ANSWERS TO QUESTIONS FOR CHAPTER 9

(Questions are in bold print followed by answers.)

1. Describe the trading blocs that are used in classifying the world’s bonds markets.

The trading blocs used by practitioners to classify the world’s bond market in terms of trading bloc include the four classifications. They are: (i) the dollar bloc, (ii) the European bloc, (iii) the Japan bloc, and (iv) the emerging markets bloc. The trading bloc construct is useful because each bloc has a benchmark market that greatly influences price movements in the other markets. Investors are often focused more on the spread level of, say, Denmark to Germany, than the absolute level of yields in Denmark. More details on are given below.

The dollar bloc includes the United States, Canada, Australia, and New Zealand. The European bloc is subdivided into two groups: (i) the euro zone market bloc, which has a common currency (Germany, France, Holland, Belgium, Luxembourg, Austria, Italy, Spain, Finland, Portugal, and Greece), the euro, and (ii) the non-euro zone market bloc (Norway, Denmark, and Sweden). The United Kingdom often trades more on its own, influenced by the euro zone and the United States, as well as its own economic fundamentals. The emerging markets bloc includes Latin America, Asia (with the exception of Japan), and Eastern Europe.

2. 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 government’s 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 the U.S. life insurance company could not lock in the rising yield. Second, the U.S. company would only be able to invest in British government bonds on a regular basis. This might also be considered a disadvantage.

3. “The strongest argument for investing in nondollar bonds is that there are diversification benefits.” Explain why you agree or disagree with this statement.

There are mixed empirical findings for agreeing with the statement that diversification is the strongest argument for investing in nondollar bonds. The details are supplied below.

Several reasons have been offered for why U.S. investors should allocate a portion of their fixed income portfolio to nondollar bonds. First, there is a theoretical argument which states that diversifying bond investments across countries particularly with the currency hedged reduces risk. This is generally demonstrated using modern portfolio theory by showing that investors can realize a higher expected return for a given level of risk (as measured by the standard deviation of return) by adding nondollar bonds in a portfolio containing U.S. bonds. Second, researchers have offered evidence that diversification in nondollar bonds can lead to an optimal choice. However, this evidence comes from earlier studies in the 1980s and early 1990s. Recent research suggests that the reduction in risk may not be that great to offset lower portfolio returns.

There is another reason for investing in nondollar bonds that competes with diversification. For example, a study by Litterman (1992) suggests that while the diversification benefits may not be that great, a powerful reason for a U.S. investor to invest in nondollar bonds is “the increased opportunities to find value that multiple markets provide.” However, it is hard to quantify such a benefit because it depends on the investor’s talents. That is, nondollar bond investments with the currency hedged permits investment strategies based on interest rate changes in various countries. This provides additional dimensions to the actual investment decision or a broader range of investment choices. A final reason given for nondollar bond investing is that the decision not to hedge the currency component can then be regarded as an active currency play.

4. What arguments are offered for investing in nondollar bonds?

There are three reasons given for investing in nondollar bonds. These are described below.

A first reason for investing in nondollar bonds concerns the notion that diversification maximizes return for a given level of risk. Modern portfolio theory states that the most efficient portfolio, the market or world portfolio, contains all assets and is perfectly diversified. This portfolio is risky but generates the highest possible return for its risk level. If investors want to achieve higher returns they must invest in this portfolio. If their preference is to receive higher returns then they must allocate a portion of their total investments to purchasing this risky world portfolio, which includes nondollar bonds.

A second reason (offered for a U.S. investor to invest in nondollar bonds) is the increased opportunities to find value that multiple markets provide. The argument is that nondollar bond investments with the currency hedged permits investment strategies based on interest rate changes in various countries. This provides additional dimensions to the actual investment decision or a broader range of investment choices.

A third reason (given for nondollar bond investing) is to make what is referred to as an “active play.” This involves investing in nondollar bonds but also making a decision not to hedge the currency component.

5. What is the difference between LIBID and LIMEAN?

LIBID refers to the bid on LIBOR while LIMEAN is the arithmetic average of LIBOR and LIBID. More details are given below.

LIBOR stands for London interbank offer rate. LIBOR is an important rate in international finance. For example, consider the 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 6-month or 3-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.

6. What is the foreign bond market of a country?

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. In Japan, a yen-denominated bond issued by a British corporation and subsequently traded in Japan’s bond market is part of the Japanese foreign bond market. Yen-denominated bonds issued by non-Japanese entities are nicknamed Samurai bonds. Foreign bonds in the United Kingdom are referred to as bulldog bonds, in the Netherlands as Rembrandt bonds, and in Spain as matador bonds.

7. What is the debate regarding covenants in corporate bonds in the Eurobond market?

In 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.

