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CHAPTER XII

INTERNATIONAL BOND MARKETS

I. Introduction to International Bond Markets

The world bond market is divided into three markets:

i. Domestic bonds: Issued locally by a domestic borrower. Usually denominated in the local currency.

ii. Foreign bonds: Issued on a local market by a foreign borrower Usually denominated in the local currency.

iii. Eurobonds: Placed mainly in countries other than the one in whose currency the bond is denominated.

Example XII.1: Distinction between bond markets.(A) Domestic bonds.Amoco Canada issues a bond denominated in CAD in Canada.Issue is underwritten by a syndicate of Canadian securities houses.

(B) Foreign bonds.Amoco Canada issues bonds denominated in USD in the U.S. Issue is underwritten by a syndicate of U.S. securities houses.

(C) Eurobonds.Amoco Canada issues bonds to be placed internationally.Issue is underwritten by an international syndicate of securities houses.Issue is denominated in any currency. ¶

The Foreign bond and Eurobond markets make up the international bond market.

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1.B Type of Instruments

The most popular instruments in international bond markets are:

i. Straight or fixed income bonds.ii. Partly paid bonds.iii. Zero-coupon bonds.iv. Floating rate notes (FRNs).v. Perpetual FRNs. vi. Convertible bonds.vii. Bonds with warrants.viii. Dual-currency bonds.

• Examples

1.C Type of Instruments

Example XII.3: Straight bond 5.5% 1973 Italian Autostrada USD bond

Amount = USD 15 millionIssue date = July 1973Face value: F = USD 250Coupon: C = 5.5% = USD 13.75Maturity = 10 yearsInterest payment dates: July 1

Every year the Autostrada paid USD 13.75 to bondholders, for 10 years.

First Eurobond.

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Example XII.4: Zero-coupon bonds ("zeros").Zero June 1984 PepsiCo Overseas USD bond

Amount = USD 100 million.Maturity = June 1984 (3 years)Face value: F = USD 100Coupon: C = 0.Issue Price = 67.255.

Compounded annual interest yield: (100/67.25)1/3 - 1 = 14.14%

Example XII.5: FRNs ("floaters").LIBOR + 1/8 March 2024 Swedish Government USD bond.

Amount = USD 500 million.Maturity = March 1, 2024 (40 years).Face value: F = USD 1000Coupon: C = 6-mo. LIBOR + 1/8Interest payment dates:March 1 and September 1

At the time the notes were offered (3/84), 6-mo. LIBOR was 10(7/16)%

First Coupon = 10(7/16)% + (1/8)% = 10(9/16)%.

Afterward, at the end of each 6-mo. period the interest rates on the notes are updated to reflect the current 6-mo. LIBOR rate for dollars. ¶

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Example XII.7: Convertible bonds ("convertibles").8% 2002 Cantim (a Canadian co.) convertible USD eurobond.

Amount: USD 100 millionMaturity: May 2002 (7 years)F = USD 1000C = 8%.Conversion price = CAD 23.135Conversion St = 1.200 CAD/USDConversion period: Any time after first interest payment

Principal is convertible into Cantim common stock at a conversion price per share of CAD 23.125, where each USD of face value would be convertible to CAD at a fXIed exchange rate of 1.2007 CAD/USD.

each bond can buy 51.92 shares. ¶

Example XII.8: Convertible bonds into other assets (bonds).11.25% 1995 CEPME convertible GBP bond.

Amount = GBP 35 millionMaturity = May 1995 (12 years)F = GBP 1000C = 11.25%Conversion St = 1.55 USD/GBPConversion period: Any time after first interest payment

Conversion structure: Each bond can be converted into one USD 1550, 12-year FRN paying 6-mo LIBOR.

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Example XII.9: Bonds with equity warrants.4% 1995 Cannon Euro-USD bonds with equity warrants attached.

Amount: USD 370 million. Maturity: May 31, 1995 (5 years).F = USD 5,000C = 4%Number of warrants: 74,000Warrants per bond: 1Shares per warrant: 468.06Exercise price: JPY 1487Conversion St: 139.2 JPY/USDExercise period: At any time after the first interest payment

Almost all Japanese Euro-USD bond with equity warrant attached (USD Eurowarrants) have similar terms. ¶

Note: Eurowarrants dominated Japanese new issue financing during the Japanese bull market of the late 1980s Japanese warrants

Example XII.10: Dual-currency bonds.

Note: Dual-currency bonds are purchased in terms of one currency but pay coupons or repay principal at maturity in terms of a second currency.

1995 First City Financial CHF Eurobond.

Maturity = July 1995 (10 years).F = CHF 5000.C = 10% (=CHF 500).

