International
Finance - © 2008 Houman Younessi
International
Finance
Global Fixed Income
Markets
Assumption:
Students are familiar with basic bond
valuation techniques
International
Finance - © 2008 Houman Younessi
International
Finance
The World-wide Bond
Market
Domestic Bonds
Foreign Bonds
International Bonds
Issued locally by a domestic borrower
usually in local denomination
Issued on local markets by a foreign
borrower and usually denominated in local currency
Underwritten by a multinational syndicate
of banks and usually placed in countries other than the ones whose currency
the bond denominates
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Foreign Bonds
Expanding the pool of potential investors,
many borrowers issue bonds in foreign markets. These bonds are in the
local denomination of that foreign market and subject to the laws and
regulations of the local market authorities.
There is no direct exchange rate exposure.
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International Bonds
In 1963 the US government imposed an
interest equalization tax (IET) on foreign securities held by US investors
Later the federal Reserve restricted
the financing of FDI by US corporations
Additionally all borrowers wishing to
issue bonds in the US market must abide by the generally more stringent
US regulations.
Due to these measures and restrictions,
the US bond markets became less attractive to foreign borrowers and
simultaneously created a need for offshore financing of US corporate
foreign activities.
The Glass-Steagall Act prevented US commercial
banks from issuing and dealing in bonds. Such restrictions did not apply
to their offshore activities and foreign subsidiaries.
This gave momentum to the International
Bond (Eurobond) market a momentum that the later repeal of the IET and
the relaxation of the Glass-Steagall acts did not slow.
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World Market Size
Total world bond market size:
USD67 Trillion
Total Domestic bond market size:
USD49 Trillion
Total International bond market size:
USD18 Trillion
Source: bank of International settlements,
2007
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Finance - © 2008 Houman Younessi
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Types of Instruments
Straight Fixed-Rate Issues (66%):
Structured Notes and Floating-Rate
Notes (32%):
Equity Related Issues (2%):
A structured note is a bond with some
unusual clause or provision. Floating-Rate Notes may be deemed as one
such type. FRNs have coupons that adjust to interest rates
As the name implies they are straight
(regular) bonds with a set maturity date and fixed coupons.
Covers convertible bonds and warrant
backed bonds. They are exchangeable for equity
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Floating-Rate Notes
(FRNs)
Generally indexed to the London Interbank
Offer Rate (LIBOR)
At Time of Issue
At Coupon Date
Set Coupon Dates
Determine Applicable LIBOR
Set next coupon to LIBOR+Spread
Set Spread
Major Banks
LIBOR Quote
Dates
Spread Amounts
LIBOR Rate
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Valuing (FRNs)
To simplify, let us assume no default
risk
With no default risk and coupon values
being reset at each coupon time, the price P of the FRN itself must be 100% of the face value
at each coupon date.
Between coupon dates:
There is no reason for the price to stay
constant between coupon (reset) dates. Between two coupon dates the
bond behaves like a short term fixed-coupon bond.
So the price P can be estimated as P = 100%+reset coupon value at the next coupon
date, all discounted by the LIBOR rate pro-rata to number of days remaining
to next coupon
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Valuing (FRNs)
Example:
A very secure company (no risk of default)
has issued a 10-year FRN at LIBOR. The coupon is paid and reset semi-annually.
The FRN was issued at t0 when the six-month LIBOR was at
5%. Exactly six months later at t1, LIBOR is at 5.5%
1. What is the coupon paid at t1
per $1000 bond?
2. What is the new value of the coupon
set on the bond?
3. Three days after t1 the
six month LIBOR has dropped to 5.4%. What is the new value of the FRN?
The coupon at t1
was set at t0
at 5%, so it earns $25 per $1000
The coupon to be paid at t2
will earn $27.5 per $1000
We discount the known future
value of the bond on t2 at the new LIBOR and adjust for the
three days passed:
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Valuing (FRNs) with
Default Risk
The market will demand a risk premium
(spread) of m set under market conditions reflecting the fundamentals
of the issuer and time to maturity (longer term bonds have more time
to default and as such are riskier)
However
The risk premium or spread for a given
FRN is set at issue time n
The price volatility of the FRN then
will be proportional to the ratio of LIBOR+m and LIBOR+n
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Dual Currency Bonds
A bond issued with coupons
in one currency and the principal redemption in another
The motivation for the issuer is to borrow
in the desired currency but at a lower cost than directly issuing straight
bonds in that currency
As the coupon is paid in a low interest
rate currency (e.g. CHF) and reimbursed in a high interest rate currency
(USD), local investors (say Swiss investors buying dual currency bonds
to receive coupon payments in CHF) are attracted to this type of bond
because it pays a high coupon rate in their own currency.
