Foreign bonds include:
īˇ Yankee bonds (in the U.S)
īˇ Rembrandt bonds (in the Netherlands)
īˇ Samurai bonds (in Japan)
īˇ Matador bonds (in Spain)
īˇ Bulldog bonds (in the UK)
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7. The Global Bond Market
īEurobond market
īĄ Underwritten by a multinational syndicate of banks and are
placed mainly in countries other than the one in whose
currency the bond is denominated.
īĄ Also known as an âinternational bondâ.
īĄ Eurobonds are not traded on a specific national market.
īĄ However, there are Eurobonds listed on the Luxembourg
Stock Exchange to nominally satisfy the requirement of
obtaining a public quotation at least once a year or quarter.
īĄ Developed in the 1960s and was early recognized as an
efficient, low-cost and innovative market.
īĄ Avoids most national regulations and constraints and
provides sophisticated instruments.
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9. The Eurobond Market â Characteristics
īThe underwriting syndicate is made up of banks
from numerous countries.
īUnderwriting banks tend to use subsidiaries
established in London or a foreign country with a
favorable tax situation.
īCorporate borrowers use a subsidiary incorporated
in a country with a favorable tax and regulatory
treatment.
īFor fixed-rate Eurobonds, the frequency of coupon
payments is usually annual.
īEurobonds are sold in a multistage process.
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11. The Eurobond Market
īIssuance Process
īĄ Issuing syndicate:
īˇ issue is organized by an international bank called a lead manager.
īĄ Timetable of New Issue
(total time: 5 to 6 weeks):
īˇ discussion between lead manager and borrower
(2 weeks or more).
īˇ Announcement of Eurobond issue (1 to 2 weeks of preplacement).
īˇ offering day with final terms (2 week public placement)
īˇ Closing day: selling group pays for bonds
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12. The Eurobond Market
īIssuance Process
īĄ Dealing in Eurobonds:
īˇ Eurobond dealers created an around-the-clock market among
financial institutions across the world, forming the International
Securities Market Association (ISMA).
īĄ Eurobond Clearing Bond:
īˇ A trade is settled in three business days and the transactions are
cleared through either Euroclear or Clearstream (formerly Cedel).
īˇ Euroclear and Clearstream collect a transaction fee for each book
entry as well as a custody fee for holding the security.
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13. Brady Bonds
īA Brady plan is a debt-reduction program whereby
sovereign debt is repackaged into tradable Brady
bonds, generally with collateral.
īClose to 20 countries have issued Brady bonds and
the total market capitalization is close to $100
billion.
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14. Brady Bonds (continued)
īThree main types of guarantees can be put in
place:
īĄ principal collateral
īĄ rolling-interest guarantee
īĄ value recovery rights
īTwo major types of Brady bonds have been issued:
īĄ par bonds
īĄ discount bonds
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15. Major Differences
Among Bond Markets
īQuotation
īĄ Bonds are quoted in the form of a clean price net of accrued interest.
īĄ The full price (or value) of a bond is the sum of its clean price plus
accrued interest.
īĄ Accrued interest = Coupon à (days since last coupon date/days in
coupon period).
īCoupon Frequency and Day Count
īĄ The day count convention known as â30/360â is commonly used in
Germany, Scandinavia, Switzerland and the Netherlands.
īĄ The day count convention known as âactual/actualâ assumes a 365
day year.
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16. Exhibit 7.5 Coupon Characteristics of Major
Bond Markets
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17. Major Differences Among Bond Markets
īYield to Maturity:
īĄ The yield to maturity (YTM) is the average promised
yield over the life of the bond.
īĄ The convention used to calculate YTM varies across
markets.
īĄ In the U.S, YTM is calculated at a semiannual rate
and the result is multiplied by 2 to report an
annualized rate.
īĄ Most Europeans calculate an annual, actuarial YTM.
īĄ The simple yield approach is also used in Japan.
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18. Major Differences Among Bond Markets
īLegal and Fiscal Aspects:
īĄ Bearer form (e.g., Eurobonds)
īĄ Registered form (e.g., In the United States, owners
must be registered in the issuerâs books)
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19. Bond Valuation
īYield to maturity: Zero coupon bonds
īĄ There exists an inverse relationship between market yield
and bond price.
īYield to maturity: Coupon Bonds
īĄ The U.S. YTM is a mixture of an internal rate of return
calculation to obtain the semiannual yield, and of a
multiplication to transform it into an annualized yield.
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20. Duration and Interest Rate Sensitivity
īDuration is a measure of interest risk for a specific
bond.
īMathematically, duration, D, can be written as:
(âP/P) = âD Ã âr
īFor larger movements in yield, the convexity can
be used.
īThe bond return can be approximated as:
Return = Yield â D Ã (âyield)
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21. Credit Spreads
īThe yield reflects a credit spread, or quality spread,
over the default-free yield.
