International Bond Markets - C. T. Bauer College of Business
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4/15/2021
International Bond Markets
(for private use, not to be posted/shared online)
• Last Class
• International Equity Markets
- Differences
- Investments Vehicles: Dual Listings (ADR), International ETFs
- Valuation Methods (DDM, Discounting Free CFs, Multiples)
• International Diversification pays
• Returns in International Equity Markets
- Huge dispersion in ERP across markets. Not easy to explain with
existing models (CAPM, Fama-French Factors, etc.)
- Many proposed factors to explain ERPs.
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• This Class
• International Bond Markets
⋄ Organization and Issuing Techniques
⋄ Different Instruments
⋄ Valuation
⋄ Examples
• CASE 6: Brady Bonds (due next Thursday, April 22)
Group: Dixit, Erick
International Bond Markets
The bond market (debt, credit, or fixed income market) is the financial
market where participants buy and sell debt securities, usually bonds.
Size of the world bond market (’20 debt outstanding): USD 128 trillion.
- Governments and International Organizations: USD 87 trillion (68%).
- U.S. bond market debt: USD 49.8 trillion (38%).
Organization
- Decentralized, OTC market, with brokers and dealers.
- Small issues may be traded in exchanges.
- Daily trading volume in the U.S.: USD 822 billion
- Government debt dominates the market.
- Used to indicate the shape of the yield curve.
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• Evolution of Global Bond Market:
Huge increase in issuance in 2020 (pandemic & very low interest rates)
• Evolution of Global Bond Market
EM issues have significantly increased over the past 20 year. EM play a
significant role.
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• U.S. Bond Market
Dominated by Government & Corporate Debt, & MBS.
• Typical Bond Market: Canada
Dominated by government issues.
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• The world bond market is divided into three segments:
- Domestic bonds: Issued locally by a domestic borrower.
Usually denominated in the local currency.
Largest segment: 71% of the bond market (2008).
- Foreign bonds: Issued on a local market by a foreign borrower.
Usually denominated in the local currency.
- Eurobonds: Placed mainly in countries other than the one in
whose currency the bond is denominated.
Example: Distinction between bond markets.
(A) Domestic bonds.
In February 2015, Apple, the U.S. tech giant, issued bonds for USD 6.5B
in the U.S. for placement in the U.S. domestic market.
(B) Foreign bonds.
In August 2015, Apple issued bonds for AUD 2.25B for placement in the
Aussie market alone.
(C) Eurobonds.
In September 2015, Apple issued bonds for EUR 2.8B in London. The
issue was underwritten by an international syndicate of securities houses,
led by Goldman Sachs and Deutsche Bank. ¶
Foreign bond + Eurobond markets = International Bond Market.
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• Eurobond Issuances in Euro
• International debt issuance is close to 12% of total debt issuance by U.S.
companies.
Type of Instruments
Popular Instruments in International Bond Markets
i. Straight or fixed income bonds. (Most common type, by far)
ii. Partly paid bonds.
iii. Zero-coupon bonds. (Not very popular with investors)
iv. Floating rate notes (FRNs). (Second most common type)
v. Perpetual FRNs.
vi. Convertible bonds.
vii. Bonds with warrants.
viii. Dual-currency bonds.
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Example: Straight bond
4.375% May 2015 Slovak Republic EUR bond
Amount = EUR 2 billion
Issue date = May 14. 2009
Face value: FV = EUR 1,000
Coupon: C = 4.375% = EUR 43.75
Maturity: T = 6 years (May 2015)
Interest payment dates: May 14
Every May 14, the Slovak Republic pays EUR 43.75 to bondholders, for 6
years. At maturity, May 14, 2015 it also pays back the principal. ¶
• Tombstone of Slovak Republic’s Eurobond
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Example: Zero-coupon bonds ("zeros").
Zero June 1984 PepsiCo Overseas USD bond
Amount = USD 100 million.
Issue date = June 1981
T= June 1984 (3 years)
FV = USD 100
Coupon: C = 0.
Issue Price = 67.255.
Compounded annual interest yield: (100/67.25)1/3 - 1 = 14.14% ¶
Example: FRNs ("floaters").
LIBOR + 1/8 March 2024 Swedish Government USD bond.
Amount = USD 500 million.
Issue date = March 1 1984
T= March 1, 2024 (40 years).
FV = USD 1,000
Coupon: C = 6-mo. LIBOR + 1/8
Interest 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)% (known at issue).
