International Bond Market

Transcription

1 s and Institutions CHAPTER 12 International Bond CHAPTER OUTLINE The World s Bond s: A Statistical Perspective Foreign Bonds and Eurobonds Bearer Bonds and Registered Bonds National Security Regulations Withholding Taxes Other Recent Regulatory Changes Global Bonds Types of Instruments Straight Fixed-Rate Issues Euro-Medium-Term Notes Floating-Rate Notes Equity-Related Bonds Zero-Coupon Bonds Dual-Currency Bonds Currency Distribution, Nationality, and Type of Issuer International Bond Credit Ratings Eurobond Structure and Practices Primary Secondary Clearing Procedures International Bond Indexes Summary Key Words Questions Problems Internet Exercises MINI CASE: Sara Lee Corporation s Eurobonds References and Suggested Readings THIS CHAPTER CONTINUES the discussion of international capital markets and institutions, focusing on the international bond market. The chapter is designed to be useful for the financial officer of a MNC interested in sourcing new debt capital in the international bond market, as well as for the international investor interested in international fixed-income securities. The chapter opens with a brief statistical presentation showing the size of the world s bond markets and the major currencies in which bonds are denominated. The next section presents some useful definitions that describe exactly what is meant by the international bond market. The accompanying discussion elaborates on the features that distinguish these market segments and the various types of bond instruments traded in them. An examination of the currency distribution of the international bond market and the nationality and the type of borrower follows. Trading practices in the Eurobond market are discussed next. The chapter concludes with a discussion of international bond credit ratings and bond market indexes that are useful for performance analysis. The World s Bond s: A Statistical Perspective Exhibit 12.1 presents an overview of the world s bond markets. It shows the amounts of domestic and international bonds outstanding denominated in the major currencies. The exhibit shows that at year-end 2003 the face value of bonds outstanding in the world was approximately $51,395.8 billion. Domestic bonds account for the largest share of outstanding bonds, equaling $ 40,293.3 billion, or 78 percent, of the total. 293

2 s and Institutions 294 PART FOUR WORLD FINANCIAL MARKETS AND INSTITUTIONS EXHIBIT 12.1 Amounts of Domestic and International Bonds Outstanding (As of Year-End 2003 in Billions of U.S. Dollars) Currency Domestic Percent International Percent Total Percent U.S. dollar 17, , , Euro 8, , , Pound sterling 1, , Yen 8, , Other 4, , Total 40, , , Source: Derived from data in Tables 13B and 16A, pp. A87 and A92, respectively, in International Banking and Financial Developments, Bank for International Settlements, June Exhibit 12.1 shows that the U.S. dollar, the euro, the pound sterling, and the yen are the four currencies in which the majority of domestic and international bonds are denominated. Proportionately more domestic bonds than international bonds are denominated in the dollar (44.5 percent versus 40.5 percent) and the yen (20.2 percent versus 4.4 percent) while more international bonds than domestic bonds are denominated in the euro (43.5 percent versus 20.9 percent) and the pound sterling (7.0 percent versus 3.2 percent). Foreign Bonds and Eurobonds The international bond market encompasses two basic market segments: foreign bonds and Eurobonds. A foreign bond issue is one offered by a foreign borrower to the investors in a national capital market and denominated in that nation s currency. An example is a German MNC issuing dollar-denominated bonds to U.S. investors. A Eurobond issue is one denominated in a particular currency but sold to investors in national capital markets other than the country that issued the denominating currency. An example is a Dutch borrower issuing dollar-denominated bonds to investors in the U.K., Switzerland, and the Netherlands. The markets for foreign bonds and Eurobonds operate in parallel with the domestic national bond markets, and all three market groups compete with one another. 1 Exhibit 12.2 presents the year-end amounts of international bonds outstanding for 1999 through The exhibit classifies the amounts by type of issue. As the exhibit shows, the amounts of international bonds have increased steadily each year. At yearend 1999, $5,105.5 billion in bonds were outstanding; in 2003 the amount was $11,102.5 billion, a 117 percent increase. EXHIBIT 12.2 International Bond Amounts Outstanding Classified by Major Instruments (At Year-End in Billions of U.S. Dollars) Instrument Straight-fixed rate 3, , , , ,891.6 Floating-rate notes 1, , , , ,849.3 Convertible issues With equity warrants Total 5, , , , ,102.5 Source: Derived from International Banking and Financial Developments, Bank for International Settlements, Table 13B, p. 71, June 2000; p. A87, June 2002, 2003, In this chapter the terms market segment, market group, and market are used interchangeably when referring to the foreign bond and Eurobond divisions of the international bond market.

