The Eurobond Market10

Prices and Policies

Second Edition ©2001

Richard M. Levich

International Financial Markets

McGraw Hill / Irwin

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Overview

Historical Overview and Dimensions of the Eurobond Market A First Stimulus to the Eurobond Market: The IET A Second Round of Stimulus to the Eurobond

Market The Eurobond Market Endures

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Overview

Regulatory and Institutional Characteristics of the Market Regulatory Bodies and Disclosure Practices Issuing Costs, Ratings, and Exchange Listings Queuing, Currency of Denomination, and Speed of

Offering The Pros and Cons of Onshore and Offshore

Markets

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Overview

Issuing Practices and Competitive Conditions in the Eurobond Market A Brief Sketch of Eurobond Underwriting Tensions and Incentives within a Eurobond

Syndicate The Gray Market Evidence of Competition among Eurobond Lead

Managers Another Innovation: Global Bonds

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Overview

Pricing Eurobonds Market Segmentation and the Pricing of Eurobonds Eurobonds and Secrecy Eurodollar Bond Prices Onshore-Offshore Arbitrage Opportunities Eurodollar Bond Prices: A General Model

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Overview

Policy Matters - Private Enterprises Onshore-Offshore Arbitrage Once Again: Exxon

Capital Corporation Using the Eurobond Market to Enhance the Value

of the Firm

Policy Matters - Public Policymakers The U.S. Competitive Response European Union and the Eurobond Market

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The Eurobond Market

The Eurobond market is the market for long-term debt instruments issued and traded in the offshore market.

Like the Eurocurrency market, differences in national regulation helped developed the Eurobond market, while increasing capital mobility and greater ease in telecommunications enabled it to flourish.

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The Eurobond Market

A Eurobond is offered for sale simultaneously in a number of countries.

A domestic bond is an obligation of a domestic issuer, underwritten by a syndicate of domestic investment banks, denominated in domestic currency, and offered for sale in the domestic market.

A foreign bond is similar to a domestic bond except that the issuer is a foreign entity.

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The Eurobond Market

Foreign bonds are called Yankee bonds in the U.S. market, Samurai bonds in the Japanese market, and Bulldog bonds in the U.K. market.

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Historical Overview and Dimensions of the Eurobond Market

The Interest Equalization Tax (IET) of 1963 taxed purchases of foreign stocks and bonds issued or trading in the United States.

The IET was proposed as a temporary measure to reduce U.S. capital outflows and take pressure off the U.S. balance of payments.

However, it effectively closed down the Yankee bond market, and induced foreign borrowers to migrate offshore and set up a US$-bond market in London and Luxembourg.

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Historical Overview and Dimensions of the Eurobond Market

In 1965 and 1968, further policy measures were taken to limit the direct foreign investments made by U.S. corporations.

These programs effectively forced U.S. multinationals offshore to meet the financing needs for their foreign projects.

When the stimulating U.S. regulations were scrapped in 1974, the Eurobond market volume first collapsed and then grew steadily, before surging during the 1980s.

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Historical Overview and Dimensions of the Eurobond Market

Now, the annual volume of new issues often nears or surpasses the annual volume of new U.S. corporate bond issues.

Increasingly too, Eurobonds have been issued in currencies other than the US$, and then combined with a currency swap to achieve lower cost funds in US$, etc.

At the same time, the market has grown in terms of bond maturities, issue size, and secondary market trading.

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Comparative Characteristics of Bond Issues in the International Bond Market

RegulatoryBodies

Securitiesand Exchange Commission

Official agency approval

Minimum regulatory control

U.S. Market Non-U.S. Market Eurobond Market

Disclosurerequirements

More detailed• High initial and ongoing expense• Onerous to non-US firms

Variable Determined by market practices

Issuing costs 0.75-1.00% Variable to 4.0% 2.0-2.5%

Rating requirements

Yes Usually not No, but commonly done

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Comparative Characteristics of Bond Issues in the International Bond Market