Afterward, at the end of each 6-mo. period the interest rate on the notes is
updated to reflect the current 6-mo. LIBOR rate for dollars. ¶
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Example: Convertible bonds ("convertibles").
8% May 2002 Cantim (a Canadian firm) convertible USD eurobond.
Amount: USD 100 million
Issue date = May 1995
T= May 2002 (7 years)
FV = USD 1,000
C= 8%.
Conversion price = CAD 23.125
Conversion St = 1.2007 CAD/USD
Conversion 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 St = 1.2007 CAD/USD.
Each bond can buy 51.92 shares. (A bond + call option.) ¶
Example: Bonds with equity warrants.
4% May 1995 Cannon Euro-USD bonds with equity warrants attached.
Amount: USD 370 million.
T= May 31, 1995 (5 years).
FV = USD 5,000
C= 4%
Number of warrants: 74,000
Warrants per bond: 1 (=[370M/5,000]]/74,000)
Shares per warrant: 468.06
Exercise price: JPY 1487
Conversion St: 139.2 JPY/USD
Exercise period: At any time after the first interest payment
Almost all Japanese Euro-USD bond with equity warrant attached (USD
Eurowarrants) have similar terms. ¶
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Example: 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.
10% July 1995 First City Financial CHF Eurobond.
T= July 1995 (10 years).
FV = CHF 5,000.
C= 10% (= CHF 500).
Feature = At maturity, the bond is repaid in the amount of USD 2,800.
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 2,800 at 1.7857 CHF/USD
= (CHF 5000/USD 2800 = S7/01/95 = 1.7857 CHF/USD). ¶
Note: An investor benefits if: iCHF ↓, St (CHF/USD) ↓, & ST (CHF/USD)↑.
Eurobond Markets
Euro-what?
• Euro-zzz: The currency of denomination of the zzz instrument is not the
official currency of the country where the instrument is issued.
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 regulations
- Instruments traded in any currency.
The Eurobond market is just one segment of the Euromarket.
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Characteristics of Eurobonds
• A Eurobond is an international debt security.
Structure: Similar to the standard debt security used in domestic markets.
Basic characteristics:
- Eurobonds are transferable (usually, bearer).
- Eurobonds are intended to be tradable.
- Eurobonds are a medium- to long-term debt security.
- Eurobonds are generally launched through a public offering.
- Eurobonds are 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 & 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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Issue Procedures
Organization of a Traditional Eurobond Syndicate
• Eurobonds are issued and sold through underwriting syndicates.
• Participants in these syndicates are investment banks:
• Players:
- lead manager (organizes the managing group).
- managing group (buys the bonds).
- underwriters (commitment to buy ahead of time at a set price).
- selling group (no commitment to buy at a set minimum price).
- principal agent (responsible for receiving and making payments).
- fiscal agent & trustee (represent borrowers & bondholders, respectively).
Note: Roles in a Eurobond syndicate are nested: Managers are also
underwriters & sellers, and underwriters are usually also sellers.
• Roles in a Eurobond syndicate are nested: Managers are also underwriters
& sellers, and underwriters are usually also sellers.
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Selecting a Lead Manager
• Market for Lead Managers is very competitive. Usually, lead managers are
large banks/investment banks (Citi, JPMorgan, UBS, HSBC, etc.).
• The selection of a professional issuing house to lead-manage the issues is
a critical decision for the borrower.
• Factors:
- Established relations
- Price
- Market making ability
- Coordination of the syndicate
- Derivatives products
The advantage of a Eurobond issue may not be the cost: It may be
preferred in terms of longer maturities, early call options, issue sizes, etc.
Fee Structure for new Eurobond Issues
• Fees: Extracted by discounts on the prices provided to syndicate.
Example:
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.
Reasons:
- unenforceable contracts.
- competition.
- price discrimination.
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Example:
Lead manager pays borrower USD 975 per USD 1,000 bond.
Lead manager makes bonds available to underwriters at USD 980
Lead 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.
Traditional Time Schedule for a New Offering
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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 under the "private placement"
exemption of the U.S. Securities Act.
Then, it can be sold to U.S. nationals at issue. But, purchasers of the bonds
must meet strict requirements (with capital, sophisticated, informed, etc.)
• In 1984, the U.S. government deregulated bond & money markets:
- No U.S. withholding tax on payments to foreigner holders of US debt.
- U.S. corporations can issue bearer bonds to non-U.S. residents.