Feature = At maturity, the bond is repaid in the amount of USD 2,800.

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At the time of the issue, this bond represented a combination of

(a) a 10-year CHF bond that repays principal: CHF 5000 +(b) a 10-year forward contract to buy USD 2800 at 1.7857 CHF/USD (CHF 5000/USD 2800 S10/03/00 = 1.7304 CHF/USD).¶

• More on Dual Currency Bonds.

Japanese firms have frequently issued CHF denominated bonds convertible into common shares of a Japanese company.

A foreign investor can benefit from purchasing this bond:

i. a drop in the market interest rate on Swiss franc bonds;ii. a rise in the price of the company's stock; oriii. a rise in the JPY relative to the CHF.

Dual currency bonds represent a combination of an ordinary bond combined with one or more forward contracts.

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II. Eurobond Markets

2.A Historical development of Euro Markets

• Euro-xxxx: the currency of denomination of the instrument traded is not the official currency of the country where the transaction takes place.

Example: a Malayan firm deposits USD not in the U.S. but with a bank outside the U.S., for example in Singapore or in Switzerland.

• Euromarket:offshore money market low costs and lack of regulationsinstruments traded in any currency.

The Eurobond market is just one segment of the Euromarket.

• Birth and DevelopmentDecline of the GBPRise of the USD as the international currencyCold war forced Russia to deposit USD not in the U.S.EEC allowed financial deregulationMore important:

Interest Equalization Tax (IET) (1963)Foreign Credit Restraint Program (1965)Foreign Investment Program (1968)

These restrictions brought the major financial institutions to European money centers like London, Zurich, and Luxembourg.

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2.B Characteristics of Eurobonds

• A Eurobond is an international debt security.

Structure: similar to the standard debt security used in domestic markets.

Basic characteristics:a Eurobond is transferable (usually bearer).a Eurobond is intended to be tradeable.a Eurobond is a medium- to long-term debt security.a Eurobond is generally launched through a public offering.a Eurobond is generally listed on a stock exchange.

Transferability should be simple:bearer bond (you have it, its yours)registered bond (your name should be in a book to own the bond)

the majority of Eurobonds are bearer bonds.

• Attractive characteristic of Eurobond markets for issuers:The Eurobond and foreign bond markets seem to be segmented.

Example: The World Bank has issued in the U.S. foreign bond market and in Euromarkets. Issues of similar maturity have yielded 10 to 20 bps less.

Usual explanation: no requirement of registered form for Eurobond. ¶

Formal characteristics of Eurobonds: no different from domestic or foreign bonds.

The structure of the underwriting syndicate is the main difference between other bonds and Eurobonds.

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II. Issue Procedures in the Eurobond Market

2.B.1.i Organization of a Traditional Eurobond Syndicate

• Eurobonds are issued and sold through underwriting syndicates.

• Participants in these syndicates are investment banks:Players:

i. lead manager (organizes the managing group). ii. managing group (buys the bonds). iii. underwriters (commitment to buy ahead of time at a set price).iv. selling group (no commitment to buy at a set minimum price).v. principal agent (responsible for receiving and making payments).vi. fiscal agent and trustee (represent the borrower and bondholders respectively).

• Roles in a Eurobond syndicate are nested: Managers are also underwriters and sellers, and underwriters are usually also sellers.

Exhibit XII.2Role players in a new eurobond issue

Issuer of bonds Banking syndicate

Fiscal Agent; else Trustee and principal agent.

Managing groupUnderwritersSelling group

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Investors

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2.B.1.ii Selecting a Lead Manager

• Market for Lead Managers is very competitive.

• The selection of a professional issuing house to lead-manage the issues is a critical decision for the borrower.

• Factors: Established relationsPriceMarket making abilityCoordination of the syndicateDerivatives products

The advantage of a Eurobond issue may not the cost. An issue may be preferred in terms of longer maturities, early call options, issue sizes.

2.B.1.iii Fee Structure for new Eurobond Issues

• Fees: extracted by discounts on the prices provided to syndicate members.

Example XII.11: A French company issues USD 1,000 bonds at 100 (100% of FV, "par"). Managing group pays the borrower USD 975 for each USD 1,000 bond.

The USD 25 discount (2.5%) is the flotation cost. ¶

• Syndicate members really receive the full flotation cost if the bonds are actually sold to retail at the issue price. This might not happen.

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Reasons:(i) unforceable contracts.(ii) competition.(iii) price discrimination.

