International Bonds

The international bond market has greatly expanded in recent years because of the readily available information provided over the Internet, and more deregulation in financial markets throughout the world. There is greater opportunity to not only diversify a portfolio, but to also earn higher yields. Furthermore, new financial instruments, such as interest rate swaps and currency swaps, allow issuers of bonds to take advantage of foreign markets, and to pay out lower rates than would otherwise be possible.

However, there are 2 additional risks in holding international bonds that are not found in domestic bonds: sovereign risk and foreign-exchange risk. Sovereign risk (synonyms: country risk, political risk) is the risk associated with the laws of the country, or to events that may occur there. Particular events that can hurt a bond are the restriction of the flow of capital, taxation, and the nationalization of the issuer. Foreign exchange risk is the possibility that the foreign currency will depreciate against the domestic currency. Currency exchange rates are changing all of the time, so if the bond currency depreciates against the investor's domestic currency during the term of the bond, then the investor will either lose money or not make as much profit.

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The world of bonds can be subdivided based on domicile of the issuer and the buyers, and currency denomination.

Domestic bonds are issued by a company or bank within a country, in the country's currency, and traded within the country, and are subject to that country's rules and regulations.

Foreign bonds are issued by a foreign entity, but are underwritten and sold in a domestic market.

Eurobonds are denominated in a particular currency, but are issued and sold outside of the jurisdiction of the country that issues that currency; hence, Eurobonds are not euro bonds. They are underwritten by an international syndicate to be sold primarily outside the domestic market, which does not necessarily include Europe, but usually does. For instance, samurai bonds are denominated in yen but sold outside of Japan; eurosterling bonds are denominated in sterling, but are sold outside of the United Kingdom; Eurodollar bonds pay in United States dollars (USD), but are issued and sold outside of the United States. Most Eurobonds are bearer bonds that pay an annual coupon, but they often have special characteristics to appeal to different markets, such as a floating-rate coupon rate. Most Eurobonds are traded over-the-counter, but some are traded on public exchanges located in London, Dublin, and Luxembourg in lot sizes of 1000, 5000, and 50,000 units of the underlying currency. Their primary advantages include, to the issuer, reduced regulation, which reduces costs, and a much larger market, and to bondholders, no withholding taxes on the interest payments and, since they are bearer bonds, bondholders can remain anonymous. Their main disadvantage is that they are illiquid.

Global bonds are underwritten by an international syndicate to be sold both domestically and internationally.

Another way to classify international bonds is whether they pay in USD or a foreign currency. U.S.-pay bonds are sensitive to interest rates in the United States, while foreign-pay bonds are sensitive to the interest rates of the currency's country of origin. With the exception of the emerging market debt, U.S.-pay bonds have a risk profile similar to domestic U.S. bonds. With foreign-pay bonds, however, the investor must consider currency exchange risk, trading hours and procedures, the laws of the country (for instance, what happens if a company goes bankrupt?), and especially taxation.

U.S.-Pay International Bonds

U.S.-pay bonds are bonds that are from issuers domiciled in other countries, but that are denominated and pay in USD. Foreign pay bonds pay in foreign currency, and so there is a foreign exchange risk with these bonds. If the dollar strengthens against the bond's currency, then the value of the bond will decline; but if the dollar declines, then the bond's value increases.

Yankee Bonds

Because the United States market is large and safe, many foreign companies and banks choose to issue bonds in this country to raise capital. Yankee bonds are issued in the United States by foreign companies and banks, but are underwritten by a United States syndicate, and are sold in the United States and pay interest semi-annually in U.S. dollars. They are also registered with the Securities and Exchange Commission (SEC), so they are much like domestic bonds. Many Yankee bonds are sovereign or sovereign-guaranteed issues, so they are of high credit quality. Supranational agencies and Canadian companies and agencies have been the major issuers of Yankee bonds. The size of the Yankee bond market increased substantially after the abolition of the interest equalization tax (effective 1963-1974), which taxed U.S. buyers of foreign securities.