Eurobond secondary market
• The secondary bond market handles the reselling of bonds by investors.
- It is almost entirely an OTC market. Most trades are conducted on
closed, proprietary bond-trading systems or via phone.
- It is self-regulated. Participants follow ICMA’s market standards.
ICMA: International Capital Market Association, similar to US NASD
• ICMA
⋄ ICMA has over 400 members, located in over 50 countries.
⋄ Majority of the members are in the U.K. (more than 50%), the U.S.
and Luxembourg.
• Eurobond issues are listed on one or more stock exchanges (mainly,
Luxembourg & London; but, usually, also the home stock exchange).
• There is no legal obligation to deal on the exchanges OTC market.
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Microstructure
• Market-makers & dealers in Eurobonds are members of the ICMA.
• A market-maker quotes a net bid-ask price (no commissions charged).
• Bid-ask spreads on Eurobonds are around .50% (USD & EUR domestic
spreads close to .10%).
• Settlement takes place on the value date, approximately a week later.
• Standard-size transaction is 100 bonds (with USD 1,000 of face value).
• Quoted prices apply to standard-size transactions, smaller transactions are
negotiated at higher spread costs.
• Two international securities clearing systems (now linked):
- Euroclear was the first, set up in Brussels (1968).
- Clearstream, first established in Luxembourg (1970).
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.
• It is estimated that 50% of the yield premium is a liquidity premium.
• Issuers take liquidity considerations into account:
The bigger the size of the issue, the more liquid in the secondary market:
Issues tend to have sizes larger than USD 50M equivalent.
Mega issues (bigger than USD 1B) are common (10% of total)
Example: In September 2013, Verizon issued a USD 15B 30-year bond &
a USD 11B 10-year bond. ¶
• But, price impact (due to the big size) is a problem for Mega issues!
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Foreign Bond Markets
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.
• No withholding tax on coupon payments to foreigners.
• Secondary market for Yankee bonds is more liquid than that for USD
Eurobonds and bid/ask spreads are smaller.
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 legally the same as a German foreign bond.
Samurai Bonds and JPY Eurobonds
• Japanese and non-Japanese corporations make public Euroyen issues.
• Foreign banks are allowed to serve as lead managers.
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.
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Differences Among Bond Markets
US Market Non-US Market Eurobond Market
Regulation Yes (SEC) Yes (Local SEC) No (Informal Rules)
Disclosure High (regulated) Varies (according Usual Market Practices
to local SEC)
Issuing cost 0.75%-1% Varies (1%-4%) 1.5%-2.5%
Speed of issue Slow: 2-4 weeks. Varies. Fast: 14 days or less
Currency USD, but no Usually local, but Any. No restrictions.
restrictions. with some
restrictions.
Rating? Yes Varies. Not required, but it is
common.
Bearer Bonds? No In general, no. Yes.
Listing? Some (NYSE). Many. Very Rare.
Liquidity Very liquid. Varies, according Not very liquid.
to size.
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.
Accrued Interest
Bonds also differ in the way accrued interest is calculated.
Example: U.S.
An investor holding a U.S. straight bond for February 2021 receives 30/360
or 1/12 of the annual coupons (1/6 of the semiannual coupon).
Example: Japan
An investor holding a Japanese straight bond for February 2021 will receive
28/365 of the annual coupon.
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Yields
Financial institutions around the world calculate YTM on bonds.
The methods differ across countries YTM are not comparable.
- U.S.: Institutions publish a semiannual actuarial yield.
- Europe: Annual actuarial YTM using the ICMA-recommended formula.
Example: 12% 2010 IBM USD bond
- U.S.: It pays USD 6% semiannually and it has a YTM of 12% (s.a.).
- Europe: It has a (annual) YTM of 12.36% = (1.06)(1.06) – 1 = .1236. ¶
Coupons
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.
BOND PRICING
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Pricing Bonds: Brief Review
• Price of a Bond
The price of a bond (P) is determined by computing the NPV of all future
cash flows generated by the bond discounted at an appropriate interest rate
–i.e., the yield-to-maturity, or YTM.
P = C1/(1+YTM) + C2/(1+YTM)2 + C3/(1+YTM)3 +...+ CT/(1+YTM)T
Ct = Cash flows the bond pays at time t. (CT = CouponT + Face ValueT)
• One-to-one relation between P and the YTM of a bond:
You know the YTM, you know P –given that you know the Ci’s.
Example: A straight Eurodollar bond matures in 1 year.
