债券市场分析与策略第7版答案.docx

CHAPTER 9NON-U.S. BONDSCHAPTER SUMMARYU.S. investors have become increasingly aware of non-U.S. interest-rate movements and their relationship to U.S. interest rates. In addition, foreign countries have liberalized their bond markets, making them more liquid and more accessible to international investors. And in general, there is an increased awareness of the non-U.S. bond markets as potential sources of return enhancement and/or risk reduction. As a result, U.S. bond managers have increasingly adopted a global approach and invested in bonds from several countries. Many global investors participate only in the foreign government bond markets rather than the nongovernment bond markets, because of the low credit risk, the liquidity, and the simplicity of the government markets. In this chapter we look at the Eurobond market and several non-U.S. government bond markets.CLASSIFICATION OF GLOBAL BOND MARKETSThe global bond market can be classified into two markets: an internal bond market and an external bond market. The internal bond market or national bond market can be decomposed into two parts: the domestic bond market and the foreign bond market. First, the domestic bond market is where issuers domiciled in the country issue bonds and where those bonds are subsequently traded. Second, the foreign bond market of a country is where bonds of issuers not domiciled in the country are issued and traded. For example, in the United States the foreign bond market is the market where bonds are issued by non-U.S. entities and then subsequently traded. Bonds traded in the U.S. foreign bond market are nicknamed Yankee bonds. Regulatory authorities in the country where the bond is issued impose certain rules governing the issuance of foreign bonds.The external bond market, also called the international bond market, includes bonds with the following distinguishing features: (i) they are underwritten by an international syndicate; (ii) at issuance they are offered simultaneously to investors in a number of countries; (iii) they are issued outside the jurisdiction of any single country; and (iv) they are in unregistered form. The external bond market is more popularly called the Eurobond market. A global bond is one that is issued simultaneously in several bond markets throughout the world.Another way to classify the worlds bond market is in terms of trading blocs. The trading blocs used by practitioners for this classification are dollar bloc, European bloc, Japan, and emerging markets. The dollar bloc includes the United States, Canada, Australia, and New Zealand. The trading bloc construct is useful because each bloc has a benchmark market that greatly influences price movements in the other markets.FOREIGN EXCHANGE RISK AND BOND RETURNSThe return to U.S. investors from investments in non-U.S. bonds that are denominated in a foreign currency consists of two components: (i) the return on the security measured in the currency in which the bond is denominated (called local currency return), which results from coupon payments, reinvestment income, and capital gains/losses; and (ii) changes in the foreign exchange rate.An exchange rate is the amount of one currency that can be exchanged for another currency, or the price of one currency in terms of another currency. Since the early 1970s, exchange rates between currencies have been free to float, with market forces determining the relative value of a currency. When a currency declines in value relative to another currency, it is said to have depreciated relative to the other currency. Alternatively, this is the same as saying that the other currency has appreciated.If the foreign currency depreciates (declines in value) relative to the U.S. dollar, the dollar value of the cash flows will be proportionately less. This risk is referred to as foreign exchange risk. This risk can be hedged with foreign exchange spot, forwards, futures, or options instruments (although there is a cost of hedging).Several reasons have been offered for why U.S. investors should allocate a portion of their fixed income portfolio to nondollar bonds. The party line is that diversifying bond investments across countriesparticularly with the currency hedgedmay provide diversification resulting in a reduction in risk.EUROBOND MARKETThe Eurobond market is divided into sectors depending on the currency in which the issue is denominated. For example, when Eurobonds are denominated in U.S. dollars, they are referred to as Eurodollar bonds. Eurobonds denominated in Japanese yen are called Euroyen bonds.Issuers of foreign bonds include national governments and their subdivisions, corporations (financial and nonfinancial), and supranationals. A supranational is an entity that is formed by two or more central governments through international treaties. The purpose for creating a supranational is to promote economic development for the member countries.In the Eurobond market, indications for trades are initially expressed on a spread basis. In the U.S. market, the spread is relative to the U.S. Treasury yield curve.Corporate Bonds and CovenantsIn the Eurobond market, there is a debate regarding the relatively weak protection afforded by covenants. The chief reason for this is that investors in corporate Eurobonds are geographically diverse. As a result, it makes it difficult for potential bond investors to agree on what form of covenants offer true protection.Securities Issued in the Eurobond MarketThe Eurobond market has been characterized by new and innovative bond structures to accommodate particular needs of issuers and investors. There is the “plain vanilla,” fixed-rate coupon bonds, referred to as Euro straights. Because these are issued on an unsecured basis, they are usually issued by high-quality entities.Coupon payments are made annually, rather than semiannually, because of the higher