Lecture 14: The International Bond Markets

With Discussion of The Globalization of the World’s

Capital Markets

Where is this Financial Center?

NYSE

Financial Market Globalization Financial market globalization refers to the

integration of national financial markets. This process can be represented by:

(1) various financial institutions including banks and institutional investors expanding their activities geographically, thus acting as intermediaries to channel funds from lenders to borrowers across national borders and

(2) securities markets becoming more cross-border orientated.

Bottom line: Financial market globalization has greatly expanded the range of borrowing, lending and investing possibilities available to economic agents (companies, governments, individuals) throughout the world.

History of Financial Market Globalization Some researchers argue that the integration of

financial markets, when measured by cross-border capital flows across national borders, is not a new phenomenon.

For example, in the 50 years prior to WWI (1914), the world saw massive capital flows from Western Europe to overseas regions of recent settlements (mainly the Americas).

During this time, private capital moved cross border with essentially no restrictions, much of it going into bonds financing railroads and other infrastructure investment and long term government debt.

Measuring Financial Market Globalization Bordo, Eichengreen and Kim (1998) argued that

a good indicator of cross-border financial flows is the absolute value of the ratio of current account balance over GDP, averaged across a number of countries. Current account balance = (imports of goods and

services – exports of goods and services) + net returns on investments abroad. Thus it measures the excess of payments to foreigners over payments received from foreigners.

Their research showed that this indicator has increased somewhat since the mid-1960s but still remains below the levels seen from the mids-1870s to 1914 (see next slide).

Ratio of Current Account Balances to GDP for 12 Counties

Measuring Financial Market Globalization Other measures of financial market globalization

examine trends in “financial home bias,” i.e., the tendency for domestic saving to be invested at home.

According to IMF data, recent years have seen a pronounced decline in financial home bias, with a record fraction of global saving going to cross-border investments Since the mid 1980s, the trend toward greater cross-

border investment has been world wide approaching 50% for the first time, with the United States, other advanced economies, and emerging economies all investing a markedly higher fraction of their savings abroad (see next slide).

Cross Border Investment Share of Global Savings (5-Year Moving Average to Smooth out Business Cycles)

Origins of Recent Financial Market Globalization The recent upsurge in financial market globalization can

probably be traced to the demise of Bretton Woods in the early 1970s.

The move towards floating exchange rates (with less government intervention) ushered in an era of progressive dismantling of controls on cross-border financial flows as well as the liberalization of national financial markets more generally.

In addition, technological advances played a key role. Information systems are now able to compute and store more

data more rapidly. Telecommunications networks have made it possible to connect in more efficient ways.

As a result, cross-border financial deals have become both easier and more secure, effectively lowering the barrier constituted by distance.

Major Deregulations of Financial Markets: U.K. and Japan U.K. 1979: Margaret Thatcher removed all

exchange controls on the pound. Japan 1984: Yen-Dollar Agreement:

Opened up access of Japan’s financial markets to foreign firms.

Removal of controls regarding conversion of yen in FX markets.

Permitted yen offshore transactions. U.K. 1986: “Big Bang, “ London stock exchange:

Removal of barriers to foreign brokers on the exchange.

Implications of Financial Market Globalization The globalization of financial markets has resulted

individual markets become more integrated and more open to non-resident borrowers and investors.

As a result, opportunities for obtaining capital and investing capital have widened. Today it is commonplace for a corporation to consider

raising capital in foreign countries and denominating in any one of a number of currencies.

Today it is also commonplace for an investor to consider investing in foreign countries and doing so in any one of a number of currencies.

Evolution of the Global Bond Market Historically, the U.S. bond market dominated the global

bond market, with the U.S. market representing a key source of financing for U.S. and foreign corporations.

However, since the expansion of the European Union and the advent of the Euro-Zone, Europe’s importance in the global bond market as grown. In 2001, the U.S represented 44% of the world’s bond market; the

European Union represented 28% (the Euro-zone countries: 23%). By 2009, the U.S. share of the global bond market had fallen to

34% and the European Union’s share had grown to 36% (the Euro-zone countries: 30%).

While today the U.S. market is dominated by U.S. firms, an increasing amount of U.S. company bond financing is taking place in the European bond markets.

Trends in Debt Markets, 2001 - 2009

Institutional Arrangements in Corporate Funding The historical institutional patterns of corporate borrowing

in various countries have influenced the development the a country’s long term capital markets (i.e., both bond markets and equity markets). In Japan and Germany, companies have relied less on equity

markets for funds than their counterparts in the U.S. In both of these counties, banking has been a relatively more important source of funds (see next slide). Japan: Keiretsu arrangements: interlocking business relationships

including banks. Germany: The German law allows banks to hold equity shares in

industrial firms. In Europe, the close ties between banks and their corporate

clients slowed the development of a European corporate bond market. That changed, however, with the launch of the euro in 1999, which

promoted the development of Europe’s bond market (see slides 17 and 18).