3 s and Institutions CHAPTER 12 INTERNATIONAL BOND MARKET 295 In any given year, roughly 80 percent of new international bonds are likely to be Eurobonds rather than foreign bonds. Eurobonds are known by the currency in which they are denominated, for example, U.S. dollar Eurobonds, yen Eurobonds, and Swiss franc Eurobonds, or, correspondingly, Eurodollar bonds, Euroyen bonds, and EuroSF bonds. Foreign bonds, on the other hand, frequently have colorful names that designate the country in which they are issued. For example, Yankee bonds are dollar-denominated foreign bonds originally sold to U.S. investors, Samurai bonds are yen-denominated foreign bonds sold in Japan, and Bulldogs are pound sterling denominated foreign bonds sold in the U.K. Bearer Bonds and Registered Bonds National Security Regulations Withholding Taxes Eurobonds are usually bearer bonds. With a bearer bond, possession is evidence of ownership. The issuer does not keep any records indicating who is the current owner of a bond. With registered bonds, the owner s name is on the bond and it is also recorded by the issuer, or else the owner s name is assigned to a bond serial number recorded by the issuer. When a registered bond is sold, a new bond certificate is issued with the new owner s name, or the new owner s name is assigned to the bond serial number. U.S. security regulations require Yankee bonds and U.S. corporate bonds sold to U.S. citizens to be registered. Bearer bonds are very attractive to investors desiring privacy and anonymity. One reason for this is that they enable tax evasion. Consequently, investors will generally accept a lower yield on bearer bonds than on registered bonds of comparable terms, making them a less costly source of funds for the issuer to service. Foreign bonds must meet the security regulations of the country in which they are issued. This means that publicly traded Yankee bonds must meet the same regulations as U.S. domestic bonds. The U.S. Securities Act of 1933 requires full disclosure of relevant information relating to a security issue. The U.S. Securities Exchange Act of 1934 established the Securities and Exchange Commission (SEC) to administer the 1933 Act. Securities sold in the United States to public investors must be registered with the SEC, and a prospectus disclosing detailed financial information about the issuer must be provided and made available to prospective investors. The expense of the registration process, the time delay it creates in bringing a new issue to market (four additional weeks), and the disclosure of information that many foreign borrowers consider private historically have made it more desirable for foreign borrowers to raise U.S. dollars in the Eurobond market. The shorter length of time in bringing a Eurodollar bond issue to market, coupled with the lower rate of interest that borrowers pay for Eurodollar bond financing in comparison to Yankee bond financing, are two major reasons why the Eurobond segment of the international bond market is roughly four times the size of the foreign bond segment. Because Eurobonds do not have to meet national security regulations, name recognition of the issuer is an extremely important factor in being able to source funds in the international capital market. Eurobonds sold in the United States may not be sold to U.S. citizens. To prevent this, the initial purchaser receives the bearer bond only after a 90-day waiting period and presentation of identification that one is not a U.S. citizen. Of course, nothing prevents a U.S. investor from repurchasing bearer bonds in the secondary market after 90 days. Prior to 1984, the United States required a 30 percent withholding tax on interest paid to nonresidents who held U.S. government or corporate bonds. Moreover, U.S. firms issuing Eurodollar bonds from the United States were required to withhold the tax on interest paid to foreigners. In 1984, the withholding tax law was repealed. Additionally, U.S. corporations were allowed to issue domestic bearer bonds to nonresidents, but Congress would not grant this privilege to the Treasury.

4 s and Institutions 296 PART FOUR WORLD FINANCIAL MARKETS AND INSTITUTIONS The repeal of the withholding tax law caused a substantial shift in the relative yields on U.S. government and Eurodollar bonds. Prior to 1984, top-quality Eurodollar bonds sold overseas traded at lower yields than U.S. Treasury bonds of similar maturities that were subject to the withholding tax. Afterwards the situation was reversed; foreign investors found the safety of registered U.S. Treasury bonds without the withholding tax more attractive than higher yields on corporate Eurodollar bond issues. Other Recent Regulatory Changes Two other recent changes in U.S. security regulations have had an effect on the international bond market. One is Rule 415, which the SEC instituted in 1982 to allow shelf registration. Shelf registration allows an issuer to preregister a securities issue, and then shelve the securities for later sale when financing is actually needed. Shelf registration has thus eliminated the time delay in bringing a foreign bond issue to market in the United States, but it has not eliminated the information disclosure that many foreign borrowers find too expensive and/or objectionable. In 1990, the SEC instituted Rule 144A, which allows qualified institutional investors in the United States to trade in private placement issues that do not have to meet the strict information disclosure requirements of publicly traded issues. Rule 144A was designed to make the U.S. capital markets more competitive with the Eurobond market. A large portion of the 144A market is composed of Yankee bonds. Global Bonds Global bond issues were first offered in A global bond issue is a very large international bond offering by a single borrower that is simultaneously sold in North America, Europe, and Asia. Global bonds denominated in U.S. dollars and issued by U.S. corporations trade as Eurobonds overseas and domestic bonds in the U.S. domestic market. Global bond offerings enlarge the borrower s opportunities for financing at reduced costs. Miller and Puthenpurackal (2002) document that U.S. issuers are able to borrow at 15 basis points lower using global bonds relative to domestic bonds, all other things being the same. Purchasers, mainly institutional investors to date, desire the increased liquidity of the issues and have been willing to accept lower yields. The largest corporate global bond issue to date is the $14.6 billion Deutsche Telekom multicurrency offering. The issue includes three U.S. dollar tranches with 5-, 10-, and 30-year maturities totaling $9.5 billion, two euro tranches with 5- and 10-year maturities totaling 3 billion, two British pound sterling tranches with 5- and 30-year maturities totaling 950 million, and one 5-year Japanese yen tranche of 90 billion. Another large global bond issue is the AT&T package of $2 billion of percent notes due 2004, $3 billion of percent notes due 2009, and $3 billion of percent notes due 2029 issued in March The Republic of Italy issued one of the largest sovereign global bond issues in September 1993, a package of $2 billion of percent notes due 2003 and $3.5 billion of percent debentures due One of the largest emerging markets global bond issues to date is the Republic of Korea package issued April 1998 of $1 billion of percent notes due 2003 and $3 billion of percent bonds due SEC Rule 415 and Rule 144A have likely facilitated global bond offerings, and more offerings in the future can be expected. Types of Instruments The international bond market has been much more innovative than the domestic bond market in the types of instruments offered to investors. In this section, we examine the major types of international bonds. We begin with a discussion of the more standard