C = 10%
FV1 = USD 100
1) P = USD 95 YTM = ?
P = (C + FV1)/(1+YTM) 95 = 110 / (1+YTM).
YTM = 110/95 – 1 YTM = .1578947
2) YTM = .1578947 P = ?
P = 110/1.1578947 = 95. ¶
• Terminology
– P = 100 (or 100% or 1) “par” or “face value.”
Simple mathematical fact: P = 100 YTM = C.
– 100 bps = 1%
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• YTM
YTM is determined by:
YTM = Base Rate (kf) + Spread (Risk of Company)
kf = rf = risk free rate = government bond (of similar maturity)
Spread (in bps) = Risk of company = determined by investment bank
The spread is related to credit risk. Given a risk category, there is a
corresponding risk spread.
Other factors:
- Liquidity (50% of bond spread?)
- Size of issue (price pressure or price impact)
• Huang & Huang (2013): Corporate bond spreads are unusually high, given
the low probability of default (“credit spread puzzle”).
• Technical detail
Straight Eurobonds pay annual coupons, with annual YTMs (p.a.). But,
reference yields are usually expressed s.a. (6-mo YTM).
Adjustments needed to align YTMs.
Example: A company issues a new Eurobond.
Data: A similar bond has a 6-mo YTM (s.a.) = 7.365% s.a.
Transform a 6-mo YTM (s.a.) into an annual YTM (p.a.):
YTM (p.a.) = (1 + 0.07365/2)2 – 1 = 7.501% p.a.
If in addition, the bond sells at par at inception –i.e., P=100–, then,
CST = YTM (p.a.) = 7.50%.
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• Bonds: YTM and Prices Move A Lot (Like any other financial asset)
Example: 4.5% October 2020 Morocco EUR Eurobond
• As expected, there is an inverse relation.
Pricing and Selection of a New
Eurobond Issue
Situation: Issuing house needs to price a new bond issue.
• Same domestic pricing techniques and models.
⋄ Pricing mistakes are common:
- Tight competition
- Issues are too complex.
- Poor distribution.
- Weak market conditions.
⋄ Pricing process involves:
(1) Collection of information
(2) Evaluation of information
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• Information
Borrowing Requirements
– Amount to be raised over a certain period.
– Currency of exposure.
– Maturity range
– Call options
– Target cost of funds.
Preliminary Analysis of the Issue
Guide to pricing a new issue:
(1) Assessment of the borrower's outstanding issues.
(2) Benchmark issues.
Market Conditions
Place an issue in relation to relevant markets:
– Bond Markets (International and Domestic)
– Derivative Markets
– Swap Markets
Perception of the Issuer
For issuers with outstanding issues: Check YTM on secondary market.
Caution: An issue maybe trading poorly because of bad design; not
negative perception.
For first-time issuer: More analysis needed:
– Perception of the borrower by its competitors.
– Relative perception of the issuer within its domestic market
– Perception of the borrower, if any, in the Euromarkets.
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• Evaluation
• Sometimes, pricing looks like informed guesswork.
• In established markets, however, pricing proposals tend to converge.
• Benchmarking is the key.
Case Study I: Merotex
Pricing a New Straight Bond: Merotex
The Borrower
- Leading construction firm, based in Gorizia, Italy.
- Recently bought two U.S. construction companies.
- Financed by bank loans: USD 250 million
Borrowing requirements
- Amount: USD 250 million
- Currency of exposure: USD
- Maturity: Merotex wants to refinance with medium-term USD debt.
- Preference: Simple straight bond with no early call options.
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• Information
Market conditions:
- Good for a USD Eurobond issue.
- U.S. economic conditions are above expectations
- USD is currently very strong.
- Recent successful placement of 10-year Euro-USD issue by Fica,
a competitor.
Merotex's Perception:
– Merotex has issued GBP Eurobonds: obtained best terms.
– Merotex has no outstanding Euro-USD issues.
• Perception of similar international borrowers
(1) Comenti: Italian construction company
- Several Eurodollar issues.
- Last issue has 6 years of remaining life.
- Currently trading at 40 bps over 6-yr U.S. Treasuries.
- Excellent reputation in Euromarkets
(2) Fix Constructions (FC): major U.S. competitor in Florida.
- Launched a 10-yr Eurodollar issue five years ago.
- It has a call option two years from now.
- Currently trading at a 65 bps over 5-year U.S. Treasuries.
- Well-regarded but performance has been just average.