Exchange listing

Usually not listed Listing is usual Listing is usual

U.S. Market Non-U.S. Market Eurobond Market

Queuing No queue Queuing is common

No queue

Currency of denomination restrictions

United States does not restrict the use of US$

Part of queuing• Many countries have in the past or now restrict use of currency

No restrictions on use of US$ or C$

Speed of issuance

Relatively slow until Rule 415 on shelf registration

Variable Usually fast - bought deal leads to fast issuance

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Comparative Characteristics of Bond Issues in the International Bond Market

Borrower / Issuer incentives

+ Large market, great depth– Disclosure is costly to foreigners, speed

+ Local visibility, diversification of funding sources– Markets may be small, queuing may prevail

+ Lower annual interest expense, speed of placement– Cannot sell issue in U.S. until seasoned

U.S. Market Non-U.S. Market Eurobond Market

Lender / Investor incentives

+ Great depth & liquidity, appeal of standardized information– Reporting to tax authorities, withholding tax prior to 1984

+ Diversified currency portfolio– Reporting to tax authorities, withholding tax may apply

+ Diversified currency portfolio, bearer bonds, no withholding tax– Less liquidity & information disclosures

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Bond InvestorBond Investor

Bond IssuerBond Issuer

Structure of a Eurobond Syndication

Selling GroupSelling Group

Fiscal Agentor Trustee

& PrincipalPaying Agent

Fiscal Agentor Trustee

& PrincipalPaying AgentUnderwritersUnderwriters

A Eurobond offering brings together the bond issuer and investor.

Intermediaries

The process is facilitated by intermediaries.

and then assembles other firms to share in the underwriting risks of the issue.

Finally, the management group organizes a group of firms to place the bonds with the ultimate investors.

ManagementGroup

ManagementGroup

The lead management group meets with the issuer to design the issue size, currency, maturity,coupon, etc...

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Structure of a Eurobond Syndication

In practice, a single firm may play more than one role.

In the case of a bought deal, lead management, underwriting, and bond sales are all provided by a single intermediary.

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Tensions and Incentives withina Eurobond Syndicate

Selling agents were happy to avoid taking on any underwriting risks in return for the prospective fees and prestige associated with a Eurobond deal.

On the other hand, lead managers were confident that the selling group will meet their selling commitments out of fear of being dropped from future syndicates.

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Tensions and Incentives withina Eurobond Syndicate

As a result, lead managers felt they could form syndicates to sell “overpriced” bonds in order to enhance their volume of business.

Then, the bonds left unsold have to be marked down in price, thus cutting into the profits of the selling group and the investors who purchased the bonds at par.

Financial journalists characterized this situation as excessive competition.

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Tensions and Incentives withina Eurobond Syndicate

The variable-price reoffering system of the Eurobond market during the 1960s and 1970s resulted in another problem too. As portfolio managers were often employed by the

same financial institutions as the selling group, portfolio managers faced a possible conflict of interest - to assist their colleagues in the selling group by selling as many bonds as possible at full price, or to maximize the performance of their retail clients’ investment portfolios

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The Gray Market

In the 1970s, market participants developed a method to deal with excessive competition. Some firms sell their allotment of bonds forward for

delivery on a when-issued basis, so as to hedge against further price declines.

Lead managers criticized this gray market, but could not effectively monitor the transactions.

Ultimately, the prices in the gray market have to be considered by the lead managers and issuers, and they also enabled the retail investor to monitor the performance of his/her portfolio manager.

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Evidence of Competition Among Eurobond Lead Managers

The Eurobond market has been characterized by competition to participate in the selling group, and competition to lead manage primary issues.

Statistics suggest that there has been considerable competition and mobility of firms across the rankings for the top lead managers and underwriters.

Firms also exhibit a willingness to switch lead managers when launching separate Eurobond issues.

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Another Innovation: Global Bonds

Like a Eurobond, a global bond issue is offered for sale in many countries simultaneously.

However, unlike a Eurobond, it is a registered security, usually in the U.S. and sometimes in other countries as well. This will enhance secondary market trading in local

markets and among investors in different regions.