5 s and Institutions CHAPTER 12 INTERNATIONAL BOND MARKET 297 types of instruments and conclude with the more exotic innovations that have appeared in recent years. Straight Fixed-Rate Issues Euro-Medium-Term Notes Floating-Rate Notes Straight fixed-rate bond issues have a designated maturity date at which the principal of the bond issue is promised to be repaid. During the life of the bond, fixed coupon payments, which are a percentage of the face value, are paid as interest to the bondholders. In contrast to many domestic bonds, which make semiannual coupon payments, coupon interest on Eurobonds is typically paid annually. The reason is that the Eurobonds are usually bearer bonds, and annual coupon redemption is more convenient for the bondholders and less costly for the bond issuer because the bondholders are scattered geographically. Exhibit 12.2 shows that the vast majority of new international bond offerings in any year are straight fixed-rate issues. The U.S. dollar, euro, British pound sterling, and Japanese yen have been the most common currencies denominating straight fixed-rate bonds in recent years. Euro-Medium-Term Notes (Euro MTNs) are (typically) fixed-rate notes issued by a corporation with maturities ranging from less than a year to about 10 years. Like fixedrate bonds, Euro-MTNs have a fixed maturity and pay coupon interest on periodic dates. Unlike a bond issue, in which the entire issue is brought to market at once, a Euro-MTN issue is partially sold on a continuous basis through an issuance facility that allows the borrower to obtain funds only as needed on a flexible basis. This feature is very attractive to issuers. Euro-MTNs have become a very popular means of raising medium-term funds since they were first introduced in All the statistical exhibits in this chapter include the amounts outstanding of MTNs. An example of straight-fixed rate bonds is the EUR 2,000,000 of 5.00 percent notes due in 2008, issued in March 1998 by the European Investment Bank. The first floating-rate notes were introduced in Floating-rate notes (FRNs) are typically medium-term bonds with coupon payments indexed to some reference rate. Common reference rates are either three-month or six-month U.S. dollar LIBOR. Coupon payments on FRNs are usually quarterly or semiannual and in accord with the reference rate. For example, consider a five-year FRN with coupons referenced to sixmonth dollar LIBOR paying coupon interest semiannually. At the beginning of every six-month period, the next semiannual coupon payment is reset to be.5 (LIBOR X percent) of face value, where X represents the default risk premium above LIBOR the issuer must pay based on its creditworthiness. The premium is typically no larger than 1/8 percent for top-quality issuers. As an example, if X equals 1/8 percent and the current six-month LIBOR is 6.6 percent, the next period s coupon rate on a $1,000 face value FRN will be.5 ( ) $1,000 $ If on the next reset date six-month LIBOR is 5.7 percent, the following semiannual coupon will be set at $ Obviously, FRNs behave differently in response to interest rate risk than straight fixed-rate bonds. All bonds experience an inverse price change when the market rate of interest changes. Accordingly, the price of straight fixed-rate bonds may vary significantly if interest rates are extremely volatile. FRNs, on the other hand, experience only mild price changes between reset dates, over which time the next period s coupon payment is fixed (assuming, of course, that the reference rate corresponds to the market rate applicable to the issuer). On the reset date, the market price will gravitate back close to par value when the next period s coupon payment is reset to the new market value of the reference rate, and subsequent coupon payments are repriced to market expectations of future values of the reference rate. (The actual FRN market price may deviate somewhat from exact par value because the default risk premium portion of the coupon payment is fixed at inception, whereas the credit quality of the borrower may change through time.) FRNs make attractive investments for investors with a strong