(3) Other large Italian companies:
- Many Euro-USD bonds with 5-year maturity
- Currently trading within a range of 40-70 bps.
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• Evaluation
• The FC issue is trading at a relative high spread.
– The issue might suffer from poor design.
– Deterioration of perception
– Call provision.
• Merotex's track record is limited but very good.
– Merotex's GBP bonds have been well received in the market.
– Merotex plans to include one UK house in management group.
Proposed Issue
Amount:
– Size should be sufficient to promote liquidity.
– But not so much as to make the placement process difficult.
– Proposed size: USD 200 million with a possible increase.
Maturity:
– For first timers shorter maturities are better: 5 years.
Yield spread:
– Aggressive spread = 40 bps over 5-yr U.S. Treasuries.
– First-time issue: Add a small premium: Spread = 45 bps.
The lead manager is able to formulate a pricing scheme:
U.S. Treasury: 6.915% s.a. (semiannual)
Merotex spread: 0.45% s.a.
Merotex yield: 7.365% s.a., or 7.501% p.a. (annual)
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Terms for investors: a 5-year Eurobond at a price to yield 7.50% p.a.
• Fees (1¾% = USD 3.5M):
Selling concession: ¾% (Sellers buys the issue at 99¼).
Underwriting allowance: ¾% (Underwriters pays 98½)
Managing fee: ¼% (Lead manager pays (98¼)
• Final terms:
Competitive bidding: Issuing house sells the issue at 99.24
Coupon required to yield 7½% is lower.
Assuming YTM = 7½, T = 5, P = 99.24, and FV = 100, solve for C
C = 7.3113%.
Rounding up, the coupon rate is set at 7 (5/16).
Total coupon payment = (7 + 5/16) * 200 M = USD 14.625 M
The issue is priced at the selling concession.
Expenses
1.- Paying Agency: 100,000 bonds in USD 1,000 denominations
10,000 bonds in USD 10,000 denominations.
Total number of bonds: 110,000.
Coupon charge p.a.: USD .07 per coupon payment (USD 7,700)
Redemption charge: USD .70 per bond or USD 77,000
Authentication: USD 4,000 on delivery of bonds.
Administration: USD 2,000 (p.a.).
2.- Listing: USD 20,000 payable in advance.
3.- Trustee: USD 8,000 (p.a.) payable in advance.
4.- Other expenses: USD 80,000.
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Pro Forma of the Issue
Borrower: Merotex C.A.
Guarantor: None
Amount: USD 200 million
Maturity: 5 years
Coupon: 7 (5/16) (= 7.3125%)
Issue price: 100%
Amortization: Bullet repayment on final maturity date
Issuer's call option: None
Listing: London
Denominations: USD 1,000 and USD 10,000
Form: Bearer securities
.....
Commissions: 1¾% flat
Yield: 7.3125% (at issue price), 7.5% p.a. (at 99.24%)
Cash Flows of Merotex C.A. (in USD million):
Year 0 1 2 3 4 5
Principal 200 - - - - -200
Interest - -14.625 -14.625 -14.625 -14.625 -14.625
Commissions -3.500 - - - - -
Paying Agency - -0.0077 -0.0077 -0.0077 -0.0077 -0.0847
Auth. & Adm. -0.004 -0.002 -0.002 -0.002 -0.002 -0.002
Listing -0.020 - - - - -
Trustee -0.008 -0.008 -0.008 -0.008 -0.008 -0.008
Reimburs. exp. -0.080 - - - - -
Cash Flow 196.39 -14.6427 -14.6427 -14.6427 -14.6427 -214.7117
Cost of funds (IRR) = 7.7778% p.a.
Note: Sometimes, IRR is calculated by excluding annual & minor expenses
(listing, trustee, authentication, etc.). Under this method,
IRR = 7.7580%.
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Cost of Funds Exclusive Annual and Minor Expenses: Details
• This figure takes account:
- Coupon payments (USD 14.625 M)
- Commissions of 1¾% flat on the issue amount (USD 3.5 M)
- Reimbursable managers' expenses (USD 80,000)
The issuer receives the net proceeds of:
USD 200,000,000 - USD 3,580,000 = USD 196,420,000 (or 98.21%)
• All-in cost: IRR of a 5-year project:
- Positive cash flow of USD 196.42 M in year zero.
- Negative cash flows of USD 14.625 M every year.
- Negative cash flow of USD 200 M in year 5.