For investment-grade corporate issues in the Eurobond market, documentation is somewhat standardized. Key terms and conditions in Eurobond documentation are: governing law, security, negative pledges, subordination, cross-default clauses, and prohibition on the sale of material assets. These items are described below.

Governing law: UK law governs most transactions, although New York state law is an occasional alternative.

Security: As a rule, issues are not secured by the company’s assets.

Negative pledges: Negative pledges are common. They prohibit an issuer from creating security interests on its assets, unless all bondholders receive the same level of security.

Subordination: Except for bank or insurance capital issues, most bonds are sold on a senior basis.

Cross-default clauses: Cross-default clauses state that if an issuer defaults on other borrowings, then the bonds will become due and payable.

Prohibition on the sale of material assets: In order to protect bondholders, most documentation prohibits the sale or transfer of material assets or subsidiaries.

8. Explain the step-up and step-down structure used in the Eurobond market.

The coupon rate of certain securities can either increase or “step up” over time or decrease or “step down” over time. The coupon rate change occurs for either the passage of time or a change in the reference interest rate might. A unique structure in the Eurobond market, particularly for large issues of telecom bonds, has been coupon step-up and step-down provisions where the change in the coupon is triggered by a change in the issuer’s credit rating. A rating upgrade would result in a lower coupon rate while a rating downgrade would result in a higher coupon rate.

9. Suppose that the yield to maturity on a Eurodollar bond is 7.8%. What is the bond-equivalent yield?

Because 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].

If the yield to maturity on a Eurodollar bond is 7.8%, then the bond-equivalent yield is:

2[(1.078)1/2 – 1] = 0.0765355 or about 7.6534%.

Notice that the bond-equivalent yield will always be less than the Eurodollar bond’s yield to maturity.

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.

For example, suppose that the yield to maturity of a U.S. bond issue quoted on a bond equivalent yield basis is 7.65355%.

The yield to maturity on an annual-pay basis would be:

[1 + (0.0765355 / 2] 2 – 1 = [1.0382678] 2 – 1 = 0.0780 = 7.80%.

The yield to maturity on an annual basis is always greater than the yield to maturity on a bond-equivalent basis.

10. This excerpt, which discusses dual currency bonds, is taken from the International Capital Market, published in 1989 by the European Investment Bank:

“The generic name of dual-currency bonds hides many different variations which are difficult to characterize in detail. These variations on the same basic concept have given birth to specific names like Index Currency Option Notes (ICON), foreign interest payment bonds (FIPS), forex-linked bonds, heaven and hell bonds, to name but a few. Despite this diversity it is, however, possible to attempt a broad-brush classification of the various types of dual-currency bonds.

The first category covers bond issues denominated in one currency but for which coupon and repayment of the principal are made in another designated currency at an exchange rate fixed at the time of issue. A second category comprises dual-currency bonds in which coupon payments and redemption proceeds are made in a currency different from the currency of denomination at the spot exchange rate that will prevail at the time of payment.

Within this category, one finds the forex-linked bonds, foreign currency bonds and heaven and hell bonds. A final category includes bonds which offer to issuers or the holder the choice of the currency in which payments and/or redemptions are to be made at the future spot exchange rate. ICONs fall into this latter category because there is an implicit option due to the exchange rate revision formula. Usually, these bonds are referred to as option currency bonds.

Irrespective of the above-mentioned categories, all dual-currency bonds expose the issuers and the holders to some form of foreign exchange risk. . . . Pricing dual-currency bonds is therefore an application of option pricing, as the bonds can be looked at as a combination of a straight bond and a currency option. The value of the straight bond component is obtained according to traditional fixed-rate bond valuation models. The pricing of the option component is, ex post, equal to the difference between the dual currency bond price and its straight bond component …”

(a) Why do all currency bonds “expose the issuers and the holders to some form of foreign exchange risk” regardless of the category of bond?

Foreign exchange risk refers to the risk associated with receiving cash flows in another country’s currency. From the perspective of the holder of a currency bond (the investor), the cash flows denominated in a foreign currency expose the investor to uncertainty as to the cash flow to be received in their country’s currency. This is because the cash flow they actually receive depends on the exchange rate between their country’s currency and the foreign currency received. If the foreign currency depreciates (declines in value) relative to their country’s currency, then they will receive proportionately less. From the issuer’s view, they are at risk since expected depreciation may make their bonds less marketable driving down the price.