6 s and Institutions 298 PART FOUR WORLD FINANCIAL MARKETS AND INSTITUTIONS need to preserve the principal value of the investment should they need to liquidate the investment prior to the maturity of the bonds. Exhibit 12.2 shows that FRNs are the second most common type of international bond issue. The euro and the U.S. dollar are the two currencies denominating most outstanding FRNs. As an example of FRNs, in February 2002 the National Bank of Kuwait issued at par $450,000,000 of FRNs due 2005 indexed to 3-month LIBOR plus 25 basis points. Equity-Related Bonds Zero-Coupon Bonds Dual-Currency Bonds There are two types of equity-related bonds: convertible bonds and bonds with equity warrants. A convertible bond issue allows the investor to exchange the bond for a predetermined number of equity shares of the issuer. The floor-value of a convertible bond is its straight fixed-rate bond value. Convertibles usually sell at a premium above the larger of their straight debt value and their conversion value. Additionally, investors are usually willing to accept a lower coupon rate of interest than the comparable straight fixed coupon bond rate because they find the conversion feature attractive. Bonds with equity warrants can be viewed as straight fixed-rate bonds with the addition of a call option (or warrant) feature. The warrant entitles the bondholder to purchase a certain number of equity shares in the issuer at a prestated price over a predetermined period of time. Zero-coupon bonds are sold at a discount from face value and do not pay any coupon interest over their life. At maturity the investor receives the full face value. Alternatively, some zero-coupon bonds originally sell for face value and at maturity the investor receives an amount in excess of face value to compensate the investor for the use of the money, but this is really nothing more than a semantic difference as to what constitutes face value. Zero-coupon bonds have been denominated primarily in the U.S. dollar and the Swiss franc. Japanese investors are particularly attracted to zero-coupon bonds because their tax law treats the difference between face value and the discounted purchase price of the bond as a tax-free capital gain, whereas coupon interest is taxable. More generally, zero-coupon bonds are attractive to investors who desire to avoid the reinvestment risk of coupon receipts at possibly lower interest rates. Examples of zero-coupon bond issues are the DM300,000,000 due in 1995 at 50 percent of face value and DM300,000,000 due in 2000 at percent of face value, issued in 1985 by Commerzbank Overseas Finance B. V., chartered in the Netherlands Antilles. Another form of zero-coupon bonds are stripped bonds. A stripped bond is a zerocoupon bond that results from stripping the coupons and principal from a coupon bond. The result is a series of zero-coupon bonds represented by the individual coupon and principal payments. This practice began in the early 1980s when several investment banks created stripped bonds to satisfy the demand for zero-coupon U.S. Treasury securities with various maturity dates. For example, Salomon Brothers offered CATS, which is an acronym for Certificates of Accrual for Treasury Securities. The stripped bonds are actually receipts representing a portion of the Treasury security held in trust. In 1985, the U.S. Treasury introduced its own product called STRIPS, for Separate Trading of Registered Interest and Principal of Securities. Investment firms are allowed under Treasury regulations to sell the stripped bonds in bearer form to non- U.S. citizens, but, as previously mentioned, the Treasury does not have this privilege. Nevertheless, the Treasury s STRIPS dominate the stripped-bond market. Dual-currency bonds became popular in the mid-1980s. A dual-currency bond is a straight fixed-rate bond issued in one currency, say, Swiss francs, that pays coupon interest in that same currency. At maturity, the principal is repaid in another currency, say, U.S. dollars. Coupon interest is frequently at a higher rate than comparable straight fixed-rate bonds. The amount of the dollar principal repayment at maturity is set at inception; frequently, the amount allows for some appreciation in the exchange rate of

7 s and Institutions CHAPTER 12 INTERNATIONAL BOND MARKET 299 EXHIBIT 12.3 Typical Characteristics of International Bond Instruments Frequency Size of of Interest Coupon Instrument Payment Payment Payoff at Maturity Straight fixed-rate Annual Fixed Currency of issue Floating-rate note Quarterly or Variable Currency of issue semiannual Convertible bond Annual Fixed Currency of issue or conversion to equity shares Straight fixed-rate with Annual Fixed Currency of issue plus equity warrants equity shares from exercised warrants Zero-coupon bond None Zero Currency of issue Dual-currency bond Annual Fixed Dual currency the stronger currency. From the investor s perspective, a dual-currency bond includes a long-term forward contract. If the dollar appreciates over the life of the bond, the principal repayment will be worth more than a return of principal in Swiss francs. The market value of a dual-currency bond in Swiss francs should equal the sum of the present value of the Swiss franc coupon stream discounted at the Swiss market rate of interest plus the dollar principal repayment, converted to Swiss francs at the expected future exchange rate, and discounted at the Swiss market rate of interest. Japanese firms have been large issuers of dual currency bonds. These bonds were issued and pay coupon interest in yen with the principal reimbursement in U.S. dollars. Yen/dollar dual currency bonds could be an attractive financing method for Japanese MNCs desiring to establish or expand U.S. subsidiaries. The yen proceeds can be converted to dollars to finance the capital investment in the United States, and during the early years the coupon payments can be made by the parent firm in yen. At maturity, the dollar principal repayment can be made from dollar profits earned by the subsidiary. Exhibit 12.3 summarizes the typical characteristics of the international bond market instruments discussed in this section. Currency Distribution, Nationality, and Type of Issuer Exhibit 12.4 provides the distribution of the amounts of international bonds outstanding by currency for 1999 through The exhibit shows that the U.S. dollar, euro, yen, British pound sterling, Swiss franc, and Canadian dollar have been the most frequently used currencies to denominate issues. EXHIBIT 12.4 Currency Distribution of International Bond Amounts Outstanding (At Year-End in Billions of U.S. Dollars) Currency U.S. dollar 2, , , , ,492.5 Euro 1, , , , ,834.5 Yen Pound sterling Swiss franc Canadian dollar Other Total 5, , , , ,102.5 Source: Derived from International Banking and Financial Developments, Bank for International Settlements, Table 13B, p. 71, June 2000; p. A87, June 2002, 2003, 2004.

