Foreign Bonds Development - Essay Example

? Foreign Bonds First Middle Initial, al Affiliation This paper summarizes important details regarding debt securities, specifically foreign bonds. It explains how foreign bonds work, and the significant reasons multinational corporations attempt to acquire funds from outside their home country. It also enumerates the different risks associated with capitalizing in foreign bonds along with proposed strategies to minimize possibility of loss. Furthermore, are quotes and theories related to foreign bonds derived from a number of references both online and offline. Foreign Bonds Introduction to Foreign Bonds “Foreign bonds are a debt security issued by a borrower from outside the country in whose currency the bond is denominated and in which the bond is sold” (Scott 2003). Whatever country the bonds come from, they fall into either of two classes: government bonds and corporate bonds (Brigham & Eharhardt 2009). The former is supported by the issuing governments and their agencies. For example, a bond denominated in Philippine peso that is issued by the government of the United Sates is a foreign bond. Bonds that are partially backed by the U.S. government are called “Brady bonds” after Nicholas Brady, former treasury secretary under the administration of presidents Reagan and Bush (Brigham & Ehrhardt 2009). Corporate bonds, on the other are issued by foreign or multinational corporations (MNCs) (Madura 2006). For instance, Sharp Corporation (a Japanese firm) may need U.S. dollars to finance the operations of its holdings in the United States. If it decides to raise the needed capital in the United States, then the bond would be financed by a group of U.S. investment bankers, denominated in U.S. dollars, and sold to U.S. investors in accordance with SEC and applicable state regulations. The bond is no different from those issued by equivalent U.S. corporations except for its foreign origin, thus making it a foreign bond. Alternatively, if Sharp Corporation issued bonds in the Philippines that were denominated in pesos then they would also be considered as foreign bonds. “Foreign bond issues carry prefixes that indicate the country in which the offering is made” (Shailaja 2008). If Sharp Corporation would make a U.S. dollar denominated bond issue in the U.S. capital market, it is making an issue of Yankee bonds. Similarly a Samurai bond is a yen denominated bond issue made by a foreign borrower in the Japanese capital market to Japanese investors. A Bulldog bond is a pound sterling denominated bond issue made by a foreign borrower in the British capital market to British investors. Foreign bonds may be subject to withholding tax. “This is a tax levied by the country to which the foreign borrower belongs, on interest payments made to foreign bondholders” (Shailaja 2008). Suppose Sharp Corporation makes a Yankee bond issue and the Japanese tax law stipulates that a 15% withholding tax must be levied on interest payments made by Sharp Corporation to the bond holder. If the face value of each bond is $100 and the fixed coupon rate is 10%, the interest receivable by a bondholder is $10. But with the 15% withholding tax, he receives only $8.5—that is, $10 less 15%. The Reason Foreign Bonds Exist “Foreign bonds are designed to cater to the investment needs of the target market” (Shailaja 2008). They have certain attributes that appeal to investors in the capital market where they are tendered. Foreign firms or multinational corporations that aspire to expand their business portfolios choose to issue bonds in several foreign countries. This is also one strategy to obtain support from the government of each foreign country that they plan to do business with. Issuers understand that they may be able to attract a stronger demand by offering their bonds in a particular foreign country rather than in their home country (Madura 2008). Some countries have a limited investor base, so companies in those countries seek financing overseas (Madura 2008). Also multinational corporations may prefer to finance a specific foreign project in a particular currency and therefore will attempt to obtain funds where the currency is widely used (Madura 2008). Supposing Sharp Corporation would like to venture in new versions of a certain air conditioning model. Since most of the raw materials, along with the workforce would have to come from the Philippines, it may be more feasible to finance the project in Philippine peso. To raise funds, Sharp Corporation then would issue bonds to entities in that country that will take interest on the aforesaid project. “Financing in a foreign currency with a lower interest rate may enable a multinational corporation to reduce its cost of