Importance of Banking Markets for the U.S., Japan and Germany

Bond Market Growth in Europe: Pre and Post the Euro

Growing Importance of Bond Markets in Europe

Classifying the World’s Bond Markets The world’s bond market can be divided into two

broad groups: (1) the domestic bond market and (2) the international bond market. The domestic bond market is comprised of all

securities issued in each country by “domestic” government entities and corporates. In this case, issuers are domiciled (i.e., headquartered) in

the country where those bonds are issued. The international bond market is comprised of non-

residents borrowing in another country’s bond markets.

The distribution of these two bond markets varies considerable by country (see next slide).

Domestic Versus International Bond Market by Country; % of GDP, 2009

The International Bond Market The international bond market is normally

divided into two groups: (1) Foreign Bonds (2) Euro-bonds

The distinction between the two is essentially the currency that the bond is denominated it. Foreign bonds: denominated in the currency of the

country in which it is being issued. Euro-bonds: denominated in an offshore currency (i.e.,

a eurocurrency). In recent years, the Eurocurrency bond market

has dominated the international bond market (see next slide).

Relative Growth of International Bond Market (% of Total)Classification by Type ofBond

1978 1980 1981 1983 1984 1990-95

Foreign Bonds 58.8% 46.7% 39.6% 35.1% 25.4% 18.2%

Eurobonds 42.0% 53.3% 60.4% 54.9% 74.6% 81.8%

Amount (Billions USD)

$35.7 $38.3 $51.8 $77.2 $109.5 $2,200 (total)

Foreign Bonds: Characteristics Foreign Bonds are bonds issued by a non-resident

and denominated in the currency of the country in which it is being placed (i.e., issued). Example: Ford Motor Corporation issuing a yen denominated

bond in Japan Foreign bonds are subject to the regulations of the

country in which the bond is being offered. The SEC regulates foreign bond offerings in the U.S.

Historically, the most important foreign bond markets have been in Zurich, New York, and Tokyo. Zurich and Tokyo because of low market interest rates; the

U.S. because of its large market. Foreign bonds are often swapped out for another

currency.

Unique Names for Foreign Bonds Financial markets have

come up with unusual nicknames for foreign bonds. These include: Yankee bonds

Issued in the United States. Matador bonds

Issued in Spain. Rembrandt bonds

Issued in the Netherlands. Samurai bonds

Issued in Japan.

Bulldog bonds Issued in the United

Kingdom. Kiwi bonds

Issued in New Zealand. Kangaroo bonds

Issued in Australia. Maple bonds

Issued in Canada. Panda bonds

Issued in China. Matilda bonds

Issued in Australia.

Eurobonds: Characteristics Eurobonds are bonds issued by a non-resident

and denominated in other than the currency of the country in which it is being placed. The bond’s currency of denomination is an offshore

currency. Example: Coca Cola issuing a U.S. dollar denominated

bond in Europe. They are generally issued and sold simultaneously

in more than one market and thus the advantage of the Eurobond market is that issuers can raise large sums of capital from investors all around the world.

Issuers include national governments, supranational organizations (such as the World Bank),“AAA” corporations and global banks.

The U.S. dollar has been the dominant currency of denomination for Eurobonds (although the euro has grown in important).

Eurobonds: Main Features Eurobonds are not regulated by the country of the currency in

which they are denominated. Eurobonds are “bearer bonds”, i.e., they are not registered

anywhere centrally, so whomever holds (or bears) the bond is considered the owner. Bearer status also enables Eurobonds to be held anonymously.

The Eurobond market investor market is largely a wholesale (market with bonds held by large institutions. Pension funds, insurance companies, mutual funds

Since Eurobonds are denominated in an offshore currency, investors in euro-bonds assume both credit and foreign exchange risks (if the currency if denomination is other than their home currency).

Some publically offered eurobonds trade on stock exchanges, normally in London or Luxembourg. Others are placed directly with institutional investors without a listing (private placement).

Comparative Characteristics of Bonds: Domestic and International

US Market: Domestic and Foreign Bonds

Non-US Market: Domestic and Foreign Bonds

Eurobond Market

Regulatory Bodies Securities and Exchange Commission (SEC)

Official agency approval Minimum regulatory control

Disclosure requirements More detailed• High initial expense• High ongoing expense• Onerous to non-US firms

Variable Determined by market practices

Issuing costs 0.75-1.00% Variable to 4.0% 2.0-2.5%

Rating requirements Yes Usually no. No, but commonly done

Exchange listing Usually not listed Listing is usual. Listing is usual.