8 s and Institutions 300 PART FOUR WORLD FINANCIAL MARKETS AND INSTITUTIONS EXHIBIT 12.5 International Bond Amounts Outstanding Classified by Nationality and Type of Issuer (At Year-End in Billions of U.S. Dollars) Nationality Australia Canada France Germany , ,810.3 Italy Japan Netherlands United Kingdom ,032.1 United States 1, , , , ,011.8 Other developed countries , ,559.0 Off-shore centers Developing countries International institutions Total 5, , , , ,102.5 Type Financial institutions 2, , , , ,032.5 Governments a 1, , ,122.3 International institutions Corporate issuers 1, , , ,446.6 Total 5, , , , ,102.5 a Includes central banks and state and local governments. Source: Derived from International Banking and Financial Developments, Bank for International Settlements, Table 13B and 15B, pp. 71 and 75, June 2000; pp. A87 and A91, June 2002, 2003, Exhibit 12.5 is divided into two panels that show the nationality and type of issuer of international bonds. The top panel indicates that the United States, Germany, the United Kingdom, France, and the Netherlands have been major issuers of international bonds during the past several years. In terms of type of issuer, the bottom panel of Exhibit 12.5 shows that financial institutions and governments have been the largest issuers of international bonds in recent years. The International Finance in Practice box, Heineken Refreshes Euromarket with Spectacular Unrated Bonds, discusses a Eurobond offering issued by Heineken. International Bond Credit Ratings This is the website of Fitch Ratings, an international bond rating service. Information about Fitch and its philosophy can be found here. This is the website of Moody s Investors Service. Information about the investment services that Moody s provides and their bond ratings can be found here. Fitch Ratings, Moody s Investors Service, and Standard & Poor s (S&P) have for years provided credit ratings on domestic and international bonds and their issuers. These three credit-rating organizations classify bond issues into categories based upon the creditworthiness of the borrower. The ratings are based on an analysis of current information regarding the likelihood of default and the specifics of the debt obligation. The ratings both reflect creditworthiness and exchange rate uncertainty. Moody s rates bond issues (and issuers) into nine categories, from Aaa, Aa, A, Baa, and Ba down to C. Ratings of Aaa to Baa are known as investment grade ratings. These issues are judged not to have any speculative elements; interest payments and principal safety appear adequate at present. The future prospects of lower-rated issues cannot be considered as well assured. Within categories Aa through Caa, Moody s has three numeric modifiers, 1, 2, or 3, to place an issue, respectively, at the upper, middle, or lower end of the category.

9 s and Institutions INTERNATIONAL FINANCE IN PRACTICE Heineken Refreshes Euromarket with Spectacular Unrated Bonds Heineken launched the euro market s largest unrated bond this week with a spectacular two tranche Eu1.1bn debut transaction. The deal, in 6- and 10-year tranches, was more than four times oversubscribed and priced well inside price guidance. Heineken s success demonstrates the depth of demand for unrated credits in the Eurobond market, despite the growing prevalence of ratings and well publicized investor calls for borrowers to have at least two ratings. The major factor in Heineken s favour was the global reach of its brand the brewer has operations in over 170 countries. The 10 year bond the first from an unrated corporate was five times oversubscribed, enabling bookrunners Barclays Capital, Citigroup, Credit Suisse First Boston and JP Morgan to increase it from Eu500m to Eu600m. There was no clear guidance in the market about what we could achieve for Heineken or where they could be positioned as a credit we had to convince people, said Chris Tuffey, head of corporate syndicate at CSFB in London. Unrated issues are typically tough to sell investors on, but the Heineken transaction was exactly the opposite both tranches were heavily oversubscribed. Although the lead managers looked at brand names such as Louis Vuitton Moet Hennessy, McDonald s and Carlsberg in pricing the transaction, the price was decided by investors perception of the credit. Heineken was priced as a single-a credit, although it paid a small premium for the absence of a rating. Rene Hooft Graafland, a member of Heineken s executive board, said the Heineken family retains a controlling interest in the company and maintains a very conservative approach in running it. He said the diversity of the company s cashflows and profit sources made Heineken an attractive credit. Explaining why Heineken is not rated, Hooft Graafland said the bond was a one-off issue to partially finance the Eu1.9bn acquisition of Brau-Beteiligung AG, Austria s largest brewer, which was completed on October 15. Heineken does not intend to become a regular bond issuer. The decision not to obtain a rating was not taken lightly but there were clear indications that there was demand among investors for the Heineken name on an unrated basis, said Hooft Graafland. The Heineken business model is relatively straightforward and there is high transparency in the way the company is run. The acquisition of BBAG makes Heineken the leading regional player in central eastern Europe, with a market share of 27%. Besides its lack of a rating, investors were concerned by the level of subsidiary indebtedness and the possibility that the new bonds would be subordinated to the company s outstanding debt. Both issues were tackled by management on the five-day roadshow and successfully so, judging by the level of oversubscription. The reason that Heineken s previous debt had been concentrated in the operating subsidiaries rather than the holding company was simply that it was more cost effective under Dutch tax law, which has changed in the last month. However, we made it clear that the debt level is modest and is historically concentrated in the three big operating companies, said Hooft Graafland. In addition to the standard covenant package, the bond has a covenant that limits the level of subsidiary indebtedness at 35% of the total consolidated group assets. The main buyers of the 2010s were investors in Switzerland taking 25%, the UK with 22%, and France and the Benelux each with 17%. There was a large retail bid for the shorter maturity at 38%, while fund managers and insurance companies took 32% and 26% respectively. UK investors were by far the largest players in the 2013s, accounting for 36%, followed by French accounts with 14%, while Switzerland and Austria each took 10%. Fund managers predominated by taking 39% of the book, the retail bid was strong at 31%, and insurance companies followed closely with 28%. Source: Excerpted from Euroweek. London: Oct 26, 2003, p. 1 This is the website of Standard & Poor s, a provider of investment information, such as bond ratings. Information about S&P can be found here. Standard & Poor s rates bond issues (and issuers) into 10 categories. For bond issuers, the categories are AAA, AA, A, BBB, and BB down to CC and R, SD, and D. Categories AAA to BBB are investment grade ratings. An obligor rated R is under regulatory supervision owing to its financial condition. An obligor rated SD on D has failed to pay one or more of its financial obligations when due. Ratings for Categories AA to CCC may be modified with a plus ( ) or minus ( ) to reflect the relative standing of an issue to others in the category. Fitch uses ratings symbols and definitions similar to S&P s. It has been noted that a disproportionate share of Eurobonds have high credit ratings in comparison to domestic and foreign bonds. For example, Claes, DeCeuster, 301