Local investors are also attracted to
the opportunity for limited currency speculation only on the principal.
Our Swiss investors are betting on an appreciation of the USD.
Also as for regulatory purposes the issues
are considered CHF bonds although they are USD linked. They allow Swiss
institutional investors to increase their fixed income investment in
higher-yield currencies
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Dual Currency Bonds-
Valuation
The bond can be dismantled into two parts:
A sequence of fixed coupons in CHF. The
current value of this stream of cash flow is determined by discounting
at the CHF yield curve
A USD zero-coupon bond for the principal.
The current value of this investment is determined by discounting at
the USD yield curve.
The valuation is trivial
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Currency-Option Bonds
Please: These are not
options, these are bonds
In a currency-option bond the coupon
and/or the principal can be paid in two or more currencies as chosen
by the bond-holder.
The choice must be made a
priori and not at the payment
time.
This gives investors a longer term currency
play with limited risk. Of course the investor could purchase an option
in a currency for the same play but the durations with currency-option
bonds are usually much longer than afforded by options (only a few months).
Valuation is done by breaking down the
bond into a straight bond in currency X and an option to swap a bond
in currency X for another of same rate in currency Y at an a priori
set exchange rate of X:Y
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Collateralized Debt
Obligations (CDOs)
A structured note or set of notes backed
by some assets usually a portfolio of bonds or loans.
It allows for creation of securities
with widely different credit risk characteristics (called Tranches or
slices)
Valuation is difficult and will not be
discussed
Bond 1
Bond 2
Bond 3
:::::::::::
:::::::::::
:::::::::::
Bond 120
Average yield 7.5%
CDO
Trust
Tranche 1
1st 5% of loss
Y=30%
Tranche 2
2nd 10% of loss
Y=15%
Tranche n
Residual loss
Y=5.5%
::::::::::::
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Emerging Markets
When investing in debt securities from
the emerging markets, investors have several options:
Domestic bonds issued
by the emerging countries
(government or corporate)
Foreign bonds issued
by the emerging countries (government or
corporate)
International bonds
issued by emerging countries or corporations
in those countries. These may be denominated in USD or
some
other currency (e.g. GBP)
Brady bonds issued
by the government of some emerging
countries as a form of debt restructuring according to
the Brady
Plan (1990)
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Brady Bonds
Emerging countries in need of debt restructuring
can work with the IMF and upon presentation of a credible economic reform
plan, to re-package their debt (or part thereof) into tradable bonds
the sum total of the market value of which is less than the original
debt. However, Brady bonds are made more attractive than the original
debt as they carry an array of guarantees These bonds are then offered
through international commercial banks.
Brady bonds are complex to understand,
analyze and value as they come with a plethora of options, risks and
guarantees
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Brady Bonds
Three basic types of guarantees can be
instated:
Principal collateral:
The US treasury issues
long-term zero-coupon bonds to back the
principal of the Brady bond.
Rolling-interest
guarantee: The first few
(generally three) semi-annual coupons are
guaranteed by securities deposited in
escrow with the NY Federal Reserve Bank.
Value recovery
rights: Some nations (e.g.
Mexico and Venezuela) link the interest
paid on the bond to their economic success,
for example a rise in price of oil.
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Bond Indices
Bond indices are gaining in popularity.
They are most often a total-return index. The index cumulates the total
return on a bond portfolio (i.e. price movement and the accrued interest).
A bond index calculated daily can allow
quick assessment of the direction and magnitude of the movement of the
market. Unlike a stock index, bond indices must be based on a small
but representative sample (as not all bonds trade every day). Sometimes
a single actively traded bond called a benchmark bond is used.
A total-bond index is also used to measure
the performance of a bond portfolio in a domestic or multi-currency
setting.