By reaching the widest possible investor audience, the global bond strategy is designed for issuers with substantial funding needs.

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Another Innovation: Global Bonds

On January 19, 2000, the World Bank issued a $3 billion “electronic” global bond. The 5-year issue was sold and distributed entirely

over the internet. This offering format allows the World Bank to

monitor the order flow in real time to gauge the demand for the issue.

It also allows all investors, including retail investors, to purchase bonds in the primary market at identical transaction fees.

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Pricing Eurobonds

As a parallel market, the Eurobond market must offer prices and terms that are advantageous to both issuers and investors to attract them from the traditional onshore markets.

In particular, the Eurobond market often allows firms to issue bonds more quickly and with lower disclosure costs.

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Pricing Eurobonds

But even more important is the ongoing savings that comes from a lower annual interest cost in the Eurobond market than in the onshore market. The Eurobond market has appeared to function as a

segmented capital market, such that investors may willingly pay higher prices for debt securities in the Eurobond market.

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Pricing Eurobonds

The retail investor often sacrifices yield, apparently in exchange for a bearer instrument with no withholding taxes and no disclosures made to the tax authorities.

For institutional investors, the Eurobond market offers a greater variety of high-quality issuers, ease of clearing and settlement, and larger issues with good liquidity.

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Eurodollar Bond Prices

The magnitude of the yield differential between offshore and onshore bonds has varied over time, and there are also differences across firms.

In particular, investors whose base currency is not the US$ may be more willing to sacrifice yield when they expect foreign exchange gains from a strong US$.

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Onshore-Offshore Arbitrage Opportunities

During some periods, certain U.S. firms were able to issue Eurodollar bonds not only at prices below onshore rates, but also at prices below U.S. Treasury rates.

This raises the prospect of arbitrage: Firms may issue debt in the Eurodollar market and

close their position by purchasing U.S. Treasury securities with the same maturities.

The U.S. Treasury itself may reduce its funding costs by going to the Eurobond market.

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Eurodollar Bond Prices:A General Model

Arbitrage should link the prices of Eurodollar bonds with the prices of similar bonds in the onshore market.

For example, a regression of issuer cost (Y1),

reoffering yield (Y2), and underwriting spread

(Y3) against a set of control variables (Xi) and a

dummy variable for the location of sale (EURO) may be set up:

EUROE22110 bXbXbXbbY nni

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Policy Matters - Private Enterprises

Both retail and institutional investors have benefited from the Eurobond market.

The market has also been a venue for financial innovation. Institutional investors may find Eurobonds with

unusual features that allow them to tailor a portfolio or take on uncommon bets.

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Policy Matters - Private Enterprises

For issuers, the issue is how to make the most effective use of this alternative marketplace. When Eurobond rates are lower than the yield on

government securities, issuers may engage in arbitrage by issuing securities onshore and covering their liability with risk-free government securities. Example: Exxon Capital Corporation in 1984.

Issuers are also concerned with funding strategies and opportunities to exploit their excess borrowing capacity and scarcity. The lower interest rate available to some firms is one measure of this value.

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Policy Matters - Public Policymakers

The Eurobond market was too large to be ignored by the U.S. financial regulators and European policymakers.

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Policy Matters - Public Policymakers

The U.S. competitive response includes: A “shelf registration” procedure introduced in 1982

lowered the amount of paperwork and time required for a capital issue.

In 1984, the withholding tax on interest paid to foreigners was dropped. U.S. corporations were also permitted to issue Eurobonds to foreigners directly.

Introduced in 1990, the Rule 144a market essentially enhances the private placement market such that it becomes similar to the Eurobond market.

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Policy Matters - Public Policymakers

The European Union’s competitive response includes: In 1985, the European Commission drafted the

“Europe 1992” plan, which called for unified banking and financial markets (as well as markets for goods and services), to be achieved primarily through the removal of internal barriers.

The specification of the common core regulations for the financial community is still evolving within the present European Union.