CHAPTER 5

GLOBAL BOND INVESTMENT

1. The global bond market
1.1 The overview
Debt certificates have been traded internationally for several centuries. The bond
market took place well before the start of any equity market.
The global bond market is divided into three broad groups: domestic bonds,
foreign bonds, and international bonds.
 Domestic bonds are issued locally by a domestic borrower and are usually
denominated in the local currency.
 Foreign bonds are issued on a local market by a foreign borrower and are
usually denominated in the local currency. Foreign bond issues and trading are
under the supervision of local market authorities.
 International bonds are underwritten by a multinational syndicate of banks and
are placed mainly in countries other than the one in whose currency the bond is
denominated. These bonds are not traded on a specific national bond market.
Domestic bonds make up the bulk of a national bond market. Different issuers
belong to different market segments: government, semigovernment, and
corporate.
Foreign bonds issued on national markets have existed for a long time. They
often have colorful names, such as Yankee bonds (in the United States), Samurai
bonds (in Japan), Rembrandt bonds (in the Netherlands), Matador bonds (in
Spain), Caravela bonds (in Portugal), or Bulldog bonds (in the United
Kingdom).
World Bond Market Size
The International bond market
The international bond market is an attractive one to the global investor. It avoids
most national regulations and constraints and provides sophisticated instruments
geared to various investment objectives.
In general, several points distinguish an international bond from a domestic
bond, and some can be spotted on the tombstone in Exhibit 3:
■ The underwriting syndicate is made up of banks from numerous countries.
■ U.S. commercial banks can participate, as well as U.S. investment banks. This
would not be the case for a domestic or foreign bond issued on the U.S. market.
■ Underwriting banks tend to use subsidiaries established in London or a
foreign country with a favorable tax situation. This can be easily recognized
by the label appearing at the end of the banks’ names listed on the tombstone:
Limited (Britain or a British Isle), SA (usually Luxembourg)
The Issuing Syndicate
The issue is organized by an international bank called the lead manager. This
bank invites several comanagers to form the management group (from 5 to 30
banks, usually). For large issues, there may be several lead managers.
The managers prepare the issue, set the final conditions of the bond, and select
the underwriters and selling group. One of the managers is appointed as the
principal paying agent and fiscal agent.
The Timetable of a New Issue
1.2 Major Differences among Bond Markets.
Types of Instruments
The international market’s major difference from domestic markets lies in its multicurrency
nature. Many international bonds are designed to have cash flows in different currencies.
Example 1: Swiss franc Japanese convertible bond
Japanese firms have frequently issued Swiss franc–denominated bonds convertible into
common shares of a Japanese company. This is a bond issued in Swiss francs, paying a
fixed coupon in Swiss francs, and repaid in Swiss francs. But the bond can also be
converted into shares of the Japanese issuing company.
The reasons the investors choose this Bond:
 A drop in the market interest rate on Swiss franc bonds (as on any straight Swiss franc
bond).
 A rise in the price of the company’s stock (because the bonds are convertible into stock).
 A rise in the yen relative to the franc (because the bond is convertible into a Japanese yen
asset).
•  Quotations, Day Count, and Frequency of Coupons

Quotation: Bonds are usually quoted on the basis of price plus accrued interest in
percentage of face value.
The full price P of a bond (expressed in the percentage of nominal value) is equal to the sum
of the quoted or clean price (Q = percentage of nominal value) plus accrued interest (AI =
percentage of nominal value).
P = Q + AI
AI = Coupon x

Example 2: Full price and clean price

The clean price of a Eurobond is quoted at Q = 95 percent. The annual coupon is 6 percent,
and we are exactly three months from the past coupon payment. What is the full price of the
bond?
P = Q + Accrued interest = 95% + 90/360 * 6% = 96.5%
Coupon Frequency and Day Count: Bonds differ internationally by the frequency
of their coupon payments and in the way accrued interest is calculated.
In the United States, straight bonds usually pay a semiannual coupon equal to half
of the annual coupon reported. The day-count method used in accrued interest rate
calculations for agency, municipal, corporate and foreign bonds assumes months of
30 days in a year of 360 days.
Canada and Japan use a day count based on the actual
number of days in a 365-day year (even in years of 366 days).
2. Bond valuation
2.1 Zero coupon Bond
 

