Recent Trends in Eurobond Market - Essay Example

What are the recent trends in Eurobond Market Concentrate on issues of size, Volume, Borrowers and Innovations Introduction Eurobonds are international bonds that are issued in countries other then the country of currency used to denominate the bond. Eurobonds are usually issued simultaneously to investors in a number of countries, outside the jurisdiction of any single country. Starting in 1960s, Eurobonds now dominate the international bond market. Eurobond market is basically unregulated, although it does have self-imposed standards of practice which are different from legal requirements. Whereas firms or corporations issuing the bond are regulated by national authorities, there is no requirement to provide for investor protection or law to deal with disputes. Therefore, the market is highly dependent on the reputation of the issuer. The following discussion will see how the Eurobond market has grown since its inception to its current size. The essay will also discuss the current volume of the market and the diversity of the borrowers participating in the market. Finally, the essay will look at the innovations in the Eurobond market with major types of products offered in the market. 2. Growth of Eurobond Market The bond market is the primary provider of medium or long-term financing for corporations and the market is dominated by the Eurobonds in the international environment. Prior to the appearance of Eurobonds, long-term capital from international source was raised by floating a bond issue in some other country denominated in the currency and meeting the requirements of the country it was issued in. These are called foreign bonds and the total annual volume was an average of $2.6 billion from the period 1964 to 1974 (Smith, 2003). The number of foreign bonds increased substantially after 1974 because of the removal of US capital market controls. However, the number of foreign bonds traded is very small compared to the total international bond market. Smith (2003) points to the various reasons which hampered the growth of foreign bonds. These include the fact that issuers had to meet local requirements which caused delays while issuers prepared the necessary documents or permissions. Expenses were also high because of the underwriting fees and other expenses incurred by the issuer. The 1960s saw the emergence of Eurobonds which rapidly went on to dominate the international bond market. Originally, Eurobonds were unsecured promissory notes denominated in US dollars. They were not registered with US Securities and Exchange Commission (SEC) and therefore could not be sold in US or to US citizens. They were sold to non-US residents, primarily wealthy individuals and foreign institutional investors. Madura (2006) mentions that the emergence of Eurobond market has been highly influenced by the introduction of Interest Equilisation Tax (IET) by the US government in 1963. This IET of 15% on interest received from foreign borrowers was originally designed to restrict foreign debt sold in US market and discourage investors in US from investing in foreign securities. However, the tax actually stimulated the development of Euromarkets and dollar driven financial activity in London. IET was removed in 1974. Eurobonds found further boost in 1984 when the US government repealed the 30% withholding tax on interest income paid to foreign persons or corporations. This allowed US corporations to issue bonds directly to non-US investors. Previously, many foreign investors showed reluctance in purchasing US corporate securities as US issuers were required to withhold part of the required interest payments in order to ensure any tax due would be paid. They were also required to disclose their names and addresses to the issuer. To attract such investors, American companies had to issue bonds in the bearer form through subsidiaries in various tax-haven jurisdictions, such as the Netherlands Antilles (Smith, 2003). Thus removing the withholding tax ensured that foreign investors could obtain the bonds directly from the US corporations. Many other countries followed the lead and eliminated or relaxed their tax structure. As demands for Eurobonds increased, competition between the investors intensified which ultimately benefited the issuers. Smith (2003) mentions that during the period of 1981 to 1985, US corporations rated AA or better could borrow long term money in Europe more cheaply then they could in US and in some cases even at a cheaper rate then US Treasury could borrow. The high demand of Eurobonds resulted in a surge of new issues. 3. Current Volume Both the U.S. bond and Eurobond markets are the largest and most viable sources of debt financing for internationally active American and foreign companies. However, the US bond market, which used to be the largest site for debt underwriting, has now been surpassed by the Eurobond market (fig 1). Peristiani (2007) attributes this to various factors such as major transformation in the European financial system because of the financial liberalisation in the 1990s, lesser reliance on banks as intermediaries between savers and borrowers and the euro's emergence as a leading global currency. Other advantages of Eurobond market include self-regulatory environment and greater variety of financing instruments offered. Unlike the equity market, in the US bond market a large fraction of US issuers also rely on the Eurobond market for funding. The U.S bond market has shown a steady decline in the share of American firms issuing domestically, from 92 % in 1995 to 82 % in 2006. The decline is also noticed in US domestic nonfinancial issuers from 95 percent in 1995 to 83 percent in 2006 as more firms seek greater access to the Eurobond market. The decline is also seen in the share of European issuers as European firms are increasingly turning to the Eurobond market for their debt financing. European issuers borrowing in the U.S. bond market dropped from more than 20 percent in 2000 to approximately 9 percent in 2006 (Peristiani, 2007). (Billions of Dollar) Fig 1: Corporate Issuances in the U.S. Bond Market and the Eurobond Market (Source: Securities Data Corporation; obtained from Peristiani, 2007) It should be noted that the chart above depicting the corporate issuances in the U.S. Bond Market and the Eurobond Market (fig.1) does not include asset-backed issues. The global market share of Eurobonds market would be substantially larger if we also include specialised asset-backed issues such as collateralized debt and loan obligations. The total volume of asset-backed issues in the Eurobond market has increased from $45 billion in 2000 to more than $700 billion by the end of 2006 (Peristiani, 2007). 