financing, although it may be exposed to exchange rate risk” (Madura 2008). As discussed earlier, foreign bonds have fixed coupon rates—a percentage of the principal amount that is added to the amount payable by the issuer at the end of the term specified in the bond. A multinational corporation like Sharp Corporation may prefer to issue bonds in a foreign country if interest rate in Japan is relatively higher. The Risks in Foreign Bonds Author Jeff Madura identifies three risks associated with foreign bonds: exchange rate risk, interest rate risk, and credit risk (2008). By exchange rate risk, Charles de Vaulx, portfolio manager of First Eagle Sogen funds, refers to the possibility that a foreign currency may lose value against the U.S. dollar. If a coupon rate is at 15% but the currency in which the bond is denominated is devalued by 20%, American investors end up losing money (Korn 2000). Changes in the value of the foreign currency denominating a bond affect the U.S. dollar cash flows generated from the bond and thereby affect the return to U.S. investors who invested in the bond (Madura 2008). From the perspective of investors, the most attractive foreign bonds are those that offer a high coupon rate and are denominated in a currency that strengthens over time. This is the reason it may be more advisable to issue bonds in “Canada, Europe, Japan and other countries where financial markets are relatively efficient” (Korn 2000). Although the coupon rates of some bonds are fixed, the future value of any foreign currency remains uncertain (Madura 2008). Thus, there is a risk that the currency will depreciate and more than offset any coupon rate advantage. Meanwhile, “if the risk free interest rate of a currency changes, the required rate of return by investor in that country changes as well” (Madura 2008). Thus, the present value of a bond denominated in that currency changes. Madura added that a reduction in the risk-free interest rate of the foreign currency will result in a lower required rate of return by investors who use that currency to invest, which results in a higher value for bonds denominated in that currency (2008). Conversely, an increase in the risk-free rate of that currency results in a lower value for bonds denominated in that currency (Madura 2008). In general, the return on a bond denominated in a specific currency over a particular holding period is enhanced if the corresponding interest rate declines over the period; the return is reduced if the corresponding interest rate increases over that period. Finally, as the perceived credit risk of a foreign bond changes, the risk premium within the required rate of return by investors is affected (Madura 2008). In result, the face value of the bond changes. “An increase in risk causes a higher required rate of return on the bond and therefore lowers the present value of the bond” (Madura 2008). A reduction in risk causes a lower required rate of return on the bond and increases the present value of the bond. Thus, investors who are concerned about a possible increase in the credit risk of a foreign bond monitor economic and political conditions in the relevant factors that could affect the credit risk. Conclusion When investors attempt to capitalize on investments in foreign bonds that have higher interest rates than they can obtain locally, they may spread their foreign bond holdings among countries to reduce their exposure to different types of risk. Foreign bonds may possibly offer higher returns, but are exposed to a number of risks. Investors can reduce their exposure to these risks by diversifying among various currency denominations. The value of a foreign bond represents the present value of future cash flows to be received by the bond’s local investors. Thus, the bond’s value changes over time in response to the changes in the risk-free interest rate of the currency denominating the bond and in response to changes in the perceived credit risk of the bond. Since these two factors affect the market price of the bond, they also affect the return on the bond to investors over a particular holding period. References Brigham, E.F. & Ehrhardt, M.C. (2009). Financial Management: Theory and Practice. Ohio: South-Western Cengage Learning. Korn, D. J. (2000, November). Investing Abroad at Home. Black Enterprise , p. 52. Madura, J. (2006). Financial Markets and Institutions, 8th Edition. Ohio: Cengage Learning, Inc. Madura, J. (2008). International Financial Management, 9th Edition. Ohio: Cengage Learning. Scott, D. L. (2003). Wall Street Words: An A to Z Guide to Investment Terms for Today's Investor . New York: Houghton Mifflin Company. Shailaja, G. (2008). International Finance. Hyderabad: Universities Press Private Limited. Read More