Zero coupon Bond do not pay a coupon but only pay a cash flow at the maturity.
Yield to Maturity is the internal rate return of the bond.
Example 3: a bond that promises a payment of C1 = $100 one year from now, with a current
market value of P = $90.91, has a YTM given by
P = => 90.91= => YTM = 10%/year
We can use the following formula to compute the YTM of zero-coupon bonds maturing in t
years:
P=
Example: a two-year zero-coupon bond paying C2 = $100 two years from now and currently
selling at a price P = $81.16. Calculate the YTM of this zero coupon bond?
Notes:
The market yield and the bond price have the inverse relationship.
Yield Curves is the graph of YTMs on bonds with indentical characteristics but
different maturity.
 Group discussion

What is inverted yield curve? Why do stock invetors concern of inverted yield
curve of US treasury bonds?
2.2 Bond with coupon
Valuing a Bond with coupons: we will call C1, C2, . . ., Cn, the cash flows paid by the
bond at times 1, 2, to n. The last cash flow will generally include a coupon and the
principal reimbursement. We then have the pricing formula:

P: market price of the bond

ri: discount interest of year i.
Example: Calculate market price of a coupon bond with the following information

Year 1 2 3 4 5
Ci 50 50 50 50 150
ri 10% 11% 13% 9% 8%
2.2 Bond with coupon
Calculating yield to Maturity of a bond with coupons

Example 4: Calculate YTM of a coupon bond with Market price: P =500 USD.
Cash flow generated by this bond from year 1 to year 5 as following:

Year 1 2 3 4 5
Ci 50 50 60 60 560
•A  perpetual bond pays a coupon forever. If the coupon were fixed at C, the
bond could be valued as an annuity. The value of such an annuity, assuming a
market-required yield of r, is given by

To calculate to YTM of perpetual bond we must have coupon paid by the issuer
and the market price of the bond

P=
European versus U.S. YTM
In United States, the tradition is to calculate a YTM over a six-month period and
multiply it by 2 to report an annualized yield.
The method for computing an annualized semiannual yield r’ can be described by
the formula

where r’ is the U.S. yield, and the cash flow dates are still expressed in number of years
Example 5
Duration and Interest Rate Sensitivity
There is an inverse relationship between the price of a bond and
changes in interest rates.

D: duration of the bond

∆P/P: the change in price
∆r: the change in the interest rate.
Example 6: You hold a government bond with a duration of 10. Its
yield is 5 percent. You expect yields to move up by 10 basis points in
the next few minutes. Give a rough estimate of your expected return.
The return on a bond is equal to the yield over the holding period plus any capital
gain or losses due to movements in the market yield, Δ yield. Using the bond
return can be approximated as:
Return = Yield - D * (∆yield )
Over a short holding period, the risk-free rate is the short-term interest rate or
cash rate. Hence, the return on a bond investment can be expressed as the sum of
Over a short holding period, the risk-free rate is the short-term interest rate or
cash rate. Hence, the return on a bond investment can be expressed as the sum of:
■ The cash rate.
■ The spread of the bond yield over the cash rate.
■ The percentage capital gain/loss due to a movement in yield.

Return = Cash rate + (Yield - Cash rate) - D * (∆yield )