Example:Lead manager pays borrower USD 975 per USD 1,000 bond.Lead manager makes bonds available to underwriters at USD 980Lead manager makes bonds available to sellers at USD 985

$1,000 - $975 = $25"Flotation cost" or "spread" (100% of spread)$1,000 - $985 = $15"Selling concession" (60% of spread)$985 - $980 = $5 "Underwriting allowance" (20% of spread)$980 - $975 = $5 "Management fee" (20% of spread)

• Typical spread for USD Eurobonds:2% for issues ten years or longer. Less than 2% for shorter maturities.

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2.B.1.iv Traditional Time Schedule for a New Offering

Exhibit XII.3Timetable of New Eurobond Offering

7-10 day subscription period(Gray market period)

Syndicate stabilization (Two weeks)

Announcement of Eurobond Issue

Signing of final terms;Offering day

Closing day; Selling group members pay for bonds; Borrower receivers funds

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2.B.1.v Gray Market

• A seller knows she will receive bonds at a 1.5% discount:

"I am getting a discount of 1.5% on a certain number of bonds."

"I could sell these now for 1%, I would lock in a .5% profit."

"I could avoid the risk that interest rates (and bond prices!) will change."

• The bonds themselves (and the terms!) are not yet in formal existence.

This premarket is the gray market.

Bonds trade in the gray market at a discount on the future (yet-unknown) issue price.

Example XII.12: A price of "less 1" would mean a price of 98.75 if the bonds are issued at 99.75. A USD 1,000 bond would then be exchanged between the two parties for 98.75% of its face value, or USD 987.50.

The gray market -or forward- price represents the price at which potential demand is brought into equilibrium with potential supply.

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2.B.1.vi Variations on Issuing Procedure

• Bought deal (lead manager buys the entire bond issue at set terms).

Example XII.14: In April 1980, CSFB bought an entire USD 100 million issue overnight from GMAC. ¶

• Auction issue, (the borrower announces the maturity and the coupon rate of a new bond issue and invites investors to submit bids).

It eliminates management fees and the costs of syndication.

Auction systems are popular domestically: government securities.

Example XII.15: The Peruvian Central Bank announces an issue of 100,000 USD 1,000 8.5% Treasury Bonds with a maturity of 1 year.

GMAC bids 95.3 percent for an amount of 30,000.Cut-off rate: 95.0 (all offers above 95.0 are accepted).GMAC pays USD 28,590,000 for the bonds. ¶

• Fixed price reoffer (FPRO), (lead manager and comanagers sign a contract obligating them not to discount fees).

It is the way bonds are underwritten in the U.S. domestic market.

20% of new eurobonds are issued under FPRO terms.

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Typical spreads are (5/16) to (3/8) percent instead of 2 percent.

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2.B.2 U.S. Legal Aspects of Eurodollar Bond Issues

• U.S. authorities do not attempt to control the issuing of USD-denominated eurobonds by foreigners.

• U.S. regulations affect the management and sale of USD eurobonds.

• Only U.S. investment banks get involved in USD Eurobond issues.

• U.S. banks can participate in Eurobond issuing syndicates only if they guarantee that U.S. investors cannot purchase the bonds.

• A Eurobond offering could be structured to fall under the "private placement" exemption of the Securities Act of 1933.

Then it can be sold to U.S. nationals at issue. But, this exemption applies when the purchasers of the bonds meet the following features:

1.- They are limited in number.2.- They are "sophisticated."3.- They are able to bear the loss if the bond issuer defaults.4.- They purchase bonds as principals (i.e., not for resale).5.- They have access to information similar to that which would be contained in a registered offering prospectus.

• In 1984, the U.S. government deregulated bond and money markets:

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no U.S. withholding tax on payments to foreigners who hold U.S. government or corporate bonds.

U.S. corporations are allowed to issue bearer bonds directly to

non-U.S. residents.

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2.C.1 Eurobond secondary market

• History:

i. In 1968, Eurobond dealers created the AIBD (Association of International Bond Dealers).

ii. In 1991, the AIBD was reorganized into the International Securities Market Association (ISMA), which is based in Zurich.

The ISMA is similar to the U.S. NASD.

Table XII.C shows the geographical location of AIBD members

TABLE XII.CGeographical Breakdown of ISMA Members

Locality Number of membersU.S. 48Belgium 33Far East 33France/Spain 52West Germany/Austria 57Italy 26Luxembourg 63Middle East 33Netherlands 47Scandinavia 55Switzerland 141U.K. 219

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Public Eurobond issues are listed on one or more stock exchanges.

The principal exchanges for issues are Luxembourg and London.

European currency issues tend to be listed on the home exchange.

There is no legal obligation to deal on the exchanges:

OTC market.

• Microstructure:

Market-makers and dealers in Eurobonds are members of the ISMA.

