4.2. Eurobond

MH BOUCHET (c) CERAM 1

MScIF- INTERNATIONAL FINANCE

Winter 2003

The Euromarkets: evolution, structure, instruments

INTERNATIONAL SECURITIES

Michel Henry BOUCHET


INTERNATIONAL FINANCE


Origins and developments Eurocredits and Eurobonds Legal Clauses in Syndication Capital adequacy guidelines Tax, accounting and regulatory framework


The EUROBOND MARKET

Origins Development Structure

Instruments Volume



Preparation: Clark, Chap. 5, pp. 113-130 Madura: Chap. 3 Eiteman, Stonehil & Moffett, MBF, chapter 13 BIS Annual Report, Chap. VIII BIS Quarterly Review, Statistical Annex Bouchet: Credit Creation, Multiplication and Maturity

transformation in the Euromarkets, USC, United States. Milton Friedman, The Euro-dollar Market, Federal Reserve Bank of

Saint Louis, July 1971. ISMA Annual Report BIS Annual Report


What is a Eurocurrency? Any freely convertible currency, such as a $ or a

DM or £, deposited in a bank outside its country of origin. It is the residency of the bank and not its nationality that determines the “euro” nature of the deposit.

Eurocurrency deposits are typically short-term deposits <1 year, whereas eurocredits are longer term, hence a maturity transformation in the Eurobanks’ balance sheets.


The Balance of Advantage forThe Borrowers

Availability of international capital in larger amounts and to a wider range of borrowers than in the fixed-interest bond markets

Capital is available more quickly, with fewer formalities and with fewer conditions (balance of payments financing)

Flexibility against interest and exchange rate risk with currency options and variable roll-over period length (despite drawbacks of floating and unpredictable LIBOR cost of Eurocredits)


The EUROBOND MARKET Whilst the international financing of public and private projects has

existed since the 19th century, the market in its current form began life in the early 1960s. The driving factor behind its growth and development was the tax regime introduced by the US government in 1963, aimed at discouraging foreign issuers from borrowing from US investors. US tax law also made difficult for US multinationals to fund their overseas subsidiaries from within the USA. Until that time, the vast majority of international borrowing had been channeled through NY.

After 1963, borrowers wishing to raise US$ denominated debt came to Europe, where a growing pool of investors was ready to provide those funds without the burden of expensive taxes. The Eurobond market was born.


The EUROBOND MARKET

Since the 1960s the market experienced rapid growth. Dealers and brokers worldwide trade issues denominated in a host of currencies, structured in a number of innovative ways, and issued to investors from every corner of the globe. In 1999, market size - a measurement of the total volume of outstanding international bond issues, reached some US$3 trillon equivalent. The range of instruments traded has grown substantially, and includes warrants, global depository receipts, international FRNs, and medium-term notes, Euro commercial paper and debt denominated in Euro. As a result the term Eurobond has given way to a wider, and more appropriate, label for all these forms of borrowing as “international securities”.


The EUROBOND MARKET

The international nature of the market means that it is not subject to the same controls which govern the primary and secondary markets in purely domestic securities. Since 1969, ISMA (International securities market association) has performed a central role by providing a global framework of industry-driven rules and recommandations which regulate and guide trading and settlement in this market.

Membership has now exceeded 700 institutions based in some 50 countries.


EUROBONDS

Eurobonds: long-term financial instruments issued by MNCs, IFIs or country governments, and denominated in a currency other than that of the country of placement. Eurobonds are underwritten by a multinational syndicate of investment banks and simultaneously placed in many countries. They are issued in bearer form, and coupon payments are made yearly.

The US$ accounts for about 50% of eurobonds. Liquidity in the secondary market is monitored by Euro-clear. Highly tradeable securities.


Bonds Contractual obligation on the part of the seller/issuer of

the bond (the borrower) to pay a fixed amount per year for a set number of years to the buyer of the bond (the lender). At maturity, the borrower repays the original face value of the sum borrowed.

Coupon= number of $ paid the lender per year Maturity= number of years over which the bond runs Par value= original sum borrowed Coupon rate= coupon expressed as a % of the par value


Bonds Coupon, par value and coupon rate are invariant over the

life of the bond. The coupon rate is established by competitive pricing in the market. The coupon rate is set so that the bond will be able to compete with comparable instruments in terms of maturity, yield, credit risk…

The bond can be traded on the secondary market at a market price which depends on the current market rate of interest for that type of bond. When the market rate of interest fluctuates, the price of the bond will adjust in such a way that the ratio coupon/price will equal the current interest rate.