Example 7: You hold a government bond with a duration of 10. Its yield is 5
percent, although the cash (one-year) rate is 2 percent. You expect yields to move
up by10 basis points over the year.
Give a rough estimate of your expected return?
What is the risk premium on this bond?
Credit Spreads
Credit risk is an additional source of risk for corporate bonds. The yield required by the market
on a corporate issue is a function of the default risk of the bond: The greater the risk, the
higher the yield the borrower must pay. The quality spread for a specific bond captures three
components:
 An expected loss component. Investors expect that the bond will default with some
probability. To compensate for that expected loss, the issuer must pay a spread above the
default-free yield.
 A credit-risk premium. The investors require a risk premium to compensate for systematic
market risk.
 A liquidity premium.
Example 8: A one-year bond is issued by a corporation with a 1 percent probability of default
by year end. In case of default, the investor will recover nothing. The one-year yield for
default-free bonds is 5 percent.
What yield should berequired by investors on this corporate bond if they are risk-neutral?
What should the credit spread be?
Solution
Let’s call y the yield and m the credit spread, so that y = 5 percent + m
If the bond defaults (1% probability), the investor gets nothing in a year. In case of no default
(99% probability), the investor will get (100 + y) percent.
So, the yield should be set on the bond so that its expected payoff is equal to the expected
payoff on a risk-free bond (105%).
105 = 99% * (100 + y) + 1% * 0 => y = 6.06%
=> m =1.06%
3. Bond valuation with Multicurrency Approach
3.1 Implied Forward Exchange Rates and Break-Even Analysis in Bond valuation
A higher yield in one currency is often compensated for, ex post, by a depreciation in this
currency and, in turn, an offsetting currency loss on the bond. It is important to know how
much currency movement will compensate for the yield differential.
Let’s first consider a one-year bond with an interest rate r1 in domestic currency (e.g., U.S.
dollar) and r *1 in foreign currency (e.g., yen). The current exchange rate is S, expressed as the
foreign currency value of one unit of a domestic currency (e.g., 120 yen per dollar).
One year from now, the exchange rate must move to a level F1 in order to make the two
investments identical (i.e., have the same total return). We call F 1 the forward exchange rate. It
is expressed as follows
The implied offsetting currency depreciation is given by

Assume that the dollar one-year yield is r1 = 4.8 percent, the yen one-year yield is r *1 = 0.4
percent, and the current exchange rate is S = 120 yen per dollar. From the equation above we
see that the forward exchange rate should equal

which is an implied depreciation of 4.2 percent for the dollar. Thus, a 4.2 percent depreciation
of the dollar will exactly offset the yield advantage on the dollar bond relative to the yen bond.
This is the break-even exchange rate. If the dollar is above 114.96 in a year, a dollar bond will
have been a better investment; if it is below, a yen bond would have been a better investment.
For zero coupon bonds, the implied forward exchange rate for a t-year bond is
given by

Calculating the break even-point forward exchange rate provides investors with
a yardstick against which to measure their own foreign exchange forecasts. In
our hypothetical example, Japanese bond investments are clearly not attractive
if we expect a stable dollar relative to the yen
3.2 The Return and Risk on Foreign Bond Investments
The return from investing in a foreign bond has three components:
 During the investment period, the bondholder receives the foreign yield.
 A change in the foreign yield (Δ foreign yield) induces a percentage capital
gain/loss on the price of the bond.
 A currency movement induces a currency gain or loss on the position.
Return = Foreign yield - D * (∆ foreign yield) + Percentage currency movement
Example 8:
You are British and hold a U.S. Treasury bond with a full price of 100 and a duration of
10. Its yield is 5 percent. The next day, U.S. yields move up by 5 basis points and the
dollar depreciates by 1 percent relative to the British pound. Give a rough estimate of
your loss in British pounds.
The dollar price of the bond should drop by