cost of distributing interest to geographically dispersed bondholders. There are also zero-coupon bond issues and deferred-coupon issues.There is a wide variety of floating-rate Eurobond notes. The coupon rate on a floating-rate note is some stated margin over the London interbank offered rate (LIBOR), the bid on LIBOR (referred to as LIBID), or the arithmetic average of LIBOR and LIBID (referred to as LIMEAN). The size of the spread reflects the perceived credit risk of the issuer, margins available in the syndicated loan market, and the liquidity of the issue. Typical reset periods for the coupon rate are either every six months or every quarter, with the rate tied to six-month or three-month LIBOR, respectively; that is, the length of the reset period and the maturity of the index used to establish the rate for the period are matched.A floating-rate note issue will either have a stated maturity date or it may be a perpetual (also called undated) issue (i.e., with no stated maturity date). There are issues that pay coupon interest in one currency but pay the principal in a different currency. Such issues are called dual-currency issues.There is a wide array of bonds with warrants: equity warrants, debt warrants, and currency warrants. An equity warrant permits the warrant owner to buy the common stock of the issuer at a specified price. A debt warrant entitles the warrant owner to buy additional bonds from the issuer at the same price and yield as the host bond. A currency warrant permits the warrant owner to exchange one currency for another at a set price (i.e., a fixed exchange rate).Comparing Yields on U.S. Bonds and Eurodollar BondsBecause Eurodollar bonds pay annually rather than semiannually, an adjustment is required to make a direct comparison between the yield to maturity on a U.S. fixed rate bond and that on a Eurodollar fixed-rate bond. Given the yield to maturity on a Eurodollar fixed-rate bond, its bond-equivalent yield is computed as follows:bond-equivalent yield of Eurodollar bond =2(1 + yield to maturity on Eurodollar bond)1/2 1.To convert the bond-equivalent yield of a U.S. bond issue to an annual-pay basis so that it can be compared to the yield to maturity of a Eurodollar bond, the following formula can be used:The yield to maturity on an annual-pay basis would be:1 + (yield to maturity on bond-equivalent basis / 2)2 1.The yield to maturity on an annual basis is always greater than the yield to maturity on a bond-equivalent basis.NON-U.S. GOVERNMENT BOND MARKETSThe institutional settings for government bond markets throughout the world vary considerably, and these variations may affect liquidity and the tactics of investment strategies. For example, in the government bond market different primary market issuance practices may affect the liquidity and the price behavior of specific government bonds in a country.The two largest non-U.S. government bond markets are those in Japan and Germany. Japanese government securities, referred to as JGBs, include medium-term bonds and long-dated bonds. The German government issues bonds (called Bunds) with maturities from 8-30 years and notes, Bundesobligationen (Bobls), which have a maturity of five years.In January 1999, the structure of the market changed with the start of the European Monetary Union (EMU). The EMU, combined with the decline in the U.S. Treasury issuance of securities, has resulted in the Euro government bond market becoming the largest government bond market in the world in terms of size and number of issues.Within the Euro bond market, the government bond sector represents half of the market of Euro-denominated bonds, followed by the German Pfandbriefe market. While many Euro government bonds can be stripped, the stripped securities are not as liquid as that of U.S. Treasury strips.Methods of Distribution of New Government SecuritiesThere are four methods that have been used in distributing new securities of central governments: the regular calendar auction/Dutch style system, the regular calendar auction/minimum-price offering, the ad hoc auction system, and the tap system.In the regular calendar auction/Dutch style auction system, there is a regular calendar auction and winning bidders are allocated securities at the yield (price) they bid. This is a multiple-price auction and the U.S. Department of the Treasury currently uses this method when issuing all U.S. Treasury securities except the two-year and five-year notes.In the regular calendar auction/minimum-price offering system, there is a regular calendar of offering. The price (yield) at which winning bidders are awarded the securities is different from the Dutch style auction. Rather than awarding a winning bidder at the yield (price) they bid, all winning bidders are awarded securities at the highest yield accepted by the government (i.e., the stop-out yield).In the ad hoc auction system, governments announce auctions when prevailing market conditions appear favorable. A regular calendar auction introduces greater market volatility than an ad hoc auction does because yields tend to rise as the announced auction date approaches and then fall afterward.In a tap system additional bonds of a previously outstanding bond issue are auctioned. The government announces periodically that it is adding this new supply.Sovereign Bond RatingsSovereign debt is the obligation of a countrys central government. Whereas U.S. government debt is not rated by any nationally recognized statistical rating organization, the debt of other national governments is rated.The two general categories used by Standard & Poors in deriving their ratings are economic risk and political risk. Economic risk is an assessment of the ability of a government to satisfy its obligations. Political risk is an assessment of the willingness of a government to satisfy its obligations.There are two sovereign debt