10 s and Institutions EXHIBIT 12.6 A Standard & Poor s Issuer Credit Rating is a current opinion of an obligor s overall financial capacity (its creditworthiness) to pay its financial obligations. This opinion focuses on the obligor s capacity and willingness to meet its financial commitments as they come due. It does not apply to any specific financial obligation, as it does not take into account the nature of and provisions of the obligation, its standing in bankruptcy or liquidation, statutory preferences, or the legality and enforceability of the obligation. In addition, it does not take into account the creditworthiness of the guarantors, insurers, or other forms of credit enhancement on the obligation. The Issuer Credit Rating is not a recommendation to purchase, sell, or hold a financial obligation issued by an obligor, as it does not comment on market price or suitability for a particular investor. Counterparty Credit Ratings, ratings assigned under the Corporate Credit Rating Service (formerly called the Credit Assessment Service) and Sovereign Credit Ratings are all forms of Issuer Credit Ratings. Issuer Credit Ratings are based on current information furnished by obligors or obtained by Standard & Poor s from other sources it considers reliable. Standard & Poor s does not perform an audit in connection with any Issuer Credit Rating and may, on occasion, rely on unaudited financial information. Issuer Credit Ratings may be changed, suspended, or withdrawn as a result of changes in, or unavailability of, such information, or based on other circumstances. Issuer Credit Ratings can be either long-term or short-term. Short-Term Issuer Credit Ratings reflect the obligor s creditworthiness over a short-term time horizon. Long-Term Issuer Credit Ratings AAA An obligor rated AAA has EXTREMELY STRONG capacity to meet its financial commitments. AAA is the highest Issuer Credit Rating assigned by Standard & Poor s. AA An obligor rated AA has VERY STRONG capacity to meet its financial commitments. It differs from the highest rated obligors only in small degree. A An obligor rated A has STRONG capacity to meet its financial commitments but is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories. BBB An obligor rated BBB has ADEQUATE capacity to meet its financial commitments. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitments. Obligors rated BB, B, CCC, and CC are regarded as having significant speculative characteristics. BB indicates the least degree of speculation and CC the highest. While such obligors will likely have some quality and protective characteristics, these may be outweighed by large uncertainties or major exposures to adverse conditions. BB An obligor rated BB is LESS VULNERABLE in the near term than other lower-rated obligors. S&P Long-Term Issuer Credit Ratings Definitions However, it faces major ongoing uncertainties and exposure to adverse business, financial, or economic conditions which could lead to the obligor s inadequate capacity to meet its financial commitments. B An obligor rated B is MORE VULNERABLE than the obligors rated BB, but the obligor currently has the capacity to meet its financial commitments. Adverse business, financial, or economic conditions will likely impair the obligor s capacity or willingness to meet its financial commitments. CCC An obligor rated CCC is CURRENTLY VUL- NERABLE, and is dependent upon favorable business, financial, and economic conditions to meet its financial commitments. CC An obligor rated CC is CURRENTLY HIGHLY- VULNERABLE. Plus ( ) or minus ( ) The ratings from AA to CCC may be modified by the addition of a plus or minus sign to show relative standing within the major rating categories. R An obligor rated R is under regulatory supervision owing to its financial condition. During the pendency of the regulatory supervision the regulators may have the power to favor one class of obligations over others or pay some obligations and not others. Please see Standard & Poor s issue credit ratings for a more detailed description of the effects of regulatory supervision on specific issues or classes of obligations. SD and D An obligor rated SD (Selective Default) or D has failed to pay one or more of its financial obligations (rated or unrated) when it came due. A D rating is assigned when Standard & Poor s believes that the default will be a general default and that the obligor will fail to pay all or substantially all of its obligations as they come due. An SD rating is assigned when Standard & Poor s believes that the obligor has selectively defaulted on a specific issue or class of obligations but it will continue to meet its payment obligations on other issues or classes of obligations in a timely manner. Please see Standard & Poor s issue credit ratings for a more detailed description of the effects of a default on specific issues or classes of obligations. N.R. An issuer designated N.R. is not rated. Local Currency And Foreign Currency Risks Country risk considerations are a standard part of Standard & Poor s analysis for credit ratings on any issuer or issue. Currency of repayment is a key factor in this analysis. An obligor s capacity to repay Foreign Currency obligations may be lower than its capacity to repay obligations in its local currency due to the sovereign government s own relatively lower capacity to repay external versus domestic debt. These sovereign risk considerations are incorporated in the debt ratings assigned to specific issues. Foreign Currency issuer ratings are also distinguished from local currency issuer ratings to identify those instances where sovereign risks make them different for the same issuer. Source: May 17, Reproduced with permission of Standard & Poor s, a division of The McGraw-Hill Companies, Inc. 302