There is also a loss of 1% in USD against GBP. So the total loss in pound is about 1.5%.
3.3 Currency-Hedging Strategies
Foreign investments can be hedged against currency risk by selling forward
currency contracts for an amount equal to the capital invested. Hence, the return
on the hedged bond will be. By arbitrage, the percentage difference (discount or
premium) of the forward rate with the current spot rate is equal to the interest
rate differential between the two currencies.
Example 9: You are British and hold a U.S. Treasury bond with a full price of 100 and
duration of 10. Its yield is 5 percent. The dollar cash rate is 2 percent, and the pound cash
rate is 3 percent. You expect U.S. yields to move up by 10 basis points over the year. Give
a rough estimate of your expected return if you decide to hedge the currency risk.
Solution
The expected return on the year is equal to the U.S. dollar expected return plus the cash
rate differential:
Expected return = 5% - (10 * 0.1) + 3% - 2% = 5%
The risk premium in pounds is equal to this expected return minus the British cash rate,
or 5 percent - 3 percent = 2 percent. It is also equal to the risk premium on the same U.S.
Treasury bond for a U.S. investor: expected return of 4 percent in dollars minus the U.S.
cash rate of 2 percent.
Hedging improves the expected return if you expect the dollar to appreciate by less than 1
percent. It also eliminates currency risk.
3.4 International Portfolio Strategies
International bond portfolio management includes several steps:
 Benchmark selection
 Bond market selection
 Sector selection/credit selection
 Currency management
 Duration/yield curve management
 Yield enhancement techniques
3.4.1 Benchmark Selection
The benchmark used is some bond index. Benchmarks selected are usually some of the widely
accepted bond indexes discussed.
3.4.2 Bond Market Selection
Managers will differ from national benchmark weights, and over- or underweight some markets based
on interest rate and currency forecasts.
The overweighting of a market is both a bet on changes in local market yields and a bet on the
currency. Such a decision must be based on sound economic analysis. Among economic fundamentals
that bond managers follow for each country, one can cite the following:
 Monetary and fiscal policy
 Public spending
 Current and forecasted public indebtedness
 Inflationary pressures
 Balance of payments
 International comparison of the real yields
 National productivity and competitiveness
 Cyclical factors
 Political factors
3.4.3 Sector Selection/Credit Selection
Within a given currency market there are also different segments grouping bonds issued by
different types of issuers. Prices on different segments of the same currency market are not
fully correlated. Besides the yield curve on government securities, different additional factors
affect prices on each segment. The yields on each segmentreflect a quality spread over
government bonds. The quality spread is influenced bycredit risk, liquidity, and possibly some
specific institutional and tax aspects. Hence,bond managers tend to over- or underweight
some segments based on their forecast of these factors.
3.4.4 Currency Management
The volatility of exchange rates tends to be higher than that of bond prices, so currency
management is an important component of active global bond management.
3.4.5 Duration/Yield Curve Management
In each currency market, the manager can adjust the duration of the portfolio
according to a forecast about changes in the level of interest rates and
deformations in the yield curve. The average duration in each market and
segment provides an estimate of the portfolio’s sensitivity to yield movements.
If an increase in yields is expected in one marketsegment, the manager can trade
bonds to reduce the duration of this segment.
Another alternative is to retain the same bonds but to reduce the interest rate
exposure through various derivatives, such as interest rate futures or swaps.
3.4.6 Yield Enhancement Techniques
 Valuation techniques are used to detect the cheapest bonds to buy
(undervalued) when the portfolio has to be rebalanced.
 Securities lending.
 Add securities with higher promised yield, because of the borrower’s credit
risk. Investors can also obtain higher yields by investing in emerging-country
bonds, for which the credit risk stems from the risk that a country will default
on its debt servicing.
4. Floating-Rate Notes and Structured Notes
4.1 Floating- Rate Notes (FRNs)
FRNs, or floaters, are a very active segment of the international bond market.
Major issuers of FRNs are financial institutions.
FRNs are generally indexed to the London interbank offer rate (LIBOR), which is the short-