Bonds

P = M (1 + i) n M is bond value at maturity, P is present

value, i is interest rate, n is number of years.There is an inverse relationship between bond prices and interest rates. For a given P, the higher i, the smaller M.


Price and YTM of a Bond Price and yieldPrice and yield to maturity are mirror reflections of each other.

The two are inversely related and one is neded to arrive at the other. This if priceprice is given, an investor can calculate the yieldyield on the bond, and compare it with his own required rate of return to see if the bond is a worthy investment or not. Alternatively, an investor can work out the priceprice he would be willing to pay for a bond given his yieldyield requirement.

Bond price and YTM are held together by the following equation: P = C_____

(1+y)1+ C_____

(1+y) 2+ …..+ C______

(1+y) n+ M

______(1+y) n

The YTM is essentially the bond’s internal rate of return, i.e., that discount rate whichmakes the present value of all the bond’s future cash infloxs equal to the current price ofthe bond (initial investment oputlay)


Yield curve

Yield spreads refer to the difference between the yield on a given bond at the time of issuance and the yield on US Treasury securities of comparable maturity or other comparable government securities if the bond is issued in other currencies than the US$. The US Treasury securities are used as proxy for risk-free return. As of end-2001, the US10-year rate is the base rate as opposed to the 30-year rate till 2000.


Eurobond Yield Curve in Per centas of May 15, and October 24, 2000 and November 30, 2001

1,00%

2,00%

3,00%

4,00%

5,00%

6,00%

7,00%

1 3 5 7 10 15 20 30

YIELD 05/99YIELD 10/99YIELD 11/01


Clearing procedures in the international bond markets

International Securities Market Association (ISMA) Euroclear (created by Morgan in 1968) CEDEL (Centrale de livraison des valeurs mobilières)

created in Luxembourg in 1970 Eurobonds are engraved certificates. Euroclear and Cedel

have a network of custodian banks where the certificates are deposited in bearer form for safekeeping. They manage the clearing of transactions on settlement date.


Emerging Markets Eurobonds High risk/high yield with low default track record

(premium of 20 basis points compared with US corporate borrowers for identical ratings)

historically, defaults only in the 1930s and late 1980s but recovery rate is better for sovereign debtors than corporate debtors (75% vs 40%)

problem of comparability of treatment with Paris Club and London Club debt (Pakistan, Ukraine, Ecuador, Argentina)

Market risk remains high due to concentration on 5 major countries (Argentina, Mexico, Korea, Brazil and Russia)


Eurobond Market By spreading the risk among thousands of investors, both private

and institutional, as opposed to a handful of banks in the loan market, the bond markets lower the cost of risk and thus reduce the cost of funding for companies and other borrowers. This in turn enables companies to raise larger amounts of debt.

Many companies took benefit of the depreciating euro in the fist half of 1999 to borrow in Euros and swap the proceeds into US$, which had an immediate downward effect on the value of the €, hence the link between the the euro’s weakness and the popularity of the euro-denominated bond market (US$300 b worth of securities issued in euros during the first half of 1999)


The Eurobond Market SizeGross= completed new bond and note issues in US$ billion

Net= Gross - redemptions and repurchases

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

GrossNetStock

Q2


Secondary market trading share/volume in 2003

Brady

Eurobonds

Local

Other37%37%

46%46%

12%12%

US$1500 billion


Currency Breakdown of the international securities market

Net bond and note issues in US$ billion

0

100

200

300

400

500

600

700

800

1997 1998 1999 2000 2001 2002

$

€

Y

Other34%

45%


Largest issuers of Euro-denominated convertible debt in 2001-03

France Telecom € 6.2 billion Vivendi Univ. € 2.8 billion Olivetti € 2.5 billion PPR € 1.4 billion Lafarge € 1.3 billion Artemis € 1.2 billion Danone € 1 billion


China and the global bond market

US$1.5 billion dollar and euro-denominated issue, as benchmark government bond: October 2003

China’s rating = A2 (Moody’s) * 10-year US$1 billion dollar tranche arranged by

Goldman Sachs, Merrill and Morgan, at 53 bp over USTB

* 5-year €400 million euro tranche arranged by Deutche Bank, BNP and UBS, at 7 bp over Euribor


Currency diversification and Eurobond issues

Between September and November of 2000, the US Agency Freddie Mac launched five-year two €-denominated bond issues of €5 billion respectively as part of Euro-reference note programme, with ANB Amro and Morgan Stanley as lead managers.