ratings assigned by rating agencies: a local currency debt rating and a foreign currency debt rating. The reason for distinguishing between local debt ratings and foreign currency debt ratings is that historically, the default frequency differs by the currency denomination of the debt. Specifically, defaults have been greater on foreign currency-denominated debt. The reason for the difference in default rates for local currency debt and foreign currency debt is that if a government is willing to raise taxes and control its domestic financial system, it can generate sufficient local currency to meet its local currency debt obligation.In assessing the credit quality of local currency debt, for example, S&P emphasizes domestic government policies that foster or impede timely debt service. The key factors looked at by S&P are: stability of political institutions and degree of popular participation in the political process; economic system and structure; living standards and degree of social and economic cohesion; fiscal policy and budgetary flexibility; public debt burden and debt service track record; and, monetary policy and inflation pressures. However, the single most important leading indicator according to S&P is the rate of inflation.For foreign currency debt, credit analysis by S&P focuses on the interaction of domestic and foreign government policies. S&P analyzes a countrys balance of payments and the structure of its external balance sheet. The areas of analysis with respect to its external balance sheet are the net public debt, total net external debt, and net external liabilities.THE EUROPEAN COVERED BOND MARKETOne of the largest sectors of the European market is the covered bonds market. Covered bonds are issued by banks. The collateral for covered bonds can be either (1) residential mortgage loans, (2) commercial mortgage loans, or (3) public sector loans. They are referred to as “covered bonds” because the pool of loans that is the collateral is referred to as the “cover pool.”Covered bonds work as follows. Investors in covered bonds have two claims. The first is a claim on the cover pool. At issuance, there is no legal separation of the cover pool from the assets of the issuing bank. The second claim is against the issuing bank. Because the covered pool includes high-quality mortgage loans and is issued by strong banks, covered bonds are viewed as highly secure bonds, typically receiving a triple A or double A credit rating. Covered bonds can be issued in any currency.The difference between these securities created from a securitization is fourfold. First, at issuance, the bank that originated the loans will sell a pool of loans to a special purpose vehicle (SPV). The second difference is that investors in RMBS/CMBS/ABS do not have recourse to the bank that sold the pool of loans to the SPV. The third difference is that for RMBS/CMBS/ABS backed by residential and commercial mortgage loans, the group of loans, once assembled, does not change, whereas covered bonds are not static. Finally, covered bonds typically have a single maturity date (i.e., they are bullet bonds), whereas RMBS/CMBS/ABS typically have time tranched bond classes.THE PFANDBRIEFE MARKETThe German mortgage-bond market, called the Pfandbriefe market, is the largest covered bonds market. In fact, it is about one-third of the German bond market and the largest asset in the European bond market. The bonds in this market, Pfandbriefe, are issued by German mortgage banks.EMERGING MARKET BONDSThe financial markets of Latin America, Asia (with the exception of Japan), and Eastern Europe are viewed as emerging markets. Investing in the government bonds of emerging market countries entails considerably more credit risk than investing in the government bonds of major industrialized countries.A good amount of secondary trading of government debt of emerging markets is in Brady bonds. Basically, these bonds represent a restructuring of nonperforming bank loans of governments into marketable securities. Countries that issue Brady bonds are referred to as “Brady countries.” There are two types of Brady bonds. The first type covers the interest due on these loans (“past-due interest bonds”). The second type covers the principal amount owed on the bank loans (“principal bonds”).ANSWERS TO QUESTIONS FOR CHAPTER 9(Questions are in bold print followed by answers.)1. What risk is faced by a U.S. life insurance company that buys British government bonds?From the perspective of a U.S. life insurance company investing in British government bonds, the cash flows of assets denominated in a foreign currency expose the investor to uncertainty as to the cash flow in U.S. dollars. The actual U.S. dollars that the investor gets depend on the exchange rate between the U.S. dollar and the foreign currency at the time the nondollar cash flow is received and exchanged for U.S. dollars. For a U.S. life insurance company buying British government bonds, if the British pound depreciates (declines in value) relative to the U.S. dollar, the dollar value of the cash flows will be proportionately less. This risk is referred to as foreign exchange risk. This risk can be hedged with foreign exchange spot, forwards, futures, or options instruments (although there is a cost of hedging).In distributing British government bonds, the Bank of England uses the ad hoc auction system. Under this system, a government announces an auction when prevailing market conditions appear favorable. From the issuing governments perspective, an ad hoc auction involves less market volatility than a regular calendar auction where yields tend to rise as the announced auction date approaches and then fall afterward. Thus, from the viewpoint of a U.S. life insurance company buying British government bonds, an ad hoc auction would not face rising yields. This would be considered disadvantageous since th