Dual-currency issues are issues that pay coupon interest in one currency but pay the principal in a different currency. This can expose both the issuer and the holders to foreign exchange risk if both the cash flows paid (by the issuer) and the cash flows received (by the holder) are not known in advance. The exact exposure can depend on the type of dual-currency bond. For a first type of dual-currency bond, the exchange rate that is used to convert the principal and coupon payments into a specific currency is specified at the time the bond is issued. A second type differs from the first in that the applicable exchange rate is the rate that prevails at the time a cash flow is made (i.e., at the spot exchange rate at the time a payment is made). A third type is one that offers to either the investor or the issuer the choice of currency. These bonds are commonly referred to as option currency bonds.

(b) Do you agree that the pricing of all dual-currency bonds is an application of option pricing?

An option gives the holder the right to future claims conditioned upon contingent outcomes. To be an application of option pricing, an option must be present or embedded in the asset (in this case a dual-currency bond). As discussed in part (a), there are three types of dual-currency bonds. Only the third type is referred to with the description option (implying that a choice can be made that will give the holder the best outcome based upon what contingent outcomes actually unfold). For the first type of dual-currency bond, the exchange rate that is used to convert the principal and coupon payments into a specific currency is specified at the time the bond is issued. Thus, the future claim is already stated and is not contingent upon some other condition occurring. Similarly, the second type does not appear to have any future claim contingent upon some condition occurring.

(c) Why should the price of the option component be “equal to the difference between the dual currency bond price and its bond component”?

In a perfect capital market environment (with no transaction costs and other frictions), the value of an asset with an embedded option should be equal to the value of the asset without the option plus the value of the option. This is because investors should be indifferent as to how the two investments are packaged. They should pay equally for either (i) the bond with the embedded option packaged together or (ii) the bond and option packaged separately.

11. Answer the below questions.

(a) Why do rating agencies assign a different rating to the debt of a sovereign entity based on whether the debt is denominated in a local currency or a foreign currency?

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. For example, an S&P survey of 113 countries found that since 1970 there were eight defaults by sovereigns on their local currency debt but 69 on foreign currency 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. This is not the case with foreign currencydenominated debt. A national government must purchase foreign currency to meet a debt obligation in that foreign currency and therefore has less control with respect to its exchange rate. Thus a significant depreciation of the local currency relative to a foreign currency in which a debt obligation is denominated will impair a national government’s ability to satisfy such obligation.

(b) What are the two general categories of risk analyzed by rating agencies in assigning a sovereign rating?

Sovereign debt is the obligation of a country’s central government. The debt of national governments is rated by the rating agencies. There are two sovereign debt ratings assigned by rating agencies: a local currency debt rating and a foreign currency debt rating. Standard & Poor’s, Moody’s, and Fitch all assign ratings to sovereign bonds. The two general categories are economic risk and political risk.

The economic risk category involves an assessment of the ability of a government to satisfy its obligations. Both quantitative and qualitative analyses are used in assessing economic risk. The political risk category involves an assessment of the willingness of a government to satisfy its obligations. A government may have the ability to pay but may be unwilling to pay. Political risk is assessed based on qualitative analysis of the economic and political factors that influence a government’s economic policies.

12. What are the different methods for the issuance of government securities?

There 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). This auction method is a single-price auction.

In the ad hoc auction system, governments announce auctions when prevailing market conditions appear favorable. It is only at the time of the auction that the amount to be auctioned and the maturity of the security to be offered are announced.

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.

13. Answer the below questions.

(a) What are covered bonds?

One 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.” The cover pool is not static over the life of a covered bond. That is, the composition of the cover pool changes over time.

(b) How do covered bonds differ from residential mortgage-backed securities, commercial mortgage-backed securities, and asset-backed securities.

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. However, if subsequently the issuing bank becomes insolvent, then at that time, the assets included in the cover pool are separated from the issuing bank’s other assets for the benefit of the investors in the covered bonds. 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.

Covered bonds in many countries are created using the securitization process. For that reason, covered bonds are often compared to residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), and other asset-backed securities (ABS). 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). By doing so, the bank has removed the pool of loans from its balance sheet. The SPV is the issuer of the securities. In contrast, with covered bonds, the issuing bank holds the pool of loans on its balance sheet. It is only if the issuing bank becomes insolvent that the assets are segregated for the benefit of the investors in the covered bonds. 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. In contrast, covered bond investors have recourse to the issuing bank. 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.

(c) What is the Pfandbriefe market?

The 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. There are two types of Pfandbriefe that differ based on the borrowing entity for the loan. Public Pfandbriefe are bonds fully collateralized by loans to public-sector entities. When the bonds are fully collateralized byresidential and commercial mortgages, theyare called Mortgage Pfandbriefe.

The Pfandbriefe market is further divided into Traditional Pfandbriefe and Jumbo Pfandbriefe. The former represents the market for issues of smaller size. Historically, it has been an illiquid and fragmented market and, as a result, has not attracted much interest from non-German investors.