term deposit rate on Eurocurrencies. This rate is called Euribor (Euro interbank offer rate)
for euros.
The coupon on Eurobond FRNs is generally reset every semester or every quarter.
The maturity of the LIBOR chosen as index usually matches the coupon period; for
example, FRNs with semiannual coupons are indexed on the six-month LIBOR.
The coupon to be paid the next period is then set equal to the LIBOR plus a spread that has
been fixed at the time of issue. In other words, the coupon C t that will be paid at time t is set
at time t - 1 (the previous coupon date) equal to the LIBOR rate it -1 plus a fixed spread m0.
All rates are annualized and quoted in percent. The spread is fixed when the
bond is issued and generally remains fixed for the maturity of the bond. For top-
quality issuers, the spread is very small, because some of them, such as banks,
can easily borrow in the Eurocurrency short-term deposit market at LIBOR.
4.1.1 Motivation
The motivation for an investor to buy FRNs is to avoid interest rate risk that
could lead to a capital loss in case of a rise in interest rates.
FRNs are generally issued by financial institutions with short-term lending
activities. These institutions wish to have long-term resources but want to index
the cost of their funds to their revenues. Because revenues on short-term loans
areindexed on LIBOR, FRNs achieve this objective.
4.1.2 Valuing FRNs
* The issuer have no default risk
-On Reset Date: The price of FRNs is equal to 100%.
-Between Reset Dates: Once the coupon is fixed on a reset date, the bond tends
to behave like a short-term fixed-coupon bond until the next reset date. FRN
prices are more volatile just after the reset date, because that is when they have
the longest fixed-coupon maturity. FRNs with a semiannual reset tend to be
more volatile than FRNs with quarterly reset dates, but both should have stable
prices on reset dates.
The period is chosen because 1979–1980 was a period of high and extremely volatile interest rates; nevertheless,
the FRN price is very close to 100 on reset dates (shown with dots on the graph)
Example 10: A company without default risk has issued a 10-year FRN at
LIBOR. The coupon is paid and reset semiannually. It is certain that the issuer
will never have default risk and will always be able to borrow at LIBOR. The
FRN is issued on November 1, 2007, when the six-month LIBOR is at 5 percent.
On May 1, 2008, the six-month LIBOR is at 5.5 percent.
1. What is the coupon paid on May 1, 2008, per $1,000 bond?
2. What is the new value of the coupon set on the bond?
3. On May 2, 2008, the six-month LIBOR has dropped to 5.4 percent. What
is the new value of the FRN?
The issuer have default risk
The market required spread at time t, mt, is likely to be different from that at time of issuance, m 0.
The market-required spread changes with the perception of credit risk.
Changes in the spread required by the market place explain these two observations.
The first observation can be explained by the fact that the default-risk premium tends to increase
with time to maturity. A 20-year loan to a corporation, rated A, seems more risky than a 3-month
loan to the same corporation.
The second observation can be explained by unexpected changes in the market required spread.
FRNs are “protected” against movements in LIBOR by their indexation clause, but they are
sensitive to variations in the required spread because they pay a spread that is fixed at issuance.
Hence, the coupon of an FRN is not fully indexed to the market-required yield, because the interest
rate component is indexed but the spread is fixed over the life of the bond. The coupon paid is
equal to LIBOR + m0, while the market requires LIBOR + mt. If the market required spread
changes over time, the FRN behaves partly like a fixed-coupon bond, precisely because of this
feature.
In fact, FRNs cannot be valued because their future cash flows are uncertain because LIBOR fluctuates
over time, and these uncertain cash flows cannot be discounted at risk-free interest rates. To evulate
FRNs we must assume that LIBOR will remain at its current value until maturity (“freezing”).
Example 11: A perpetual bond (pays a coupon forever) is issued by a corporation rated A with an annual
coupon set at yearly LIBOR plus a spread of 0.25 percent. Some time later, LIBOR is equal to 5 percent,
and the market requires a spread of 0.5 percent for such an A corporation. Give an estimate of the bond
value on the reset date using the “freezing” method.
Solution
If the coupon were fixed at C, the bond could be valued as an annuity. The value of such an annuity,
assuming a market-required yield of r, is given by