A market-maker quotes a net bid-ask price:

no commissions are charged.

Bid-ask spreads on Eurobonds are around .50%.

Settlement takes place on the value date, approximately a week later.

Standard-size transaction is 100 bonds (with USD 1000 of face value).

Quoted prices apply to standard-size transactions, smaller transactions are negotiated at higher spread costs.

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• Two international securities clearing systems (now linked):

(1) Euroclear was the first, set up in Brussels (1968).

(2) Cedel was established in Luxembourg (1970).

Eurobonds may be held in depositories in different countries.

Accounting is carried out in Brussels or Luxembourg.

• Liquidity problems:

For certain issues, liquidity is still a big problem.

Not a problem of unreliable market making.Problem: poor access to established and liquid bond

markets.

Issuers take liquidity considerations into account:

The bigger the size of the issue, the more liquid in the secondary market:

Issue tend to have sizes larger than USD 50 million equivalent.

• Volume:

The volume of trading has grown rapidly (total turnover): 1979: USD 156 billion1990: USD 6.5 trillion.

Turnover denominated in USD weakened: 1979: 90%

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1990: 38%

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III. Foreign Bond Markets

3.A Yankee Bonds

• It used to be the largest and most important foreign bond market.

• Yankee bonds must be registered under the Securities Act of 1933.

• Yankees issues are usually rated by a bond rating agency.

• There is no withholding tax on coupon payments to foreigners.

• The secondary market for Yankee bonds is more liquid than that for USD Eurobonds and bid/ask spreads are smaller.

3.B German Eurobonds and German Foreign Bonds

• Investment banking and commercial banking are not separated.

International EUR bond market is dominated by German banks.

• A German Eurobond is not legally different from a German foreign bond.

3.C Samurai Bonds and JPY Eurobonds

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• Japanese and non-Japanese corporations make public Euroyen issues

• Foreign banks are allowed to serve as lead managers.

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3.D Swiss Franc International Bonds

• Government does not allow issues in CHF outside Switzerland.

• Switzerland has the largest foreign bond market in the world.

• Common scenario: foreign savers lend to foreign borrowers in CHF.

• Swiss foreign bonds are bearer bonds and have annual coupons.

IV. Differences Among Bond Markets

4.A Issuing Techniques

Domestic bonds: issued by a syndicate of national banks. Eurobonds: issued through an international syndicate.

4.B. Dealing

U.S. domestic market: OTC with some bonds are listed (at NYSE).

Market makers and brokers.

European bond markets: Exchange markets. OTC for non-government bonds.Brokers.

Japan bond market: OTC and Exchange markets. Brokers.

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Eurobond market: OTC. Few transactions go through the

exchange.

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4.C Quotations

• Bonds are usually quoted:

Cash price = Quoted price + Accrued Interest.

Exception: U.K. bonds (gilts) with more than five years to maturity.

Cash price = Quoted price.

• Bonds also differ in the way accrued interest is calculated.

Example XII.19: U.S.An investor holding a U.S. straight bond for February 1995 receives 30/360 or 1/12 of the annual coupons (1/6 of the semiannual coupon).

Example XII.20: JapanAn investor holding a Japanese straight bond for February 1995 will receive 28/365 of the annual coupon.

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4.D Yields

• Financial institutions around the world calculate YTM on bonds.

The methods differ across countries YTM are not comparable.

Europe: Annual actuarial YTM using the AIBD-recommended formula.

U.S.: Institutions publish a semiannual actuarial yield.

Example XII.21: 12% 2010 IBM USD bondi. U.S.: it pays USD 6% semiannually and it has a YTM of 12% (s.a.).ii. Europe: it has a (annual) YTM of 12.36% =(1.06)(1.06) = 1.1236

Japan: Tend to report YTM based on simple-interest calculation:

Yield = (Coupon rate + 100 - P ) x100,

Years to maturity P

where P is the current price of the bond.

This simple yield understates the true YTM for bonds priced over par and overstates the yield for bonds priced below par. Example XII.22: A Japanese bond with:

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Years to maturity: 5 years.C = 12%. P= 95.

Yield (for a Japanese financial institution) = 13.68. ¶

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4.E Some Legal Aspects

• Bonds are issued in either bearer or registered forms.

Eurobonds: The bearer of a bond is assumed its legal owner.

U.S.: owners must be registered in the books of the issuer.

• Coupons are usually paid annually on markets where straight bonds are issued in bearer form (cost reasons):

Eurobond coupons in all currencies are paid this way.

U.S. coupons are paid semiannually.

VI. Why Invest in International Bonds?

Case LN XII: GE Capital will answer this question.