A eurobond is a debt security handled internationally by syndicates, groups of bankers and/or brokers who underwrite and distribute new issues of securities or large blocks of outstanding issues. It is typically in bearer (non-registered form) and is issued outside the country of the currency in which it is denominated.

Borrowers and lenders are spread around the world, while the intermediaries are spread across Europe, with the majority of business being done from London. The market was founded in the early 1960s and has provided a competitive source of funding for borrowers who can tap discreet but important sources of finance. Japanese banks, pension funds and insurance companies have become important lenders in recent years and there are still plenty of wealthy individuals who prefer the anonymity offered by bearer securities. The eurobond market is the world’s second largest securities market after the US bond market in terms of trading volume and the third largest after the US and Japanese bond markets in terms of debt outstanding.

Conventional eurobonds consist of straights and convertibles. Straights are normal bonds that carry unquestioned rights to the repayment of principal at a specified future date and to fixed interest payments on stated dates. They do not carry rights to any additional interest, principal or conversion privilege. Convertibles are bonds which can be converted from one form into another. In euromarket usage, the conversion is into ordinary shares at a specified future date and at a pre-determined price set when the bond is issued (usually at a premium to the current share price). Interest rates are usually lower on convertibles because lenders are attracted by the possibility of being able to buy shares at a favourable price.

FundsIn recent years, many other forms of securities have developed. These have included floating rate eurobonds and dual currency bonds. Floating rate eurobonds are popular with investors seeking the protection of capital. Interest rates are re-fixed every three or six months, removing the threat to capital value posed by very volatile interest rates. Thus, most floating rate eurobonds are bought by banks anxious to lock into assets with a yield greater than, but calculated in the same way as, the cost of their funds in the money markets: as in the case of rollover eurocurrency loans, floating rate eurobonds generally have their coupons set in terms of a percentage margin over LIBOR.

Issues of floating rate eurobonds (floaters) grew greatly during the 1980s, largely due to the increased need for banks to buy assets with low credit risk as other lending, notably sovereign lending to developing countries, became more risky. At the same time, many borrowers have found floaters a much cheaper form of borrowing than syndicated credit and have used them to repay their loans early. This has added to the banks‘ demand for them by taking other loans off their books. The average life of issues increased from 9.7 years in 1978 to over 12 years by 1984, partly as a result of the issue of perpetuals with no final maturity. Many variations on floating rate eurobonds have developed, including flip-flop options which allow the investor to switch from undated perpetuals into a four-year floater paying a lower rate of interest while maintaining the right to switch back again into the perpetual issue.

Dual currency bonds are usually issued in a currency other than US dollars (most commonly Swiss francs), with the coupon denominated in that currency but the bond repayable in dollars. The coupon interest rate is usually greater than it would otherwise be because the lender assumes a forex risk. For example, consider a one- year Australian dollar bond with an option to repay in US dollars. Assume a current exchange rate of $A1 = US$0.62, an exercise price of 64 cents and a coupon rate of 7 per cent against the 4 per cent available on an ordinary one-year bond. If, at the end of the year, the Australian dollar has appreciated, the borrower will repay in US dollars; if it has depreciated, repayment will be in Australian dollars. Reverse dual currency bonds have also been issued, with the bond payable and the coupon rate denominated in US dollars but repayable in other currencies. Sometimes borrowers are given the option to repay in any one of a number of currencies.

Among the great variety of instruments and techniques developed in recent years, perhaps the most interesting has been swaps. These are exchanges of cash flows that originated as attempts by firms to manage their asset/liability structure or to reduce their cost of borrowing. Cash flows generated by many different types of financial instrument may be swapped. Simple swaps such as interest rate and currency swaps are known as plain vanilla swaps. There are many variations on these.

Interest rate swap: An agreement to exchange periodic payments related to fixed interest rates on a notional capital sum with those representing a floating rate on the same sum in the same currency.

Closely related to the interest rate swap is the basis rate swap, which involves the exchange of one type of floating rate for another. This can happen because, as we have seen, a floating rate of interest is always expressed in two parts: a general floating rate of interest that reflects the rate at which banks themselves obtain their money (the basis rate) plus a fixed rate spread that is specific to each loan. We have seen that the most commonly used basis rate in the London market is LIBOR (the London InterBank Offered Rate). However, other rates may be used as the basis rate of a floating rate loan, notably the US dollar prime rate and now, since the establishment of the European Central Bank, EURIBOR. Thus, a basis rate swap may involve the exchange of LIBOR for the US dollar prime rate in the calculation of the interest rate payable on a loan. Let us take an example of an interest rate swap.

A company wishing to borrow will normally choose to do so in the market in which it can raise funds most easily, perhaps from a bank with which it has done a good deal of business in the past. We shall assume that this is a floating rate loan. However, the funds are being raised to undertake a long-term investment project and the firm, in order to be confident that the project is economically viable, would like to know the interest rate it is going to have to pay. That is, it would prefer a fixed rate loan. Thus, it enters into an agreement to pass the liability (the interest payment) on to another borrower in exchange for the fixed rate structure that best suits it.

Swaps such as these are guaranteed by banks, often referred to as swap or hedging banks. The swap banks do not lend anything in these transactions and so they do not affect the banks‘ assets and liabilities and thus constitute ‘off balance sheet’ business. All that the swap bank does is to bear the risk that one of the parties to the deal might default on its payments, leaving the bank partially liable for the interest payments left unpaid by the defaulting borrower. Interest rate swaps work because different intermediaries in the capital market do not always view a borrower in the same way. Thus, our original firm may have been able to obtain a fixed rate loan by issuing a straight eurobond - but, if the firm was not well known to the market, the interest rate may have been higher than it could manage by borrowing on floating rate terms from its own bank and swapping interest rate structures with another firm. Box 10.5 provides an example of an interest rate swap. This example is one in which payments are swapped, but receipts may also be swapped. Yet again, since the capital sums are only notional, it is possible to speculate on the possibility of an interest rate rise or fall through interest rate swaps. For example, a speculator might feel that interest rates are likely to fall and so offer a floating-rate stream (which will fall as market interest rates decline) in exchange for a fixed rate stream which will not. If the speculator is right about the direction of interest rate change he will profit from the swap.

The price of a swap (the charge made by the swap bank for its services) depends on the bank’s estimate of the extent of default risk, the ease with which it can obtain a counterparty, and the term structure of interest rates in the bond market.

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