where C is the coupon rate and r is the current market-required rate. With the freezing method
 The coupon is supposed to be fixed at C = 5% + 0.25%, and
 The market-required yield is supposed to be fixed at r = 5% + 0.5%
So, the price of this perpetual FRNs is
Bull FRNs
Description Bull floating-rate notes (bull FRNs) are bonds that strongly benefit investors if
interest rates drop. Example is a reverse (inverse) floater, whereby the coupon is set at a fixed
rate minus LIBOR. Consider a five-year dollar FRN with a semiannual coupon set at 14
percent minus LIBOR. The coupon cannot be negative, so it has a minimum (floor) of 0
percent, which is attractive to investors if LIBOR moves over 14 percent. At the time the bond
was issued, the yield curve was around 7 percent.
Motivation Let’s consider an investor wishing to benefit markedly from a drop in market
interest rates (“bullish” on interest rates). He can buy a bull bond.
For a straight FRN, the coupon decreases if market interest rates drop and the bond price
remains stable.
For a straight (fixed-coupon) bond, the coupon remains fixed if market interest rates drop and
the bond price increases, so this is an attractive investment.
For a bull bond, the coupon increases if interest rates drop, and hence the bond price rises by
much more than for a straight bond with fixed coupon, which is very attractive.
Valuation Bull FRNs
We separate the cash flows of a bull bond in two different sets that can be easily priced.
The bull bond could be seen by investors as the sum of three plain-vanilla securities:
 Two straight bonds with a 7 percent coupon
 A short position in a plain-vanilla FRN at LIBOR flat
 A 14 percent cap option on LIBOR. A cap option pays the difference between LIBOR and
the strike of 14 percent, if LIBOR is above 14 percent on a coupon payment date. If
LIBOR goes above 14 percent, this cap is activated and offsets the potentially negative
coupon
Bear FRNs
Description Bear floating-rate notes (bear FRNs) are notes that benefit investors if interest
rates rise.
Example: a bear bond is a note with a coupon set at twice LIBOR minus 7 percent. Again, the
coupon has a floor of 0 percent, which is attractive to the investor if LIBOR goes below 3.5
percent.
Motivation: The coupon of the bear bond will increase rapidly with a rise in LIBOR. We
know that the price of a plain-vanilla FRN is stable, because its coupon increases parallel to
LIBOR. So, the price of a bear bond will rise, because its coupon increases twice as fast as
LIBOR.
Valuation Such a bond could be replicated by the investor as a portfolio long two plain-vanilla
FRNs and short one straight bond with a coupon of 7 percent11. Because the value of the
plain-vanilla FRNs should stay at par on reset dates, even if LIBOR moves, the net result is
that the portfolio should appreciate if market interest rates rise. In summary, this bear note
could be seen by investors as the sum of
 Two plain-vanilla FRNs at LIBOR flat.
 A short position in a straight bond (with a coupon of 7 percent), and
 Two 3.5 percent floor options on LIBOR
4.2 Dual-Currency Bonds
Description A dual-currency bond is a bond issued with coupons in one currency and
principal redemption in another.
Example: NKK, a Japanese corporation, issued a 10-year bond for 20 billion yen. During 10
years, it pays an annual coupon of 8 percent in yen, or 1.6 billion yen. Ten years later, it is
redeemed in USD.
Motivation:
All borrowers to issue any of these fancy bonds is to be able to end up borrowing money in
their desired currency but at a lower cost than directly issuing straight bonds in that currency.
Local investors (e.g., Japanese) are, in part, attracted to the issues by the opportunity for
limited currency speculation, only on the principal, that they provided. Those who invested
were betting on an appreciation of the dollar.
These bonds are attractive to Japanese institutional investors because they are considered yen
bonds for regulator y purposes,although they are dollar-linked.
The interest rate of dual- currency bond is usually higher than a straight bond in one currency.
Valuation
The value of a yen/dollar dual-currency bond can be broken down into two
parts, as follows:
 A stream of fixed coupon payments in yen: The current value of this stream of
cash flow is obtained by discounting at the yen yield curve.
 A dollar zero-coupon bond for the final dollar principal repayment: The
current value of this single cash flow is obtained by discounting at the dollar
yield of the appropriate maturity.
Example 12: Let’s consider the NKK bond described above. It promises annual
coupons of 8 percent on 20 billion yen and is redeemed in 10 years for $110.48
million. The current spot exchange rate is ¥181.02824 per dollar, so that $110.48
million is exactly equal to ¥20 billion. The yen yield curve is flat at 4 percent, and
the dollar yield curve is flat at 12 percent.
1. What is the theoretical value of this dual-currency bond?
2. If the coupon on the bond was set at fair market conditions, what should
be its exact value? (A bond is issued at fair market conditions if its coupon
is set such that the issue price is equal to its theoretical market value.)
1/ The NKK bond can be valued as the sum of a stream of yen cash flows and a zero-coupon
dollar bond. The present value of this dollar zero coupon bond is then translated into yen at the
current spot exchange rate. The total market value in billion yen is V:

The percentage price is obtained by dividing by the issue amount of 20 billion, obtaining a
price P of 97.0845 percent.
2/ To be issued at fair market conditions, the coupon rate should have been set at
x percent, such that