Multicurrency and global bond issues reach US$815 billion in 2000, a 14% rise.

11/2003: the EBRD is about to issue a US$150 million rouble bond in Russia’s market for on-lending purposes


Eurobond Market Deutsche Bank Morgan Stanley Warburg Dillon Reed ABN Amro Merill Lynch Lazard Frères JP Morgan Salomon/Citibank BNP-Paribas Barclays Commerzbank Credit Suisse First Boston


Bond markets Yankee market: issues have to satisfy SEC listing

requirements. These require higher standards of accounting and disclosure than typical for Eurobond issuers. In 11/1993, the SEC adopted measures to simplify the listing of foreign companies in US markets. They include recognition of international accounting standards, easier registration procedures, and reduction in the required reporting history from 3 years to 12 months.

Samuraï market


International Debt Markets and Instruments

In ternational Securities M arket

E u rob o nd s tra ig h t f ixe d -ra te is sue F lo a tin g -ra te n o te E q u ity-re la ted issue

F ixed a nd f loa ting ra te /m e d iu m to lon g -te rm b o nd issu es


Eurocurrency market Instruments1: EURONOTE MARKET

Market of short- to medium-termshort- to medium-term debt instruments sourced in the Eurocurrency markets

I. Euronote facilities: short-term, negotiable promissory notes, provided by international investment and commercial banks (fees for underwriting and placement services).

The euronote is substantially cheaper source of ST funds than syndicated loans, because the notes are placed directly with the investor public, and the securitized form allows the ready establishment of liquid secondary markets.


Eurocurrency market Instruments

II- Note-issuance facility (NIF): A medium-term legally-binding commitment under which a borrower can issue a short-term paper in its own name, underwritten by banks which are committed either to purchase any note the borrower is unable to sell, or to provide credit.

Issuing procedures with arranger or placing agent and tender panel.


Eurocurrency market Instruments III- Euro medium-term notes (EMTNs)It bridges the gap between the ST euro commercial paper issued in

domestic markets < 6 months, and the longer-term international bond.

Market expansion when the SEC instituted Rule # 415, allowing companies to obtain shelf registrations for debt issues: once the registration was obtained, the corporation could issue notes on a continuous basis without having to obtain new registrations for each additional issue. This allows a firm to sell S/MT notes through a cheaper and more flexible issuance facility than ordinary bonds.

Maturity: from 1 year to < 10 yearsSmall denominations (from $2 to $5 million)


Eurocurrency market Instruments2: The Eurobond Market

A Eurobond is underwriten by an international syndicate of investment banks and other securities firms and is sold exclusively in countries other than the country in whose currency the issue is denominated: $-denominated bond issued by a US company, but sold to investors in Europe and Japan. Eurobonds offer tax anonimity and flexibility.

To receive interest, the bearer cuts an interest coupon from the bond and turns it in at a banking institution listed on the issue as paying agent.

Eurobonds are offered simultaneoulsy in a number of different capital markets.


Eurocurrency market InstrumentsThe Eurobond Market

1. Straight fixed-rate issue: bearer bonds, fixed coupon, set maturity date, full principal repayment upon final maturity. Coupons are normally paid annually.

2. Equity-linked bonds: convertible bonds or bonds with equity warrants (amounted to $64 billion in 1997, and $32 billion in 1998). Right to acquire equity stock in the issuing company (sometimes with detachable warrants containing the acquisition rights). The market value of an ELB is composed of the naked value and the conversion value. The conversion to stock prior to maturity is at a specified price per share, or a specified number of shares per bond. The borrower is able to issue debt with lower coupon payments due to the added value of the equity conversion feature.


Eurocurrency market InstrumentsThe Eurobond Market

3- FRNs: since the early 1980s. medium-term notes where the interest is fixed as a percentage above six-month LIBOR. Pays a semi-annual coupon determined on variable-rate base.

Negotiable and transferable securities with flexible interest rate, fixed interest periods, and issued in pre-determined and uniform amounts. FRNs are directed at institutional investors


Global bonds

Global bonds are issued simultaneously in several major international markets and allow issuers to tap into broader demand and obtain lower rates than those availabe in a single market.

Some market participants estimate that EMCs such as Brazil and Argentina have been able to reduce the interest rate on funds raised through global issues by as much as 30 basis points. Argentina was the first borrower ever to issue a global bond on 12/1993 with a US$1 billion placement.


