AC3650Risk & Capital Market

Euro Bond Market

There are three major categories of Markets

We have already looked at two: Domestic: This deals with bonds which are issued by locally domiciled

issuers. It is therefore the simplest market and the one that is usually assumed to be the case.

Foreign: The bonds are issued by a non-domiciled issuer but in all other respects are the same as domestic bonds e.g. they are denominated in the local currency.

The third one is – International or ‘Euro’ These are bonds denominated in a currency which is not the currency

of the country in which the bond is issued. These bonds depend on the existence of currency which is deposited outside the jurisdiction of the country who issued the currency (Eurocurrency).

Growth in Euro Currency EUROCURRENCY has grown mainly since World War II. There have

been a number of reasons for this, the main ones being:

a) During the ‘Cold War’ the Eastern Block countries were unable to trade internationally with their own currencies and so held U.S. dollars. Concern grew that the U.S. might freeze their assets held in American banks as part of its cold war strategy. They therefore moved their funds to two Soviet controlled banks in Europe. One of those banks was called Banque Commercial pour l’Europe du Nord (or Eurobank for short) and so the prefix Euro was used to describe such deposits.

b) The growth in the level of international trade generally lead to a flow of currency outside of national boundaries. In particular the U.S. dollar became an accepted stable currency which could be used to denominate trade, even when neither party to the deal used dollars as their own currency. This, for example, is the situation with aviation fuel.

Growth in Euro Currency (cont.) c) In the U.S. economic problems lead to a tight regulation

and control over banks. These regulations, including the minimum level of deposits to be held and the acceptable spread on interest rates, made it difficult for these banks to compete with other international banks and so many of them moved deposits offshore in order to avoid the restrictions and to allow themselves to compete internationally.

All these factors created a supply of money outside national boundaries which can be tapped into by issuing Eurobonds.

EUROBONDS: These are issued in the usual range of formats - eurostraights, zero coupon, convertible (note that the coupon is usually paid annually due to the high admin cost of making a payment).

Particular forms of Euro bond are : Dual Currency where the bond is denominated in one currency but

pays interest in another. This allows the holder to receive income in a usable form (i.e. a currency that they trade in) while holding a bond in a stable or appreciating currency so that the underlying value of the investment will not be eroded.

Warrants In addition to the usual form of warrants there are Currency Warrants which allow the exchange of currency at an agreed rate and Gold Warrants which allow the purchase of gold from the issuer at an agreed price. Both of these types help to guarantee the value of the investment.

ADVANTAGES OF THE EUROBOND MARKETS

1) As they are outside national jurisdiction they are less regulated and so it is possible to issue in several countries simultaneously.

2) They are normally issued in an unregistered bearer format, which aside from the obvious attractions to those who wish to keep their wealth secret, makes them cheap to deal in.

3) The avoidance of regulatory constraints such as reserve requirements and equity ratios means that better interest rates can be offered

It should be noted that, while they are technically not regulated by the country which issued the currency, the use of foreign exchange and capital restrictions can allow them to exert some influence on the markets.

Also, although usually traded ‘Over the Counter’, Eurobonds may be quoted on a recognised exchange so as to allow some institutional investors to buy the bonds. (Where national regulations restrict their ability to invest in certain instruments.)

In 1989 the World Bank issued a 10 year $1.5billion offering on the Eurobond markets and also on the Yankee bond market. This made it a true ‘global bond’.

Eurobonds have been a success story due to:

a) The size of the potential market b) The low cost base - allowing attractive interest

rates c) The growth of supranational bodies d) The way in which the commission basis of

selling provides immediate income for banks e) The overall trend to disintermediation.

HOW THE EUROBOND MARKETS WORK

Placement is through a syndicate of banks or security houses with one acting as the ‘lead’ bank.

Managing banks underwrite (and often buy part of) the issue

Placing agents are the intermediaries who contact potential customers and who sell on a commission basis.

Fiscal agents take care of such issues as withholding taxes.

The placing agents will circulate a prospectus to potential customers. Often an unofficial version of the prospectus (the Red Herring) will be circulated in advance and this allows trade to take place before the actual issue (the ’grey market’).

Many bonds are listed on the Luxembourg Bourse and some are on the SEAQ International computer in London but the secondary markets are not very active. This lack of liquidity is particularly noticeable for small issues and for those denominated in unattractive currencies.

Secondary market transactions can be handled through multilateral clearing houses such as EUROCLEAR (in Brussels) or CEDEL (Luxembourg).

Thank you very much for attending the lecture.