14. In the analysis of emerging market sovereign bonds, what is meant by structural factors?

In the analysis of emerging market sovereign bonds, factors structural factors involve an assessment of the country’s long-run health. Although not directly associated with the default of the sovereign entity, poor structural fundamentals provide guidance as to the likely development of economic problems. These factors include dependence on specific commodities to generate earnings from exports, indicators of economic well-being such as per capital income, and income distribution measures. Two macroeconomic measures used for gauging structural risks are the five-year average GDP per capital growth and inflation as measured by the average change year-over-year. The key in the analysis of structural factors is forecasting when the market will focus on them and, as a result, increase serviceability and solvency risks.

15. In the analysis of emerging market sovereign bonds, why is geopolitical significance important?

Traditionally, the term has applied primarily to the impact of geography on politics, but its usage has evolved over the past century to encompass wider connotations. The Free Dictionary defines geopolitics as “The study of the relationship among politics and geography, demography, and economics, especially with respect to the foreign policy of a nation.” When an emerging market country faces a major credit crisis, geopolitical significance becomes important. When a credit crisis occurs in an emerging market country that is perceived to have major global repercussions, industrialized countries and supranational agencies have stepped in to commit significant resources to prevent an economic collapse and political instability for that country. Therefore, geopolitical significance is an important political factor to consider.

16. What can one consider alleged corruption in a presidential election in an emerging market country or the change in finance minister in an emerging market country headline risk? (Headline risk was described in a prior chapter.)

Headline risk refers to the possibility that a news story will adversely affect a stock’s price. This type of risk can also impact the performance of the stock market as a whole. With respect to elections in an emerging market country, corruption factors to consider include the fairness of elections and the political opposition programs. An example of the immediate impact of these factors is provided by Loucks, Penicook, and Schillhorn. In the May 2000 presidential election in Peru, the incumbent, Alberto Fujimori, won the election. However, there were allegations of fraud. During the election period, the spread on Peruvian bonds increased by 200 basis points compared to the spread on a popular emerging bond market index. In early September 2000, it was found that Fujimori’s top security advisor had paid opposition members in congress to switch sides. Shortly thereafter, Fujimori called for new presidential and parliamentary elections and renounced his power. After a series of other scandals associated with the top security advisory, in June 2001 presidential runoffs were held, with one of the candidates being Alan Garcia, former president of Peru. During his administration, he pushed Peru into a debt crisis in 1987. Because of the uncertainty associated with his possible election to president, the spread on Peruvian bonds once again increased by 200 basis points relative to the same emerging bond market index.

17. On January 9, Reuters announced a US$2.6 billion bond offering by the Australia and New Zealand Banking Group. The following is reproduced from the announcement:

Issue: US$2.6 bln 144a reg S 2, 3-year

The offer comprised US$1.9 bln 3-year at 100bp/swap and US$700 mln 2-yr at 70bp/Libor.

Participants: (Before the offer was increased) 45 investors. For the 3-year tranche, 65% from North America, 10% from Europe, 20% Asia, 10% others. For the 2-year tranche: 40% from North America, 20% from Europe, 40% from Asia.

Describe this bond offering.

According to the Reuters announcement, an Australian and New Zealand Banking group is offering in US dollars, $2.6 billion in bonds. It is being offered under Rule 144A that provides a safe harbor from the registration requirements of the Securities Act of 1933 for certain private resale of restricted securities to qualified institutional buyers.

It can be noted that Rule 144A has become the principal safe harbor on which non-U.S. companies rely when accessing the U.S. capital markets.

It can be further noted that Regulation S is a “safe harbor” that defines when an offering of securities is deemed to be executed in another country and therefore not be subject to the registration requirement under section 5 of the 1933 Act. The regulation includes two safe harbor provisions: an issuer safe harbor and a resale safe harbor. In each case, the regulation demands that offers and sales of the securities be made outside the United States and that no offering participant (which includes the issuer, the banks assisting with the offer and their respective affiliates) engage in “directed selling efforts”. In the case of issuers for whose securities there is substantial U.S. market interest, the regulation also requires that no offers and sales be made to U.S. persons (including U.S. persons physically located outside the United States).

According to the Reuters announcement, the offer involves $1.9 billion in 3-year bonds with a 100 basis point swap and $0.6 billion in 2-year bonds at 70 basis points above LIBOR. A basis swap is a swap in which two streams of money market floating rates of two different currencies are exchanged. To further illustrate, a company lends money to individuals at a variable rate that is tied to the London Interbank Offer (LIBOR) rate but they borrow money based on the Treasury bill rate. This difference between the borrowing and lending rates (the spread) leads to interest-rate risk. By entering into a basis rate swap, where they exchange the T-bill rate for the LIBOR rate, they eliminate this interest-rate risk.