Peru and the Global Bond market 12/98: Telefonica del Peru (TDP) launched a $150 million

10-year bond backed by telephone receivables via JP Morgan, with a 7.48% coupon. The deal was priced at 315 bp over 5-year UST bills. The bonds were rated A- by DCR and A3 by Moody’s.

11/2000: Banco de Credito raised a $100 million 7-year bond backed by its inflow of hard currency electronic transfers. The $ flow was transferred to the offshore trustee for the benefit of the certificate holder. (the structure was substantially over collateralized): arranger: ING Barings.


Peru and the Global Bond market

01/2002: Peru raised $500 million of 12-year bonds, priced to yield 10.1% at a spread of 610 bp over US Treasuries (Deutsche Bank/Merrill Lynch)

03/2002: Peru reopened the issue, pricing $250 million-worth of 12-year bonds at 575 bp. The bond carries a 9.875% coupon.


Financial Clauses in Eurocurrency financing

Bullet Maturity: One-time payment of principal at maturity. Currency Redenomination: Switching of loans denominated

in one currency or currencies into the currency of the creditor country or into ECUs. (The mechanism is intended to bring about a better match between the currency mix of debt service payments and the currency composition of external receipts.)

Interest Rate Switching: Selection of a new basis for interest calculations on an existing loan. The options may include LIBOR, a domestic rate, the prime rate or a fixed rate, to which a margin is added.


Legal clauses in Eurocredits

Problem of “comparability of treatment” between various categories of creditors:

Axiom: an emerging market is a market from which you cannot emerge in an emergency!

Ex.: Paris Club insists on involving Eurobond investors in refinancing and restructuring workouts. Test cases: Pakistan, Russia, Ukraine, Romania, Ecuador and Venezuela (US$60 billion question!); Rumania alone owes US$863 million eurobonds (i.e., tradeable instruments)


Legal clauses in Eurocredits

Prepayment clause: The prepayment clause is a standard clause in loan agreements between a debtor and a creditor bank. In its various forms, it can provide the debtor with the opportunity to accelerate repayment of the loan on a voluntary basis and/or provide for acceleration of repayment due to changes in laws affecting the creditor. In rescheduling agreements, the clause is intended to prevent the obligor to grant a preferential repayment schedule to other banks which have not signed the convention and which would be paid ahead of normal maturity terms.


Legal clauses in Eurocredits pro rata sharing : A legal covenant in commercial bank

agreements which specifies that debt service payments are to be made through the agent bank for allocation on a pro rata basis to all creditor banks. Further, payments received or recovered by any one lender must be shared on a pro rata basis with all co-creditors under the loan agreement. Thus, no one lender may be placed in a more favorable position than its co-lenders with respect to payments received and/or recovered.

cross-default: A legal wrinkle which allows one creditor to declare default and exercise its remedies against the borrower in cases where other loans of the borrower have been suspended, terminated, accelerated or declared in default by other creditors.


Legal clauses in Eurocredits. Mandatory repayment clause: standard clause in loan

agreements that stipulates certain circumstances under which repayment is accelerated. The debtor, by being obligated to prepay any one creditor, must repay all lenders on a pro rata basis. In the context of rescheduling agreements, the provision is intended to neutralize "free rider" banks which do not participate in debt restructuring and new money agreements. The provision applies across the universe of public sector borrowers so that a voluntary prepayment of one or more credits by one borrower would trigger mandatory prepayment not only by that borrower but also by the other public sector borrowers.

Ex. Ecuador’s default on Brady bonds in October of 1999!


Legal clauses in EurocreditsOptional prepayment provision: The optional prepayment provision permits the borrower to prepay all or part of the loan provided it prepays all lenders under the agreement on a pro rata basis.

Pari-passu clause: Clause inserted in lending and restructuring agreements that provides for a strict equality of treatment among various categories of debts and various families of creditors.


September-October 1999: The debt default of Ecuador in the limelight

Ecuador: Brady bonds account for US$6.1 billion in Ecuador’s overall external indebtedness of US$13 billion. The Brady bonds have been subject to a lot of financial engineering, including the stripping of the collateral out of the bonds.

IMF’s position: Ecuador needs to find out some US$500 million to cover its balance of payments shortfall until the end of next year, and about US$1 billion to cover its budget shortfall, and probably more since Ecuador has foreign currency denominated domestic debt.... For the first time in 55 years, the IMF is acquiescing in a country’s decision to default on its debts to the international bond markets.