Currency of denomination

restrictions

United States does not restrict the use of US$

Many foreign countries have in past or now restrict use of their currency

No restrictions on use of US$

Speed of Issuance Relatively slow until Rule 415 on “shelf registration”

Variable. Usually fast

Comparative Advantages and Disadvantages of Bonds US Market: Domestic and

Foreign BondsNon-US Market: Domestic and Foreign Bonds

Eurobond Market

Borrower/Issuer incentives

(+) Large market, great depth/liquidity producing generally favorable terms.

(-) Disclosure is costly to foreigners (SOX)

(+) Local visibility, diversification of funding sources, hedging opportunities

(-) Markets may be small, queuing may prevail and relatively higher rates

(+) Lower annual interest expense, speed of placement

(-) Cannot sell issue in U.S. until seasoned (as determined by SEC).

Lender/Investor incentives

(+) Great depth and liquidity, appeal of standardized information and reporting requirements, adequate regulation

(+) Diversified currency portfolio

(-) Reporting to tax authorities and withholding taxed may apply

(+) Diversified currency portfolio, bearer bonds, no withholding tax on interest payments.

(-) Less liquidity and information disclosures

Appendix 1

Registration Issues

Registration of International Bonds Foreign bonds must meet the registration and listing

regulations of the country in which they are issued. Thus, Yankee bonds being offered to potential public buyers

(i.e., public placements) must comply with 1933 Securities Act requiring full financial disclosure and the offering of a prospectus.

Private placements do NOT have to be registered with the SEC. See next slide for U.S. requirements

Eurobonds, however, are not required to meet registration requirements For example, euro-dollar bond offerings outside of the United

States (“Reg S Bonds”) do not require SEC registration.

Note: Issue of time and expense in bring a foreign bond to market has resulted in a general preference for eurobond offerings by global borrowers.

Registering Bonds in the U.S. All bonds being offered to the investing public in the

United States (with the exception of U.S. government, federal agency and municipal bonds) must be registered with the Securities & Exchange Commission. This requirement applies to Yankee bonds as well.

Registration requires that specific information be disclosed to the public, such as: financial data about the borrower, how the money will be spent, how the borrower intends to repay. the terms of the bond itself.

This information is included in the bond’s indenture.

Regulation S Bonds Yankee bonds issued in the United States to the general

public must be registered with the Securities and Exchange Commission.

However, Regulation S exempts a US dollar bond offered outside the United States by a non-resident from having to register.

These bonds cannot be sold to Americans. Telekom (Malaysian telecommunications; Moody’s A3), $500M,

5.3% yield, offered September 15, 2004. Book runners: Deutsche Bank and UBS. Sold to 183 investors representing a mix of pension funds, asset

managers, banking/financial institutions, and private banks; all sales outside of the United States: 61% in Asia and 39% in Europe.

Appendix 2

Types of International Bonds

Types of International Bonds: Straight Straight Fixed Rate International Bond Most international bonds are of this type and are

characterized by: Designated maturity date, Fixed coupon payments (% of par value), Eurobond interest is typically paid annually:

Why? Less costly for borrowers to do so. No options (e.g., convertibility into stock) attached Entire issue brought to market at one time. Sometimes referred to as “plain vanilla” bonds!

International Bonds: Equity Related Equity Related Bonds (1) either fixed income convertible issues, which:

Allow the holder to exchange the bond for a predetermined number of share of common stock.

Carry lower interest rates than a straight only bond because of the conversion option.

(2) or fixed income bonds with equity warrants, which: Have a call option (or warrant) feature which allows the

holder to purchase a certain number of equity shares at a pre-stated price over a predetermined period of time.

International Bond: Zeros

Zero Coupon Bonds have the following characteristics: Sold at a discount from face (par) value, Do not pay any coupon interest payments. At maturity, holder receives full face (par) value. Return is represented by the difference between price and

face value. These zero coupon bonds are especially attractive to

Japanese investors Why? Their tax laws treat the return on zero coupon bonds as

a tax free capital gain (where in Japan coupon payments are taxable)!

International Bonds: Dual Currency Dual-Currency Bonds

Fixed rate bond that pays interest in one currency, and Upon maturity, repays the principal in another currency.

Good option for a MNE financing a foreign subsidiary. Very popular among Japanese firms: Coupon payments in yen; principal repayment in dollars.

Example of a strategy in using a dual currency bond: Used by Japanese companies wanting to establish or expand U.S.

based subsidiaries. Japanese company has a more recognized name in Japan so they

raise money initially in Japan. Eventually the subsidiary will realize profits in the U.S. and at that

time they will pay the principal on the debt in US$.