11 s and Institutions CHAPTER 12 INTERNATIONAL BOND MARKET 303 and Polfliet (2002) report that approximately 40 percent of Eurobond issues are rated AAA and 30 percent are AA. One explanation is that the issuers receiving low credit ratings invoke their publication rights and have had them withdrawn prior to dissemination. Kim and Stulz (1988) suggest another explanation that we believe is more likely. That is, the Eurobond market is accessible only to firms that have good credit ratings and name recognition to begin with; hence, they are rated highly. Regardless, it is beneficial to know about the ratings Fitch, Moody s, and S&P assign to international bond issues. Gande and Parsley (2005) study cross-border financial market linkages by examining changes in foreign U.S. dollar denominated sovereign debt yield spreads (i.e., sovereign yield above comparable U.S. Treasury yield) associated with ratings events abroad. They find an asymmetrical relationship. They find that positive ratings events in one country have no impact on sovereign spreads in other countries; however, negative ratings events are associated with a significant increase in spreads. On average, a one-notch downgrade of a sovereign bond is associated with a 12 basis point increase in spreads of sovereign bonds of other countries. They attribute the spillover among countries to highly positively correlated capital and trade flows. Exhibit 12.6 presents a guide to S&P s Long-Term Issuer Credit Ratings for sovereigns, municipalities, corporations, utilities, and supranationals. As noted in Exhibit 12.5, sovereigns issue a sizable portion of all international bonds. In rating a sovereign government, S&P s analysis centers around an examination of ten factors profiled in Exhibit The rating assigned to a sovereign is particularly important because it usually represents the ceiling for ratings S&P will assign to an obligation of an entity domiciled within that country. Eurobond Structure and Practices Given that in any year the Eurobond segment of the international bond market accounts for approximately 80 percent of new offerings, it is beneficial to know something about the Eurobond market structure and practices. Primary A borrower desiring to raise funds by issuing Eurobonds to the investing public will contact an investment banker and ask it to serve as the lead manager of an underwriting syndicate that will bring the bonds to market. The underwriting syndicate is a group of investment banks, merchant banks, and the merchant banking arms of commercial banks that specialize in some phase of a public issuance. The lead manager will sometimes invite comanagers to form a managing group to help negotiate terms with the borrower, ascertain market conditions, and manage the issuance. Exhibit 12.8 provides the 2003 and 2004 rankings for the top debt arrangers (underwriters) of international bonds and medium-term notes. Separate rankings are provided for the top underwriters of straight bonds and FRNs denominated in the dollars and the euro. The managing group, along with other banks, will serve as underwriters for the issue, that is, they will commit their own capital to buy the issue from the borrower at a discount from the issue price. The discount, or underwriting spread, is typically in the 2 to 2.5 percent range. By comparison, the spread averages about 1 percent for domestic issues. Most of the underwriters, along with other banks, will be part of a selling group that sells the bonds to the investing public. The various members of the underwriting syndicate receive a portion of the spread, depending on the number and type of functions they perform. The lead manager will obviously receive the full spread, but a bank serving as only a member of the selling group will receive a smaller portion. The total elapsed time from the decision date of the borrower to issue Eurobonds until the net proceeds from the sale are received is typically five to six