Eurodollar Bonds

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Eurodollar bonds are usually issued, mostly by sovereigns, supranational agencies, such as the World Bank, corporations, and banks, outside of the United States, and are mostly traded in foreign markets, in the so-called Eurobond market—the major trading center is London. Eurodollar bonds are usually of high quality, many are sovereign or sovereign-guaranteed issues, but they are not registered with the SEC. Eurodollar bonds constitute most of the Eurobond market and are denominated in United States dollars. They are bearer bonds, which are unregistered—like cash, possessing them is owning them. They are underwritten by an international syndicate and marketed in many different countries.

Because they are not registered with the SEC, new issues cannot be sold in the United States. Thus, Eurodollar bonds can only be purchased in the secondary market after they have been seasoned—SEC Regulation S arbitrarily defines seasoned as a security that's been on the market for 40 days (recently reduced from 90 days).

The Euro medium-term note is similar to the Eurodollar bond, but is issued in different currencies and maturities under a single agreement.

Emerging Market Debt: Brady bonds and Aztec bonds

In the 1980's, Latin America was experiencing a debt crisis. Mexico suspended debt payments in 1982, and other Latin American countries soon followed. Because United States banks held much of the debt, various solutions were considered to restructure the debt.

Aztec bonds were issued by J.P. Morgan in February, 1988 to restructure Mexican debt. Shortly thereafter, Treasury Secretary Nicholas Brady initiated a similar plan, subsequently called the Brady Plan, to restructure the debt involving other banks and other countries that had defaulted on their bank loans. This restructuring involved agreements among the debtor countries and the lending banks, whereby the debtor country would issue bonds, subsequently called Brady bonds, in exchange for the debt obligation. Thus, the banks could trade their nonperforming loans for Brady bonds.

Most Brady bonds were denominated in United States dollars, although some were denominated in other currencies. The interest rate can be fixed, floating (usually a percentage above the LIBOR rate), or step-up (interest rate increases according to a schedule), and is paid semi-annually. To guarantee principal, most Brady bonds are collateralized with U.S. Treasury zero-coupon bonds, purchased by the creditor country, with a maturity date equal to the maturity date of the Brady bond, and held in escrow at the Federal Reserve, and also have a rolling interest guarantee, collateralized with cash or money market instruments, for 6, 12, 14, or 18 months of interest payments. However, not all Brady bonds were collateralized. The first Brady agreement was reached with Mexico and the bonds were first issued in March, 1990.

The Brady bond market is now the largest and most actively traded emerging market asset class. Although retail investors can buy Brady bonds, a round lot is $2,000,000.

Foreign-Pay International Bonds

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For a United States investor, foreign-pay international bonds are bonds that pay in any currency other than the United States dollar. Consequently, a major risk with these bonds is the foreign-exchange risk. And because information about issuers is usually less than for issuers domiciled in the United States, and because standards throughout the world are frequently lower than in the United States, these bonds are more volatile.

These bonds, like the U.S.-pay bonds, are classified according to the country of the issuer, the domain of the trading market, and the bond's currency.

One class of bonds is the foreign domestic bond, which are bonds issued in single countries other than the United States, trade within that country, and are denominated in that country's currency.

The foreign bond market involves bonds issued in 1 country and in that country's currency by a foreign issuer. For instance, the Yankee bond is a bond issued in the United States by a foreign issuer and denominated in USD. Other specific foreign bond markets are the Samurai market where bonds, issued by foreign issuers, in Japan and in Japanese yen are traded, and the Bulldog market, where bonds issued in Great Britain by foreign issuers are traded in the local market in British pounds.

Bonds issued in the international market in major currencies, but outside of the currency's domestic market, are called Eurobonds. Generally underwritten by international syndicates, these bonds are sold in a number of major markets concurrently. Most Eurobonds are denominated in Euros. Other major markets include the Eurodollar, Eurosterling, and Euroyen markets.