IRR = 7.7580%. (Merotex obtains financing at a cost of 7.7580% p.a.)
Small difference between both IRRs.
Cost of Funds Inclusive Annual and Minor Expenses: Details
This figure takes account:
- Coupon payments
- Commissions of 1¾% flat on the issue amount
- Reimbursable managers' expenses
- Commissions and Expenses
IRR = 7.7778% p.a. (Merotex obtains financing at an annual
cost of 7.7778%.)
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Equity Warrants in Eurobonds
• Equity warrant issues have different components:
- A standard fixed-rate Eurobond issue
- A detachable equity warrant.
Equity warrant: A call option on the stock of the issuer.
Tend to have longer maturities than standard options.
The equity warrant is typically detached.
Exercise ratio: Number of shares a warrant buys.
• The bond is priced as normal.
• Warrant is priced as a function of: warrant premium & equity content.
• There is a unique price:
(1) 100 percent: the bond price will be at a discount to par and the
coupon at a below-market level (discount bond);
(2) in excess of 100 percent: the bond is issued at a normal
market price, that is, close to 100 percent (full coupon bond).
• Black-Scholes formula is used to price warrant.
Traders make adjustments to the BS formula based on:
(1) Prices of other warrants
(2) Market perception on the company
(3) Stock market expectations.
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• The ratio of equity raised to the issue size is the equity ratio.
Usual range: 100% to 200% of the nominal amount of the bond issue.
• Q: Why do firms use equity warrants?
A: For raising equity capital at a lower IRR.
Case Study II: VOMF
• Information
• New Zealand company in the uranium business, with good reputation.
• VOMF wants to refinance debt for USD 100 million. Seeking maturity
in the range 5-7 years maturity (the longer the better).
• Market conditions:
- Uranium prices are up.
- German economy is coming out of a recession.
- Inflation is very low.
- The stock market is expected to do well in the near future.
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VOMF's situation:
- VOMF's share price is up because of exploration agreements.
- Shareholders might increase capital in the next assembly.
- VOMF has outstanding debt in the Euro-USD segment. It is
currently paying a spread of 90 bps over US Treasuries.
An investment bank suggests an equity-linked financing
A straight bond with equity warrants attached.
Data available
US Treasury yields: 3-year 6.530% (s.a.)
5-year 6.915% (s.a.)
7-year 7.135% (s.a.)
NZ interest rate: 1-year 4.52% (p.a.)
VOMF Euro-USD bond yield: U.S. Treasuries + 90 bps
VOMF's share price (P0): NZD 120
Historic dividend yield: 5.50%
Historic stock price volatility: 3-year 19.90%
5-year 21.40%
7-year 25.50%.
Outstanding warrants
Outstanding life: 3½ years
Current price (W0): USD 10-10.80 (NZD 15.625-17)
Exercise price (X): NZD 145
Current exchange rate: .64 USD/NZD (1.5625 NZD/USD).
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• Evaluation
• Warrant maturity: 3 years (close to the life of outstanding issue).
• Equity content: 150% (good market conditions). Exercise ratio: 1
• Pricing warrant:
Black-Scholes formula (theoretical price): NZD 12.23.
VOMF's outstanding warrants trade NZD 16, with a GP:
GP = (X + W0)/P0 = (145 + 16)/120 = 1.3417. (or 34.17%)
Investment bank proposes 3-year equity warrants with a GP 35%
& X = EUR 150 (to minimize competition)
Warrant price = GP * P0 – X = 1.35 * NZD 120 – NZD 150 = NZD 12
At this price, the implied volatility is equal to 19.63%.
• Pricing bond:
Maturity = Market conditions indicate a 7-year bond.
YTM = 7-year US Treasuries + 90 bps = 7.225% sa (7.3555% p.a.)
Proposed Issue
• Terms for the warrants
(Assume a conversion exchange rate = .64 USD/NZD)
Amount of equity raised:
USD 100M * 1.50 = USD 150M = NZD 234,375,000
Number of shares created on exercise:
NZD 234,375,000/ NZD 150 = 1,562,500
Exercise ratio: 1
Number of warrants: 1,562,500/1
Number of bonds: 100,000
Number of warrants per bond: 1,562,500/100,000 = 15.625
Value of the warrants attached
to each bond of USD 1,000: 15.625 * NZD 12 = NZD 187.50
= USD 120 (12% of nominal amount)
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• Terms for the bond
Amount = USD 100 million (in denomination of USD 1,000)
Maturity = 7 years.