īThe credit spread captures three components:
īĄ An expected loss component
īĄ A credit-risk premium.
īĄ A liquidity premium.
īThe migration probability is the probability of
moving from one credit rating to another.
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22. Multicurrency Approach
īInternational interest rate differences are caused
by a variety of factors including:
īĄ Differences in monetary and fiscal policies.
īĄ Inflationary expectations.
īImplied forward exchange rates:
īĄ The formula is:
īĄ By comparing the yield curves in two currencies, we can
derive the term structure of implied forward exchange
rates and therefore, implied currency appreciation or
depreciation.
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23. Return on Foreign Bond Investments
īThe return from investing in a foreign bond has
three components:
īĄ During the investment period, the bondholder receives
the foreign yield.
īĄ A change in the foreign yield induces a percentage capital
gain/loss on the price of the bond.
īĄ A currency movement induces a currency gain or loss on
the position.
Return = Foreign yield â D Ã (âforeign yield) + % currency movement
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24. Risk on Foreign Bond Investments
īThe risk on a foreign bond investment has two major
sources:
īĄ Interest rate risk: the risk that foreign yields will rise.
īĄ Currency risk: the risk that a foreign currency will depreciate.
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25. Return and Risk
on Foreign Bond Investments
īThe expected return on a foreign bond is equal to
the domestic cash rate plus a risk premium. The
risk premium equals the
sum of:
īĄ The spread of the foreign bond yield over the domestic
cash rate.
īĄ The percentage capital gain/loss due to an expected
foreign yield movement, and
īĄ The expected percentage currency movement.
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26. Currency-Hedging Strategies
īForeign investments can be hedged against
currency risk by selling forward currency contracts
for an amount equal to the capital invested.
īThe decision to hedge depends on return and risk
considerations. Hedging will turn out to improve
return on a foreign bond if the percentage currency
movement is less than the cash rate differential
(domestic minus foreign); otherwise hedging will
not be advantageous, ex-post.
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27. International Portfolio Strategies
īInternational portfolio management includes
several steps:
īĄ Benchmark selection
īˇ for bonds, market cap weights are influenced by the relative
national budget deficits.
īĄ Bond market selection
īˇ managers can cite:
īĸ monetary and fiscal policy
īĸ public spending
īĸ balance of payments
īĸ inflationary pressures
īĸ cyclical and political factors
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28. International Portfolio Strategies
īSector selection/credit selection
īĄ government, regional and municipal bonds
īĄ Mortgage-backed and public loan backed bonds.
īĄ Investment grade corporate bonds
īĄ Inflation indexed bonds
īĄ Emerging market bonds
īDuration/yield management
īYield enhancement techniques
īĄ For example, spreadsheet analysis
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29. Structured Notes
īA structured note is a bond (note) issued with some
unusual clause, often an option-like clause.
īIssued by a name of good credit standing.
īCan be purchased as investment grade bonds by most
institutional investors.
īOffer long-term options that are not publicly traded.
īDesigned for specific investors wishing to take a bet on
interest rates or currencies.
īThe issuer will usually hedge the unusual risks of a
structured note and end up with a plain vanilla bond at a
low all-in cost.
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30. Floating Rate Notes (FRNs)
īFRNs are a major segment of the Eurobond market.
īFRNs represent a quarter of all Eurobonds, with issues in
euros and dollars playing a dominant role.
īMajor issuers are financial institutions.
īFRNs are generally indexed to LIBOR.
īThe coupon on Eurobond FRNs is generally reset every
semester or every quarter.
īFRNs have coupons that adjust to interest rates, so coupons
react to interest rate movements rather than the bond
price.
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31. Floating Rate Notes (FRNs)
īFRNs exhibit great price stability when compared with
straight bonds.
īThe motivation for an investor to buy FRNs is to avoid
interest rate risk.
īBull FRNs strongly benefit investors if interest rates drop.
īAn example of a bull FRN is a reverse (inverse) floater, set
at a fixed rate minus LIBOR.
īBear FRNs benefit investors if interest rates rise.
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33. Dual Currency Bonds
īA dual currency bond is a bond issued with coupons in one
currency and principal redemption in another.
īIssued in two currencies with very different yield levels. The
valuation ensures the fair coupon rate on the dual-currency
bond is set in between the two yield levels.
īThese are attractive because one is able to borrow money in
a preferred currency but at a lower cost than directly
issuing bonds in that currency.
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34. Currency Option Bonds
īA currency option bond is one for which the coupons
and/or the principal can be paid in two, or more currencies,
as chosen by the bondholder.
īIt benefits the investor who can always select the stronger
currency.
īThe interest rate set at issue is always lower than the yields
paid on a single currency straight bond denominated in
either currency.
īThey offer long-term currency play with limited risk.
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