12 s and Institutions 304 PART FOUR WORLD FINANCIAL MARKETS AND INSTITUTIONS EXHIBIT 12.7 Standard and Poor s Sovereign Ratings Methodology Profile Political Risk Stability and legitimacy of political institutions Popular participation in political processes Orderliness of leadership succession Transparency in economic policy decisions and objectives Public security Geopolitical risk Income and Economic Structure Prosperity, diversity, and degree to which economy is market-oriented Income disparities Effectiveness of financial sector in intermediating funds; availability of credit Competitiveness and profitability of nonfinancial private sector Efficiency of public sector Protectionism and other nonmarket influences Labor flexibility Economic Growth Prospects Size and composition of savings and investment Rate and pattern of economic growth Fiscal Flexibility General government revenue, expenditure, and surplus/deficit trends Revenue-raising flexibility and efficiency Expenditure effectiveness and pressures Timeliness, coverage, and transparency in reporting Pension obligations General Government Debt Burden General government gross and net (of assets) debt as a percent of GDP Share of revenue devoted to interest Currency composition and maturity profile Depth and breadth of local capital markets Offshore and Contingent Liabilities Size and health of nonfinancial public-sector enterprises Robustness of financial sector Monetary Flexibility Price behavior in economic cycles Money and credit expansion Compatibility of exchange-rate regime and monetary goals Institutional factors such as central bank independence Range and efficiency of monetary policy tools External Liquidity Impact of fiscal and monetary policies on external accounts Structure of the current account Composition of capital flows Reserve adequacy Public-Sector External Debt Burden Gross and net public-sector external debt, including structured debt, as a percent of current account receipts Maturity profile, currency composition, and sensitivity to interest rate changes Access to concessional funding Debt service burden Private-Sector External Debt Burden Gross and net financial-sector external debt, including deposits and structured debt, as a percent of current account receipts Gross and net nonfinancial private-sector external debt, including structured debt, as a percent of current account receipts Maturity profile, currency composition, and sensitivity to interest-rate changes Access to concessional funding Debt service burden Source: By David T. Beers, May 15, Reproduced with permission of Standard & Poor s, a division of The McGraw-Hill Companies, Inc.

13 s and Institutions CHAPTER 12 INTERNATIONAL BOND MARKET 305 EXHIBIT 12.8 Ranking of Top International Bond and MTN Underwriters Bond Issues Overall Bank Score 1 2 Citigroup Deutsche Bank JPMorgan Barclays UBS Goldman Sachs CSFB/Credit Suisse Lehman Brothers ABN Amro Morgan Stanley Merrill Lynch HSBC BNP Paribas RBS Nomura Securities 12 Best EMTN Dealer Bank Score 1 2 Citigroup Deutsche Bank Barclays UBS Morgan Stanley Dresdner Bank Lehman Brothers Goldman Sachs HSBC JPMorgan 19 Bond Instruments Dollar Straights Bank Score 1 1 Citigroup JPMorgan Lehman Brothers Goldman Sachs Merrill Lynch UBS Morgan Stanley Deutsche Bank 40 9= 9 Barclays 24 9= 12 Bank of America 24 Dollar FRNs Bank Score 1 1 Citigroup Barclays Goldman Sachs 32 4= 10 Merrill Lynch 27 4= 14 CSFB/Credit Suisse Morgan Stanley 25 7= 7 HSBC 23 7= 5 Lehman Brothers 23 7= 3 JPMorgan UBS 20 (continued)

14 s and Institutions 306 PART FOUR WORLD FINANCIAL MARKETS AND INSTITUTIONS EXHIBIT 12.8 Ranking of Top International Bond and MTN Underwriters (continued) Euro Straights Bank Score 1 1 Deutsche Bank Barclays Citigroup UBS ABN Amro CSFB/Credit Suisse BNP Paribas HSBC JPMorgan Lehman Brothers 23 Euro FRNs Bank Score 1 1 Deutsche Bank Barclays UBS BNP Paribas CSFB/Credit Suisse HSBC Citigroup ABN Amro JPMorgan Lehman Brothers 20 Source: Euromoney, October 2004, pp weeks. Exhibit 12.9 presents a tombstone (announcement) for a dollar-denominated Euromedium-term note issue and the underwriting syndicate that brought the issue to market. Secondary Clearing Procedures Eurobonds initially purchased in the primary market from a member of the selling group may be resold prior to their maturities to other investors in the secondary market. The secondary market for Eurobonds is an over-the-counter market with principal trading in London. However, important trading is also done in other major European money centers, such as Zurich, Luxembourg, Frankfurt, and Amsterdam. The secondary market comprises market makers and brokers connected by an array of telecommunications equipment. makers stand ready to buy or sell for their own account by quoting two-way bid and ask prices. makers trade directly with one another, through a broker, or with retail customers. The bid-ask spread represents their only profit; no other commission is charged. Eurobond market makers and dealers are members of the International Securities Association (ISMA), a self-regulatory body based in Zurich. makers tend to be the same investment banks, merchant banks, and commercial banks that serve as lead managers in the underwriting process. Brokers, on the other hand, accept buy or sell orders from market makers and then attempt to find a matching party for the other side of the trade; they may also trade for their own account. Brokers charge a small commission for their services to the market maker that engaged them. They do not deal directly with retail clients. Eurobond transactions in the secondary market require a system for transferring ownership and payment from one party to another. Two major clearing systems, Euroclear and Clearstream International, have been established to handle most Eurobond trades. Euroclear is based in Brussels and is operated by Euroclear Bank. Clearstream, located in Luxembourg, was established in 2000 through a merger of Deutsche Börse Clearing and Cedel International, two other clearing firms. Both clearing systems operate in a similar manner. Each clearing system has a group of depository banks that physically store bond certificates. Members of either system