Yield = 7.3555% p.a.
Total commissions are 2%.
The bonds are offered at 98.78 percent (competitive pressures)
VOMF's coupon is reduced to 7 ⅛% p.a.
Full-coupon bond which trades better in the secondary market.
Issue price (bond + warrants): 112%
Cost of funds (based on total issue
price less commissions of 2%): 5.372% p.a. or 5.302% s.a.
IRR: 183 bps (s.a.) below the yield on 7-year U.S. Treasuries.
Case Study III: Bioneth
• Selecting a Particular Bond
Simple process:
(1) Compute cost of funds of different bonds under different scenarios
(2) Based on risk tolerance, a firm decides on the best instrument.
• We present an example showing how a Portuguese firm, Bioneth
Engineering, selects a Eurobond issue with currency options attached
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Eurobonds with Currency Options Attached
Attached to a Eurobond issue, a currency option is securitized as a tailor-
made listed warrant.
• Advantages over standard currency options
For Buyers:
- Loophole: In some countries, rules may prevent investors from
buying currency options per se.
- Smaller denominations or contract sizes
- Longer exercise periods.
For Issuers:
- Adding a securitized option reduces the cost of the borrowing.
• Disadvantage for the issuer: FX exposure. But, it can be hedged.
Example: Bioneth Engineering is a firm based in Portugal.
Situation:
- Bioneth has GBP 100 million of short-term debt.
- Refinance the GBP debt with a straight 7-year 8% Euro-GBP bond.
- Commissions paid to 1¾% (or GBP 1.75M).
An investment bank approaches Bioneth and offers:
A similar straight 7-year 8% Euro-GBP bond, but with a 3-year currency
warrants attached giving entitlement to an American GBP-put/EUR call
option with
Xp = 1.50 EUR/GBP (or Xc = .6667 GBP/EUR)
Size = EUR 1,600.
Note: The warrant is a standard put. It will be exercised only when:
(Xp - St) > 0.
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• Terms of the bond.
Amount: GBP 100 million.
Maturity: 7 years.
Issue price: 100%
Denominations: GBP 1,000 ( 100,000 bonds)
Interest: 8% p.a. payable annually in arrears.
Early redemption: None.
Redemption price: 100%
Issuance commissions: 1¾% (GBP 1.75M).
Listing: London
Cost of funds (including
only commissions): 8.34%
• Terms of the currency warrants
Exercise price: 1.50 EUR/GBP (.6667 GBP/EUR)
Exercise period: At any time.
Current exchange rate: 1.60 EUR/GBP (.6250 GBP/EUR)
Structure: Each bond has a warrant giving the right to
receive the difference between:
(1) the GBP equivalent of EUR 1,600 at
Xp = 1.50 EUR/GBP, and
(2) the GBP equivalent of EUR 1,600 at St.
Warrant price: EUR 0.04935 per GBP. At St, GBP 0.0308
or GBP 30.80 per bond (3.08%).
Premium of X/S: .6667/.6250 = 1.0667 or 6.67%
Issue price (bond & warrants): 100% + 3.08% = 103.08%
Note: Warrant is a standard put. It will be exercised when:
(Xp - St) > 0.
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• Evaluation
• At expiration, two scenarios for GBP put:
if St+3 yrs > Xp = 1.50 EUR/GBP No exercise.
if St+3 yrs < Xp = 1.50 EUR/GBP Exercise.
Example: If St+3 yrs = 1.40 EUR/GBP ( .7143 GBP/EUR), exercise.
receive, per bond:
EUR 1,600 * .7143 GBP/EUR – EUR 1,600 * .6667 GBP/EUR =
= GBP 76.19.
• Bioneth is exposed to currency risk.
If St+3 yrs= 1.40 EUR/GBP, Bioneth has an additional cash flow of
GBP 76.19 * 100,000 = GBP 7,619,000.
Total CFs at t+3 = GBP -8M + GBP -7.619M = GBP -15.619M
• Evaluation
• To hedge, the investment bank offers Bioneth an identical currency
option at EUR 0.04 per GBP or GBP 25 per GBP 1,000 bond.
That is, Bioneth can buy FX insurance for an upfront cost of
GBP 25/bond * 100,000 bonds = GBP 2.5M.
At inception, Bioneth receives
GBP 100M – GBP 1.75M + GBP 3.08M – GBP 2.5M = GBP 98.83M.
