The Eurobond as a Financial Instrument - Essay Example

Contents Contents Introduction 2 Characteristics 2 Benefits 4 Conclusion 6 References 7 Introduction It is widely accepted that the Eurobond was first used in its recognizable form in 1963 by Autostrada, the Italian highway authority to issue $15 million for return over a 10-year period. The coupons for the bonds were to be paid annually in July each year (Choudhry, 2010). It is important to look at this development in the circumstances during the period. Rather than a sudden innovation in the method of raising money, it was the result of a requirement that existed for many years. The Eurobond was born mainly due to the fact that it did not consist of a withholding tax that was to be paid to the government. This has been the defining characteristic of the bonds to this day. Let us look at the Eurobond in more detail so that we can understand its other characteristics. Characteristics The Eurobond may be defined as a financial instrument that allows borrowers from one country to obtain money from investors who reside in another country in the currency which is usually that of the borrowers country. More simply, it is an international loan which is associated with an interest paid to the investor annually or semi-annually over the period of the bond. Due to the long-term nature of the bond, it is usually issued between 5 and 15 years in excess of $1 million and in denominations of $5,000 and $10,000 (Saunders, 2008). Eurobonds are one form of international bonds through which borrowers across the world have the option to raise money from overseas investors. The other options are through foreign bonds and Brady and sovereign bonds. Let us look at the characteristics of the Eurobond in depth so that it will help us differentiate it from the other forms of bonds. Investors issue Eurobonds through investment banks in the primary market. More importantly, the issuer chooses the currency in which the bond will be issued. This being the case, factors such as volatility in the interest rates and the extent of the volatility are important decision factors for the issuer since both the interest and the principal amount of the Eurobond is returned in the same currency as that of the issue. This process reflects the international nature of the bond. Another important characteristic of the Eurobond is that there is no single central authority that is responsible for regulating its structure (Choudhry, 2010). There are four main types of Eurobonds: a) Straight-debt b) Convertible notes c) Currency option d) Floating rate notes (FRNs) Straight-debt type Eurobonds are the most common type but have been recently replaced by more complex type of Eurobonds. The characteristics of such bonds are simple because they offer fixed rates of interests and maturity periods. The interest is paid until the bond matures either annually or semi-annually as practiced in America. Convertible bonds have become increasingly used in the international market mainly because, apart from the fact that they carry a fixed rate of interest, they can be converted into the common stock of the borrowing company at a particular price. Currency option bonds allow investors to buy in one currency and make payments of interest and the principal in another allowing additional amount of flexibility. In floating rate notes, the lender changes the rate of return at periodic intervals based on changes in money market rates, usually carried out every six months. It is the only form of bonds without a fixed rate of interest and thus allows changes in the market to be borne by both the lender and the borrower (Khambata, 1996). Benefits Having familiarized ourselves with the various characteristics of Eurobonds and their types, let us look at the advantages of using Eurobonds from the perspective of the investor and the issuer. Investors The main objective of an investor, put in simple words is to make more money than what he has by utilizing the money that he currently has. Eurobonds being one of the international bonds, allows the investor to diversify his investments so that his overall risk is reduced. Despite the fact that economic and political crises around the world have a significant impact on such form of investing, it has proved to be very profitable in the long run, due to which the amount of money being invested in such a form has greatly increased over the decades. Therefore, it provides a readymade measure for investors looking to expand and grow. Apart from diversifying the portfolio of investors in general, those who are targeting the foreign investment market in particular find the option of investing in Eurobonds greatly rewarding due to its tax free nature i.e. no amount of withholding tax is imposed on the bond which makes it look as if it is domestic investment. It is probably the single most important factor that has led to the increased use of the Eurobond. Another important benefit offered by the use of Eurobonds is that its’ use has diversified into a number of countries around the world, trading in Eurobonds is a 24 hour affair unlike domestic and foreign bonds that are restricted by the trading hours of the domestic market. The investor has a number of choices in investment with the various types of Eurobonds that satisfy a number of criteria. The convertible bonds allow the investor to reduce the risk of the investment by allowing the option of buying stock in the domestic company. Floating rate notes allow for better risk management by sharing the changes in the market forces by both the investor and the issuer (Khambata, 1996). Issuers The main challenge for investors around the world is to raise capital for their business. As the amount of capital raised increases, the company issuing the bonds can satisfy a number of its needs such as the use of capital for operation and expansions, to offset the effects of challenges such as inflation, etc, to build the liquidity of the company that in turn allows for better risk management, etc. With a significant amount of capital available in the Eurobond market which has resulted due to the various advantages seen by the investors, issuers of long term capital naturally look at this market. As a result a number of different Eurobonds have emerged satisfying the diverse needs of both the investor and the issuer. Another important advantage offered by Eurobonds to the issuers is that they are associated with reduced rates of interest when compared to other forms of international investment which in turn is a result of the tax free of the investment that benefits the lenders as well. Therefore, it is a win-win situation. Conclusion Eurobonds have emerged as a significant source of international capital flow. Despite the various advantages, one has to realize that due to the nature of capital markets, there is a certain amount of risk associated with this form of investment as well. In this case, currency risk exposure and price fluctuation play a major role. However, Eurobonds have evolved to satisfy the needs of both the investor and the borrower through the various types of Eurobonds. As a long term consequence they allow for some sort of balancing between the various markets of the world. References Choudhry, M. 2010. An Introduction to Bond Markets. John Wiley and Sons. Great Britain. Khambata, D. 1996. The practice of multinational banking: macro-policy issues and key international concepts. Greenwood Publishing Group. USA. Saunders. 2008. Financial Markets And Inst. Tata McGraw-Hill. Noida, India. Read More