The International Bond Market

Outline
Types of bonds Comparative bond characteristics The Gray Market Onshore-Offshore arbitrage

Classification
Foreign Bonds Global bonds

Eurobonds

Foreign Bonds
Issued by a foreign entity and denominated in domestic currency

Foreign Bonds: Examples

Samurai bonds Bulldog bonds Rembrandt bonds Yankee bonds

Global bonds
Sold simultaneously on several markets in the currency of each market

Global bonds
First offered by the World Bank, OntarioHydro, and Hydro-Quebec.

Eurobonds
Issued by a foreign entity and sold in a foreign currency, other than the currency of the country in which the issuer is located.

Eurobonds: Exemplification
A bond issued by Rhone-Poulenc and sold in the US in Swiss francs.

Eurobonds
INSTRUMENT Straight fixed-rate Floating rate note Convertible bond INTEREST FREQUENCY annual annual or quarterly annual COUPON TYPE Fixed Variable Fixed Fixed Zero Fixed Fixed CURRENCY PAYOFF Currency of issue Currency of issue Currency of issue or convertible Currency of issue plus shares Currency of issue Dual Currency Composite currency

Straight fixed-rate with annual equity warrants Zero-coupon bond Dual-currency bond Composite currency bond none annual annual

Selecting the currency of issue

Foreign exchange risk affects coupon and principal payments It is preferable to make those payments in a currency that is weakening.

Selecting the currency of issue: Exemplification

Coca-Cola wishes to raise $1 b. The company can issue dollars or pounds denominated bonds. For simplicity, assume all payments are made at maturity.
Dollars (billions) Initial amount raised Principal payment 1 [1+r($)]
n

Pounds (billions) 1/S($) [1+r(pounds)] /S

n

Selecting the currency of issue: Exemplification

Coca-Cola will float the pound bond only if:
[1+r($)]n > E[S] [1+r(pounds)]n /S
Writing E[S] = S(1+d) n, where d is the expected annual rate of change in the exchange rate, Coca-Cola will float the pound bond only if:

r($) > r(pounds ) + d

Selecting the currency of issue: Exemplification

r($) 5%

r(pounds ) 7%

d 1.2%

The pound is expected to appreciate by an average of 1.2% per year; hence, at maturity, Coca-Cola will have to make payments in a more expensive pound.

Comparative characteristics of bonds issues

North-America (US) Regulatory Disclosure Issuing costs Rating Speed of issuance Rrestrictions Other advantages SEC, provincial Detailed 0.75-1.25% required Moderate No restrictions Large market Liquidity Standardized information Other disadvantages Disclosure is costly Reporting to tax authorities Small markets Low liquidity Reporting to tax authorities Non-US Variable Up to 4% Usually not required Variable Restrictions are common Local visibility Eurobond Determined by market practice 2-3% Not required but done Fast (bought deals) No restrictions Lower interest expense Bearer bonds No withholding tax Currency diversification Less liquidity and information disclosure

Specialized agency Minimum regulatory control

Eurobond underwriting
In general, similar to regular bond underwriting
Differences: Lead manager separate from selling group Variable price re-offering

The Gray Market

It is a forward market for overpriced Eurobonds
Once the issue has been announced the seller might decide to re-sell the bonds immediately for forward delivery at 98-99% of par. This is
an attempt to disguise the fact that the issue is overpriced.

The Gray Market: Exemplification

Issuer Amount Maturity Coupon Issue price Listing Total commission Lead Manager Gray market price Weyerhauser (1983) $60 m 7 years 11.5% $100 LuxSE 1.875% Morgan Stanley -1.5 to -1.25% Osaka Gas (1993) $250 m 5 years 5.75% $101.489 London 1.875% Goldman Sachs + 0.25%

The Eurobond pricing paradox

Eurobonds yields are lower, but issuance costs are higher than in North-America.

The Eurobond pricing paradox: Exemplification

US treasury issues Specially Targeted Notes on October 24, 1984:

$ 1 b at 11.375% maturing on September 30, 1988, bearer notes to foreign investors $ 1 b at 11.7% maturing on September 30, 1988, registered notes to American and foreign investors

The Eurobond pricing paradox

Could tax withholding and/or reporting to national authorities make a difference?

Onshore-Offshore Arbitrage

O-OA represents an attempt at taking advantage of the Eurobond pricing paradox.

Onshore-Offshore Arbitrage
Issuers have an incentive to engage in arbitrage by:
issuing securities offshore and covering their liability with a purchase of risk-free government securities whose cash inflow match the cash outflow of the Eurobonds.

If the matching is perfect, and the government securities can be pledged to pay off the Eurobond liability, the transaction qualifies as a pure arbitrage.

Onshore-Offshore Arbitrage: EXXON Capital Corporation, a subsidiary of EXXON Corporation.

Date Maturity yield Net proceeds

Oct. 19,1984 November 15, 2004 11.65% +$ 198.6 m

October 1984 November 15, 2004 11.825% -$181 m

Type of security Issues $1.8 b Euro-discount bonds Buys $1.8 b of US T- bonds

Onshore-Offshore Arbitrage: EXXON Capital Corporation, a subsidiary of EXXON Corporation.

Up-front arbitrage profit: $17.6 m

Japanese investors were particularly interested in buying the Euro-discount bonds because of:
Absence of taxes on capital gains in Japan (at that time)

No coupon reinvestment risk