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• Suppose the investment bank considers likely St+3 yrs = 1.40 EUR/GBP.
Bioneth compares the cash flows under different alternative scenarios:
CO Bond CO Bond CO Bond
Date Str. Bond (NH/NExercised) (NH/Exercised) (Hedged)
0 98.250 101.330 101.330 98.830
1 -8.000 -8.000 -8.000 -8.000
2 -8.000 -8.000 -8.000 -8.000
3 -8.000 -8.000 -15.619 -8.000
4 -8.000 -8.000 -8.000 -8.000
5 -8.000 -8.000 -8.000 -8.000
6 -8.000 -8.000 -8.000 -8.000
7 -108.000 -108.000 -108.000 -108.000
IRR: 8.340% 7.747% 8.904% 8.227%
Bioneth issues bond with currency options attached and also hedge.
Case Study IV: Brady Bonds
• Brady Bonds (BBs)
• Created to bring EM (Mexico, Brazil, etc.) out of the 1980s default.
• USD 180 billion market in its heyday.
• Idea:
Banks voluntarily reduce their claims in return for credit enhancements on
their remaining exposure: Collateral accounts to guarantee the principal
and/or interest in a bond exchange in the context of buybacks.
• Mexico, Costa Rica, and Venezuela were the first three countries to issue
bonds as part of the Brady plan.
• Issued two Brady bonds for debt conversion:
- A par bond (fixed-rate)
- A discount bond (floating-rate)
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• Brady Bonds: Mexican BBs
• Mexican Brady bonds were issued in March 1990, with T = 30 years.
- Principal: Guaranteed by 30-year U.S. Treasury zero-coupon bonds.
- Rolling interest guarantee (RG) provided by a pool of collateral
sufficient to cover 18-mo of coupon payments –3 semester payments– at
an assumed coupon rate of 10%.
- Banks have a choice of BBs to exchange for defaulted debt:
- Par Bond: C = 6.25%. Bank debt exchanged for the par bond
with principal equal to the original face value of the debt.
- Discount Bond: C = LIBOR + 13/16. But, bank debt exchanged
at the discount 65% ratio.
- Both bonds include an oil price recapture clause that pays off if oil
prices rise in 1997 and beyond.
Brady Bonds: Cash Flows
The coupon CFs follow a simple binomial tree, where Pt is the probability
of default at time t, with t = 1, 2, .... , 60.
P1 1-P1
RG
P2 C/2
RG 1-P2
C/2 P3 C/2 C/2
RG 1-P3
C/2 C/2 P4
RG 1-P4
C/2 C/2 C/2
C/2 C/2 C/2 C/2 C/2 C/2 C/2
P5
1-P5
• NPV: Discount CFs with appropriate YTM (local YTM for C and US
YTM for RG). We also need a model for default!
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Brady Bonds: Cash Flows and Discount Rates
∘ Principal: Guaranteed with US T-bonds. At maturity, it will be repaid.
NPV of Principal: Use 30-year US YTM as discount rate.
∘ Coupon payments involve risk. Default can happen. There is uncertainty
regarding the amount of coupon payments.
- As a minimum, a bondholders receives RG: RG kicks in immediately
after default. It involves 3 C/2 payments.
NPV of RG: Use appropriate US YTM to discount CFs.
- The risky CFs are the ones not covered by guarantees: All coupon
payments, beyond the RG.
NPV of coupons: Use appropriate Mexican YTM.
Brady Bonds: Cash Flows and Default Probabilities
∘ We need the probability associated with each final coupon CF at the each
branch of the binomial tree.
Suppose there is default at t = 3 –i.e., after 2 coupon payments. There are 5
total payments CFs for the bondholder are: {C/2, C/2, RG}.
The probability of receiving 5 coupon payments only –i.e., default occurs
after t = 3– is given by:
(1 – P1) * (1 – P2) * P3
∘ Multiply each final coupon CFs at each branch by its probability and add
them up to compute an expected NPV of coupon CFs, or
E[NPVCoupons].
∘ E[NPVCoupons] + NPV of Principal (no uncertainty) = PBB.
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• Brady Bonds: Default Probabilities
• To calculate E[NPV], we need a model for the probability of default.
Many ways to approach this problem.
Example: Use inverted U shape:
Prob of default
(T-t) Remaining Time to Maturity
• Alternatively, we can buy a credit default swap or CDS –i.e., insurance – to
cover the event of default of coupon payments (more on this next chapter).
Although, there was no CDS market at the time.
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