Indices computed by Lehman Brothers are
most commonly used. J.P. Morgan,, Merrill Lynch and Bloomberg also offer
indices.
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Multi-currency Bond
Analysis
There is an inverse relationship
between the price of a bond and changes in interest rate
If the cash flow is fixed,
the price is solely a function of the market yield
Interest rate differences
and movement are a primary concern when dealing globally
As such, one can view duration D as the
derivative of the price wrt yield. The minus sign signifies that the
price drops when yield goes up.
But first, let us deal with bond returns
in general
It is useful to define
interest rate sensitivity (aka duration) as the approximate percentage
price change for 100 basis points change in the market yield
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Another way of saying the same thing
is that duration or sensitivity is the ratio of the percentage price
difference to the change in the yield
Multi-currency Bond
Analysis
rearranging
The return on a bond is equal to the
yield over the holding period plus any capital gain or loss due to movement
in the market yield
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Multi-currency Bond
Analysis
Over a short holding period, the risk-free
rate is the short-term interest rate. The return on a bond can then
be expressed as the sum of:
-
The risk-free rate
-
The spread of the bond yield over the risk-free rate, and
-
The percentage capital gain/loss
Where is the
interest free rate
The EXPACTED return therefore is the
risk-free rate plus a risk premium. The risk premium is therefore:
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Multi-currency Bond
Analysis
Break-even Analysis
What is the implication
for exchange rates, of yield differentials on bonds denominated in different
currencies but with similar maturities?
Higher yield in one currency is usually
compensated for with pressure on the currency and in turn a currency
loss on the bond.
We need to know how much currency movement
will compensate for the yield differential. Let us consider a one year
bond with an interest rate r in the domestic currency and a similar bond
with the foreign currency interest rate r*. The exchange rate is S0 now. We learned that due to interest rate parity,
in one year we will have:
Assuming the forward rate F0 for S1
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Multi-currency Bond
Analysis
Rearranging, we get:
The multi-period equation is:
The implied forward exchange
rate is not a forecast but a break-even point. The investor can then
compare their own FX forecast with the implied figure.
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Finance - © 2008 Houman Younessi
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Finance
Multi-currency Bond
Analysis
Risk-Return Analysis
It goes without saying that the return
from investing in a non-domestic bond has three components:
-
During the investment period, the holder receives the foreign yield
-
A change in the foreign yield induces a % capital loss/or gain
-
A currency movement induces a currency gain or loss
so:
where
is % currency movement
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The risk on a foreign bond has two major
sources:
-
Interest rate risk: that the foreign yield will rise
-
Currency risk: that the foreign currency will depreciate
Of course the risks could be somewhat
correlated.
As for any investment, the expected return
is the risk-free rate plus the risk premium. The risk premium is of
course:
Multi-currency Bond
Analysis
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Finance
Multi-currency Bond
Analysis
Currency-Hedging Strategies
By selling forward contracts, we can
hedge against currency risk.
Hence the return on a hedged bond will
be:
Which is what we have had all along
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International Bond
Portfolio Strategies
International bond portfolio management
includes several steps:
Select
benchmark
Select
market
Select
sector
Manage
currency
Manage
duration/yield curve
Optimize;
Use yield enhancement techniques
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International Bond
Portfolio Strategies
Selecting a Benchmark
This must be an appropriate bond index
What types of
issues are included?
Has there
been a floor put under credit quality (e.g. no junk bond)?
Which countries
are included?
Have they
allowed all maturities or are there restrictions (e.g. on long-term)
Is the
benchmark hedged or not?
And most importantly:
Do the components and the mix resemble my investment?
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Finance - © 2008 Houman Younessi
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International Bond
Portfolio Strategies
Selecting a Market
Monetary and
fiscal policy
Public spending
Current and forecast
public debt
Inflation and
inflationary pressure
Balance of payments
International
comparison of the real yield
National productivity
and competitiveness
Cyclical factors
Political factors
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International Bond
Portfolio Strategies
Selecting a Sector
Government securities
Regional and
municipal bonds
Mortgage backed
and public-loan-backed bonds (e.g. German Pfandbrief)
Investment grade
corporate bonds
Junk bonds
Inflation-indexed
bonds
Emerging markets
debt (Brady)
Choices include: