global bond markets

Francis & Ibbotson Chapter 19: Global Bond Markets 11

Slides by:

Pamela L. Hall, Western Washington University

Global Bond MarketsGlobal Bond Markets

Chapter 19


A Brief Tour of the Global Bond MarketA Brief Tour of the Global Bond Market

By the end of 1998 the aggregate value of all outstanding bonds in the world was $25.4 trillion– About 50% were denominated in U.S.

dollars– 15% were denominated in yen– 10% denominated in Deutschemark– 26% of world’s debt originated from

Euroland in 1998


The U.S. Bond MarketThe U.S. Bond Market

U.S. Treasury is the world’s single largest

borrower—also has the most liquid market—an informal OTC market.


U.S. Government Agency BondsU.S. Government Agency Bonds

Federal government allows governmental agencies to borrow in the name of the agency– The agencies’ debts do not appear as part of the federal

government’s debt• However, federal government implicitly guarantees the

agencies’ debts

Federal National Mortgage Association (FNMA—Fannie Mae) is the second largest borrower in U.S.– GNMA (Ginnie Mae) and FHLMC (Freddie Mac) are also

large borrowers• Subsidize home ownership by issuing low interest rate bonds

guaranteed by U.S. government


Corporate Bonds in the U.S.Corporate Bonds in the U.S.

Market for corporate bonds is less liquid than market for U.S. Treasuries– IPOs for bonds are underwritten by investment

banking firms

Largest organized secondary bond market is NYSE– Uses matrix prices for most of the bonds listed on

its Automated Bond System (ABS)• Based on price quotes for similar bonds (in terms of

coupon rate, maturity, quality rating, call provisions)


Corporate Bonds in the U.S.Corporate Bonds in the U.S.

Problems with ABS– Does not provide a liquid market free

from arbitrage opportunities– Large bond orders are difficult to execute

Most U.S. corporate bonds trade OTC– OTC bond quotes are not meaningful

• Again, large orders are difficult to execute at the quoted price


Bond Markets in the U.S.Bond Markets in the U.S.

Debt Issuers Underwriter Investors

U.S. government U.S. Treasury Governments, pensions, commercial banks, insurance companies, mutual funds, foreigners, households

Federal government agencies Investment banks Governments, pensions, commercial banks, insurance companies, mutual funds, foreigners, households

Municipalities Commercial and investment banks

Governments, commercial banks, insurance companies, mutual funds, foreigners, households

Corporations Investment banks Pensions, commercial banks, insurance companies, mutual funds, foreigners, households

Home buyers, commercial real estate developers

Mortgage banks & pool operators

Pensions, commercial banks, insurance companies, REITs

Foreign governments Investment banks Pensions, mutual funds, foreigners, households

Foreign corporations Investment banks Pensions, commercial banks, insurance companies, mutual funds, foreigners, households

U.S. government

conducts regularly scheduled

auctions for Treasury securities.


Bond Markets in the U.S.Bond Markets in the U.S. Transparency in a securities market exists when accurate price

and volume information is freely available– U.S. bond market is not transparent

Internet operations help increase the market’s transparency– TradeWeb—allows institutional investors the ability to trade U.S.

Treasury securities– Broker Tec—online interdealer bond brokerage– Trading Edge—operates a trade matching system for bonds– Bond Book—allows institutional investors and dealers to

anonymously trade corporate, junk and municipal bonds Bond markets are never expected to enjoy the same

transparency and liquidity as U.S. stock markets– There are 11,000 individual U.S. stocks vs. 4.5 million bond

issues


Sectors of the Industrialized Sectors of the Industrialized World’s Bond MarketsWorld’s Bond Markets

In almost every country, the federal government is that country’s largest debt issuer

Corporate sector for Japan, Italy and Germany is relatively small compared to their overall bond markets– Due to custom of borrowing from a bank

vs. issuing bonds


International BondsInternational Bonds

Represent a rapidly growing category– Reflects willingness of borrowers to borrow

across borders

International bond investors face two types of political risk– Repatriation-of-funds risk

• A government may block payments of principal or interest

– Sovereign risk• A government may refuse to honor its debts


International BondsInternational Bonds

Can be organized into the following categories– Domestic bonds

• Issued by a local borrower and denominated in local currency

– Foreign bonds• Issued in one country and denominated in that

country’s currency by a bond issuer from another country

– Eurobonds• Any bond not issued in a domestic market regardless of

its currency denomination and the issuer’s nationality


Foreign BondsForeign Bonds

Categories of foreign bonds– Yankee bonds

• Issued by non-U.S. borrowers within the U.S.

– Samurai bonds• Yen-denominated bonds issued in Japan by non-

Japanese borrowers

– Shogun bonds• Non-yen-denominated bonds issued in Japan by non-

Japanese borrowers

– Bulldog bonds• Issued by non-British borrowers in the U.K.—

denominated in pounds


Foreign BondsForeign Bonds

Yankee bonds are popular because liquid markets in high quality corporate bonds are nonexistent in many countries– Because governments encourage firms to

borrow from banks rather than issuing bonds


The Eurobond MarketThe Eurobond Market

Fastest growing, most diverse bond market Include the following bond types

– Fixed coupon bonds, floating rate bonds, zero coupon bonds

– Renewable ordinary bonds– Ordinary bonds containing embedded options– Exchangeable floating rate notes– Convertible bonds– Bonds with warrants attached– Index-linked bonds– Dual currency bonds


Primary and Secondary Markets for EurobondsPrimary and Secondary Markets for Eurobonds

Underwriting syndicates can be complex– Management group—can have from 4 to 30

member firms– Assemble an underwriting group—ranging from

20 to 300 banks– A selling group is also created

• Three groups split underwriting fees—ranging from 1.25% to 2.5% of the value of issue

Market’s untaxed and unregulated– Time schedule for issuing new bonds can be as

short as six weeks


Primary and Secondary Markets for EurobondsPrimary and Secondary Markets for Eurobonds

Eurobonds begin trading in the gray market weeks before final offering price is set– A forward market for bonds that do not yet exist

Most Eurobonds are listed on the Luxembourg Stock Exchange, but they don’t actually trade there– Most trades occur in the OTC market

• Similar to NASD but free from SEC-like regulation


Bearer Bonds Vs. Registered BondsBearer Bonds Vs. Registered Bonds

Registered bonds—send coupon checks to registered bond owners

Bearer bonds—have no list of registered owners– Investor must submit a dated coupon to a

bank to receive coupon payments• Many Eurodollar bonds are of this type

• Owner’s identity is unknown


Eurodollar BondsEurodollar Bonds

U.S. dollar denominated bonds– Issued as bearer bonds

– Underwritten by an international syndicate

– Issued and traded outside the jurisdiction of any single country

– Largest component of Eurobond market

Who issues Eurodollar bonds?– National governments and their agencies

– Corporations• Some countries with stringent regulations do not allow corporations

to issue bonds similar to Eurodollar bonds in their country– Thus, these corporations issue Eurodollar bonds outside their country

Investors & multinational issuers like the lack of regulation and taxes


Accrued InterestAccrued Interest

Market price of bond (or its clean price) is:

1 2 T T

1 2 T Tbond

Present Value of Coupon Payments Present Value of Par

Coupon Coupon Coupon ParPrice1 k 1 k 1 k 1 k

Bonds pay coupon payments periodically Annually, semi-annually, quarterly, etc.

When a bond is purchased on a day between its scheduled interest payment, buyer must pay seller for accrued interest Interest that has been earned but not yet paid by

issuer


Accrued InterestAccrued Interest

Accrued interest calculation:

Accrued

# of days since last coupon payment Coupon Payment Interest

# of days between scheduled coupon payment datesCalculation

Thus, the actual price for a bond is the bond’s clean price plus the accrued interest Known as the bond’s invoice price, full price or dirty price

U.S. newspapers quote clean prices But buyers must pay the dirty price, which is always higher

if bond is between coupon payment dates• However, difference is not substantial


Dirty Bond Prices Experience an Dirty Bond Prices Experience an Ex-Coupon Price Drop-offEx-Coupon Price Drop-off

Some countries use different bond invoicing methods– Quote prices with accrued interest

included (dirty prices)• Called a cum coupon price

• The quoted price will experience a drop-off in price immediately after a coupon payment is made

– Because accrued interest drops to zero


Day Counting ConventionsDay Counting Conventions

The convention used in counting days is important when calculating accrued interest– Many countries use 360-day conventions

• Corresponds to twelve 30-day months

– U.K., Canada & Japan use 365-day convention


Compounding ConventionsCompounding Conventions

The length of time between coupon payments impacts bonds’ yields and prices


Yield-to-Maturity (YTM): A First LookYield-to-Maturity (YTM): A First Look

A simple approximation of yield-to-maturity is:

Rate of Cash FlowRate of price appreciation or depreciation

Par - Current PriceYears until maturity

Non compounded YTM Coupon RateCurrent Price

Above formula does not involved compounding Used in Japan, but not in U.S.