Legal clauses in Eurocredits. Negative Pledge provisions : they deal with the granting of

security interests by a borrower over its assets to its creditors. In the case of a debt refinancing agreement, the debtor agrees with the banks not to provide any other group of creditors with security interest on the country's reserves, exports of goods, and public sector companies' assets. The objective of such a clause is to prevent a situation where a debtor would allocate significant assets to other creditors, thereby effectively subordinating the unsecured bank credits, hence an unequal and unfair treatment of creditors!

Subordination: ranking of current debt compared to future debt obligations in case of default


How do Negative Pledge clauses work in practice?

Mexcobre/Paribas Citibank/Bancomext Pemex/JP Morgan Brady bonds and zero-coupon collaterals

All required special waivers from IFIs!


Collateralization schemes To facilitate the placement of debt instruments in the international

bond market issuers use various structures of enhancements. Asset-backed securities allow borrowers to tap the bond markets at considerably lower rates.

Pemex issue in Japan secured by four offshore drilling platforms in the Gulf of Mexico.

Mexican insurance group launched an issue of mortage-backed securities with the bonds secured against US$-denominated mortgages granted to Mexican residents.

Mexican company raised $200 million to finance a highway construction project through a bond issue backed by prospective toll revenues.


Asset-backed securities October 1999: Argentina issued a $1.5 billion bond

with a WB US$250 million collateral to guarantee sequential payments on the bond, borrowing for each payment the supranational’s triple A credit rating.

January 2001: Colombia issued a US$1.3 billion WB backed bond (Goldman Sachs and JP Morgan as advisers)

November 2001: IFC, WB’s private investment bank, responded positively to a request to provide guarantees to Philippines’ private sector companies tapping offshore debt markets, to help bring down borrowing costs in the capital markets;


PERU: Jan. 2002 Debt Exchange offer

In a historic transaction, Peru returned to the global bond market for the first time in 74 years to exchange $1.21 billion of Bradys (mainly PDIs and Flirbs) for a new $930 million, 10-year global bond. The exchange reduced Peru’s debt load by $280 million, generated NPV savings of $30 million. The new bond was priced 50 bp below the outstanding Bradys and qualified for JP Morgan’s EMBI+ index of most liquid and traded investments.


PERU ’s London Club Debt Secondary Market Price (% of face value)

45

50

55

60

65

70

75

80

85

90

PDI 07/17

FLIRB

YTM 7%

Asian crisis


EMBI Spread Peru vs. Global, 1998 - 2003


Brady Bonds?

t0 t10 t20 t30

Bullet Payment at maturity

Default on interest payments triggers exercice of interest guranteeand of principal collateral guarantee

LIBOR = 5 1/4

LIBOR= 9 1/2


How to assess and calculate the market value of a collateralized Brady Bond?

Brady bonds comprise defaulted London Club debt, repackaged and backed by 30-year US Treasury bonds as collateral, often including a rolling 18-month interest guarantee.1. Strip the bond by separating the risk from the no-risk elements (interest and principal)2. Calculate the risk-adjusted NPV of the guaranteed and non-guaranteed streams of interest payments and the principal payment at maturity, by using a risk-adjusted discount rate.


New Ball Game 1997/2003: Brady Debt Exchange Offers Enhanced liability management gives rise to debt exchanges: 1997: Brazil: US$4 billion Bradys for new 30-year global bond 1997: Argentina: US$2.3 billion Bradys for new 30-year global 1997: Venezuela: US$4 billion Brady exchange 1997: Panama: US$0.7 billion Brady exchange 1999: Philippines: US$1 billion Bradys for new 10-year bond 1999: Brazil: US$2 billion Pars, Flirbs, NMBs for new 10- year bond 2000: Argentina: US$2.4 billion Pars, Discounts, FRBs for new 15-

year global bond 2000: Brazil: US$5.2 billion Bradys for new global bond 2000: Ecuador: Eurobonds and Bradys for new 12-year and 30-year

global bonds 08/2003: Venezuela’s $3.8 billion buyback of 2007 bonds financed

by new 2010 notes paying a below-market coupon


Larger and more complex ever bond issues

03/2001: France Telecom launched US$16 bn multi-currency bond issue (>Deutsche Telekom’s $14.6 bn deal in June 2000), with eight tranches in $, £, and €, with maturities ranging from 2 to 30 years, with high bond yield and coupon increases by 25 bp for every notch Moody’s or S&P rating cuts < A category.

11/2001: France Telecom (Baa1/BBB) completes €5 bn fundraising in the European bond market with two-tranches short-dated deal: 18-month floating rate tranche of €2.25 bn and €2.75bn 3-year fixed rate bond, sold to >600 different investors!

Documents

4.2. Eurobond