4. Eurobond Borrowers Eurobond market has a very diverse range of borrowers. Melnik and Nissim (2004) point that originally, the primary borrowers in the Eurobond market were international agencies, sovereign governments of developed countries and major banks. High quality corporate borrowers entered the market in the mid-80s and by the mid- 90s, corporate borrowers were dominant in the Eurobond market. Choudhry (2001) mentions the various reasons why governments and institutions access the Eurobond market. These include advantages for borrowers under certain circumstances to raise funds outside the domestic market due to tax benefits or other regulatory advantages. Further, due to the highly competitive nature of the international market, the borrower might obtain cheaper fund in the international market. Other factors that might influence the borrower's decision might be a desire to diversify sources of long term fund. Also, Eurobond issue might offer more diversity and choice compared to domestic bond issue. Eurobond issuers represent a vast variety from all over the world. Among the borrowers are a variety of different government and corporate organisations. Smith (2003) mentions that supranational institutions such as the World Bank and entities of European Union are frequent borrowers. This seems logical owning to the organisations lack of 'home' country. Other frequent borrowers include agencies of European, Asian, Australasian, Latin American and other governments. Large banks have used the Eurobond markets especially the floating rate note (FRN) to fund their own lending books or for swaps. Other active borrowers include industrial corporations and their captive finance subsidiaries. Smith (2003) further points that Japanese companies were among the heaviest Eurobond issuers as they faced a highly regulated and expensive corporate bond market in Tokyo. These Japanese companies were highly attracted by the convertible bonds with stock purchase options as this allowed the issuers to repay the debt in the future when investors presented their bonds or exercise their option to acquire shares of the company. As long as the Japanese share prices were rising, this method of financing was an attractive option. However, after the collapse of the Japanese equity market in 1989-90, the repayments had to be made in cash as the share prices were too low for converting the bonds. Regardless of this experience, many companies still found Eurobond market attractive well into the 1990s. This created considerable pressure on Japanese government to relax the regulations of new issues to attract Japanese issuers back to the home market. 5. Eurobonds Innovations Although Eurobond market is an unregulated market, it has been highly influenced by advances in the financial markets and continues to develop in response to demands of the investors. A Eurobond might be attractive to a borrower as it might offer a type of investment restricted in the home country of the investor. Again, the Eurobond may offer tax advantages to the investor which might not be offered by home investment schemes. Eurobonds have therefore, evolved into various types considering the requirements of the investors. Due to the open nature of the Eurobond market, new product innovation has been well developed. Smith (2003) points to the fact that the absence of regulations, lack of barriers to competition and the vast variety of both issuers and investors have made the Eurobond market a centre of innovations. Many popular ideas in other sectors have had their origin in the Eurobond market. Zero Coupon Bonds, the floating rate note, currency option bonds are some of the examples which have been copied elsewhere. The most common types of Eurobonds are the Straight Eurobonds, sometimes referred to as vanilla or plan vanilla Eurobond. These are fixed rate bonds with fixed redemptions. Choudhry (2001) points out that as the bonds are unsecured, they are dependent on the credit quality of the issuer to attract investors. He further mentions that Eurobonds have a typical maturity of five to ten years although many high quality corporations have been known to issue bonds with maturity of thirty years or even more. A differently designed Eurobonds are the Floating Rate Note (FRN). These were early innovations were the interest rate floats rather then being fixed. These are also of generally shorter maturity compared to straight Eurobonds. Floats are usually along the LIBOR (London Interbank Offering Rate) rate plus a certain percentage. Another type of Eurobonds is the Zero Coupon Bonds. These are also known as discount bond or deep discount bond. These bonds pay no interest but are bought at a price lower than its face value and are redeemed at face value on maturity. These are very popular bonds as they avoid some tax implications. Another example of a Eurobond is the Convertible Bond. These are obtained as bonds but may be converted into can be converted into shares of stock in the issuing company. There is usually a fixed conversion price. These generally offerer less interest as the company is providing the option of conversion which is an added benefit. A more riskier type of desing is the Dual Currency Bonds. These are bonds denominated in one currency, but pay interest in another currency at a fixed exchange rate. This puts the additional burden on both the issuer and the investor to foresee the future exchange rate. Asset-backed issues are another example of Eurobonds. Generally, interest on Eurobonds is dependent on the reputation of the issuer. Asset-backed issues however, have assets pledged as collateral in addition to the reputation of the issuer. 6. Conclusion Considering the fact that it has largely been an unregulated market, the evolution of Eurobond market is a phenomenal story. The market has brought together a very diverse range of high quality issuers from all over the world and has been result of various financial innovations which has been copied by other sectors. The US dollar has been the leading currency used in international trade and debt contracts avoiding challenges from other currencies but as euro becomes more and more popular, market activity in Europe has further expanded. Euro denominated Eurobonds are now widely issued by international institutions. The foundations of Eurobond market however, has been the restrictions and regulations present in the home market which prompted the issuers to investigate new ventures. However, there has been a substantial amount of deregulations in many countries in recent times owing to the pressure on local government officials to attract home issuers. Considering how established the Eurobond market is as of now, it is difficult to foresee what influence these deregulations will have on the future of the Eurobond. While some predict the ultimate demise of the market, many others believe there would be sufficient regulations in most countries for issuers to look for alternatives in Eurobond market. 7. References: Choudhry, M., (2001) Bond and Money Markets: Strategy, Trading, Analysis. Oxford: Elsevier Madura, J., (2006) International Corporate Finance. 8th Edition. London: Thomson South-Western Peristiani, S., (2007) 'Evaluating the Relative Strength of the U.S. Capital Markets.' Current Issues in Economics and Finance. 13 (9) [Online] Available from: http://www.newyorkfed.org/research/current_issues/ci13-6.pdf [Accessed on 12 March 2008] Smith, R.C., (2003) Global Banking. 2nd Edition. New York: Oxford University Press Inc. Read More