Ignoring compounding will result in a YTM only a few basis points different than the correct YTM But a few basis points can be thousands of dollars for a

multi-million dollar bond transaction


Compounded YTMCompounded YTM

YTM defined as the discount rate equating the present value of a bond’s future cash flows to its current market price– For bonds paying coupon payments semi-

annually, the correct formula is:

1 2 2T

1 2 T 2T

Present 2 2 2Coupon Coupon Coupon ParValue 1 YTM 2 1 YTM 2 1 YTM 2 1 YTM 2

•The YTM is identical to IRR


Compounded YTMCompounded YTM

Another method for calculating YTM– Effective YTM

• For a semi-annual coupon bond this method is:

1 2 T

0.5 1 2T 2T

Present 2 2 2Coupon Coupon Coupon ParValue 1 YTM 1 YTM 1 YTM 1 YTME E E E

Cuts the years in half rather

than the YTM.


Example: Comparing a Bond’s Example: Comparing a Bond’s Conventional and Effective YTMConventional and Effective YTM

Given information– Par value: $100

– Coupon rate: 10% (semi-annual)

– Time to maturity: 10 years

– Purchase price: $106.59

Using the conventional YTM formula, we calculate a YTM of 8.8973%

1 2 20

$10 2 $10 2 $10 2 $100$106.59

1 0.089873 2 1 0.089873 2 1 0.089873 2


Example: Comparing a Bond’s Example: Comparing a Bond’s Conventional and Effective YTMConventional and Effective YTM

Using the effective YTM (EYTM) formula, we calculate an EYTM of 9.1892%

0.5 1 20

$10 2 $10 2 $10 2 $100$106.59

1.091892 1.091892 1.091892

Difference is about 20 BPs 9.1892% - 8.9873% = 0.2019

The difference between conventional YTM and EYTM is (1 + EYTM) = (1+YTM/2)2 or YTM + YTM2/4 Or: 0.089873 + (0.089873)2/4 = 0.091892 or 9.1892%


Comparing Various YTMs for a BondComparing Various YTMs for a Bond

Many people think YTM is a very precise measure– YTM depends upon assumptions and techniques

used

– For example, a bond with a $100 par, a 10% coupon, a 10-year maturity and a current price of $106.59 can have several YTMs

• Conventional semi-annual: 8.9873%

• Effective semi-annual: 9.1892%

• Japanese semi-annual: 9.3187%


Conditions Required to Earn a Conditions Required to Earn a Bond’s Expected YTMBond’s Expected YTM

A bond’s computed YTM will only actually be earned if:– The bond is held to maturity– The bond issuer does not default in the

timing or amount of scheduled payments– All the cash flows are immediately

reinvested to earn the bond’s YTM


Reinvestment Rate Affects A Bond’s YTMReinvestment Rate Affects A Bond’s YTM

Different reinvestment rates impact the investor's actual rate of return– Example: An investor buying an 8% coupon bond at par

will expect a YTM of 8%• However, his actual return hinges on the reinvestment rate

earned on the coupon income receivedReinvestment

RateTotal Realized

Yield

0% 4.84%

5 6.64

6 7.07

7 7.53

8 8.00

9 8.50

10 9.01

Only if the reinvestment rate = YTM will the investor actually realize the YTM.


A Bond’s Holding Period ReturnA Bond’s Holding Period Return

An investor’s holding period return (r) is:

1 0

0beginning of holding period

CFPrice change Cash Flow P Pr

Price P

Can be positive, negative or zero Depends on how the price moved over the

holding period• A bond’s price movements are determined by

fluctuations in the bond’s YTM


Inverse Relationship Between a Inverse Relationship Between a Bond’s Price and YTMBond’s Price and YTM

The price and YTM of a bond move inversely

NOTE: Price-yield curves are convex to the origin.


Other Measures of Bonds’ YieldsOther Measures of Bonds’ Yields

Yield-to-call (YTC)– A bond issuer may call a bond before its

original maturity date• Need to calculate the bond’s YTC

– Similar to YTM, except replace T as the time-to-call rather than time-to-maturity


Example: Comparing a Callable Example: Comparing a Callable Bond’s YTC & YTMBond’s YTC & YTM

Compute the YTC:

20

201

$175 $10,000$8,140.32 or YTM = 6% a year

1.03 1.03tt

Given information– Par value: $10,000

– Time to maturity: 10 years

– Coupon rate: 7% (3.5% semi-annually)

– Current price: $8,140.32

– Call premium: 7% in 5 years (meaning the bond is callable at 107% of par in 5 years)

Compute the YTM:

10

101

$175 $10,000 1.07$8,140.32 or YTM = 9.373% a year

1.04686 1.04686tt


Other Measures of Bond’s YieldsOther Measures of Bond’s Yields

Floaters– A bond with a fixed par but a fluctuating (or

floating) interest rate• Rate varies according to a specified reference rate

– LIBOR or U.S. T-bill rates are commonly used

Current yield—every non-zero bond has a positive current yield

Annual coupon $ interestCurrent Yield

Current price of bond

Investors desiring high investment cash flows are interested in a bond’s current yield


Brady Bonds Aid Emerging CountriesBrady Bonds Aid Emerging Countries

An international debt crisis occurred in late 1980s due to falling commodity prices and recessions– Many loans were defaulting ($200 billion)

• Mostly from Latin America

– Many emerging countries vanished from international financial markets

Debt banks created Paris Club organization– Also organized a secondary market for the non-

performing bank loans• Typically priced at less than half original face value



In 1989 the U.S. Secretary of Treasury, Nicholas Brady proposed the Brady Plan– Provided a way to finance the defaulted loans

until they could be paid off• Emerging country must get an economic reform plan

approved and obtain loans through International Monetary Fund and World Bank or elsewhere

– Development banks established repayment plans

» Made the defaulted debt marketable by guaranteeing repayments

» Allowed troubled banks to exchange illiquid defaulted bank loans for liquid Brady bonds



No Brady bonds are 100% guaranteed Types of Brady bonds

– Most popular• Discount bonds (AKA: principal-reduction

bonds)– Issued at a deep discount from par

• Par bond (AKA: interest-reduction bond)– Face value equals par value of defaulted debts

» Debt reduction occurs by setting coupon rate below current market rate



Less popular Brady bonds– Debt-conversion bonds (DCBs) and new-money

bonds (NMBs)• Each dollar invested in NMBs can be converted into a

larger amount of more desirable DCBs

– Front-loaded interest-reduction bonds (FLIRBs)• Pay low coupon rates during early years but coupon

rate increases over time

– Past-due interest bonds (PDIs)• Issued to pay for past omitted interest payments



Outcome of the Brady Plan– Emerging nations able to settle defaulted debt at

a reduced cost– Reduced debt allowed countries to renew

economic growth– Troubled countries able to regain access to

capital markets

Critics of Brady Plan argue– Too costly

• Developed nations finance the development banks

– Subsidizes financial mismanagement


International Bond Index StatisticsInternational Bond Index Statistics

U.S. $ U.K. Pound Hong Kong $ German Mark

Return SD Return SD Return SD Return SD

Australia 8.5% 15.5% 9.9% 18.3% 9.5% 16.4% 5.0% 20.2%

Belgium 11.6 17.2 13.0 14.7 12.7 16.2 8.1 8.6

Canada 9.3 10.4 10.7 19.3 10.3 13.2 5.8 17.0

France 10.8 15.6 12.2 15.3 11.8 15.6 7.2 12.2

Germany 12.0 14.9 13.4 16.7 13.0 13.4 8.4 8.4

Japan 12.2 17.5 13.7 18.4 13.3 18.3 8.7 17.3

Netherlands 11.7 14.2 13.1 15.8 12.7 14.0 8.1 8.2

Switzerland 10.2 17.1 11.6 16.8 11.2 16.0 6.7 9.8

U.K. 10.2 22.3 11.6 17.2 11.6 17.2 11.3 23.4

U.S. 9.3 12.2 10.6 21.3 10.3 14.7 5.8 16.8

No single bond

investment appears to be the most or least risky.


Components of International Bond ReturnsComponents of International Bond Returns

Capital Appreciation

Income Return

Currency Return

Total Return (US$)

Australia -1.2% 10.4% -1.3% 8.5%

Belgium 0.3 9.1 1.6 11.6

Canada 0.1 9.6 -0.9 9.3

France 0.3 9.7 0.3 10.8

Germany 0.5 7.6 3.2 12.0

Italy 0.1 12.2 -3.3 9.5

Japan 1.0 6.4 4.1 12.2

Netherlands 0.3 8.0 2.7 11.7

Switzerland 0.4 5.0 4.2 10.2

UK 0.2 11.0 -1.3 10.2

US 0.4 8.4 N/A 9.3

Returns are from the

standpoint of a U.S. investor.

Results suggest investor needs to

analyze all three

components.


Correlations of International Bond ReturnsCorrelations of International Bond Returns

Aus’l A’str Belg Can Fra Ger Ire Ita Jap Net NZ Safr Swi UK US

Australia 1.00

Austria 0.22 1.00

Belgium 0.20 0.86 1.00

Canada 0.28 0.22 0.25 1.00

France 0.20 0.82 0.82 0.25 1.00

Germany 0.20 0.91 0.86 0.28 0.82 1.00

Ireland 0.24 0.59 0.60 0.27 0.59 0.61 1.00

Italy 0.17 0.50 0.47 0.22 0.52 0.47 0.46 1.00

Japan 0.19 0.59 0.59 0.26 0.57 0.59 0.45 0.33 1.00

Netherlands 0.21 0.88 0.83 0.30 0.83 0.93 0.57 0.47 0.59 1.00

New Zealand 0.32 0.26 0.27 0.07 0.24 0.23 0.24 0.21 0.23 0.26 1.00

South Africa 0.21 0.39 0.35 0.06 0.34 0.37 0.29 0.26 0.25 0.34 0.14 1.00

Switzerland 0.18 0.82 0.77 0.24 0.75 0.83 0.56 0.39 0.61 0.82 0.18 0.31 1.00

UK 0.23 0.43 0.46 0.30 0.45 0.47 0.74 0.34 0.40 0.46 0.23 0.23 0.42 1.00

US 0.16 0.18 0.22 0.67 0.24 0.26 0.23 0.18 0.21 0.29 -0.05 0.05 0.24 0.21 1.00

High correlations result from:•Bilateral trade agreements•Policies to align currencies•Cultural similarities


Correlations of International Bond ReturnsCorrelations of International Bond Returns

What’s important is the fact that there are some relatively low correlations among international bond returns resulting from– Dynamics of business cycles within countries

– Different monetary policies

– Different government financing practices

– Differing inflation levels

– Social trends, foreign policies ad political forces

Correlations are unstable over time


Markowitz Analysis of Markowitz Analysis of International Bond PortfolioInternational Bond Portfolio

U.S. investor can achieve a

dominant position by

investing 40% of portfolio in

non-U.S. bonds.

Caveats:

• Based on historical data—no guarantee future will be the same

• Ignores commissions and other expenses


Actively Managing International Actively Managing International Bond InvestmentsBond Investments

Active international bond investors can use different approaches:– Political analysts begin with a top-down approach and

analyze sovereign risks, etc.– Macro-economists study macro factors (income,

employment, etc.) to determine which nations are economically strong

– Monetary economists forecast a nation’s level and structure of market interest rates by analyzing central bank and their policies, etc.

– Industry analysts analyze financial data from different industries

– Security analysts have a bottom-up approach—focus on bond issuer’s financial conditions, protective provisions, etc.


The Bottom LineThe Bottom Line

Governments are the largest borrowers in the world Most rapid growth occurring in Eurobond market

– Unregulated and untaxed

Some countries publish clean bond prices while others publish dirty prices which includes accrued interest

Day counting conventions differ across countries YTM calculations methods also differ across

countries



If a bond’s cash flows are not invested at the bond’s YTM the investor will not earn the YTM

Other yield measures exist– Holding period return– Current yield– Yield to call



Brady Plan generated an array of packages of defaulted bank loans from emerging countries

Investors need to analyze capital appreciation, coupon interest return and foreign exchange return when considering investments in international bonds

Markowitz portfolio analysis is applicable for international bond investing

global bond markets

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