10.3 Techniques and instruments in the eurobond and euronote markets

emerging markets’ became very popular. This term described the nancial markets of two

groups of countries – the rapidly growing Asian economies such as Malaysia, Thailand,

Indonesia, South Korea, and more recently, China; and the former Communist countries of

Eastern Europe, where edgling stock and other nancial markets were being developed.

The newly emerging markets were seen as high risk but potentially highly protable avenues

for nancial investment. Speculation increased rapidly on the prospects of these markets.

Problems began in the middle of 1997 with the collapse in the value of the major Asian

currencies, the process beginning with the collapse of the Thai baht. Political, economic

and social problems had been mounting for a number of years in the Asian ‘tiger’ eco-

nomies as they sought to maintain the extraordinarily high growth rates of the 1980s and

1990s. Condence is very ckle and soon serious doubts began to be expressed about

the futures of these economies. A trickle of doubt soon becomes a ood in nancial

markets and the economies, starting with South Korea, quickly came under pressure.

The steep decline in the values of currencies helped to create deep recessions in the

Asian countries and these had signicant knock-on effects in Western countries as Asian

governments cut back on foreign expenditure and Asian imports fell.

Losses in one market frequently cause investors temporarily to become risk-averse,

and the long-term doubts about the ability and willingness of Russia to transform itself

into a model market economy along Western lines provided the next threat to the inter-

national nancial markets. Problems spread again to Latin America, with heavy selling

of the Brazilian currency. By October 1998, economists and nancial journalists were

talking openly of a massive worldwide recession. This did not happen, and by June 1999

the nancial world was again calm and optimistic.

However, the episode illustrates the fragility of condence in nancial markets. We

need also to remember that many people suffered during the nancial turmoil. Financial

statistics can easily come to be seen as mere numbers that have little contact with

the real world – but the impact of nancial frenzy on exchange rates and interest rates

causes unemployment, hunger, and cutbacks in important areas of social expenditure

such as health and education.

On the other hand, it is sometimes argued that the banks know that the govern-

ments of the industrial countries cannot afford to let the international banking sys-

tem collapse and will thus always act to rescue the major banks. This view goes on

to suggest that this increases the feeling of security of banks and encourages them

to make risky loans with high prot potential. Thus, one side of the debate over the

causes of the international debt crisis points to irresponsible behaviour by the banks

as a principal factor.

10.3	Techniques and instruments in the eurobond and euronote markets

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 out-

side the country of the currency in which it is denominated.

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Chapter 10 • International capital markets

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 nance. 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 anony-

mity 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 specied future

date and to xed interest payments on stated dates. They do not carry rights to any

additional interest, principal or conversion privilege. Convertiblesare bonds which

can be converted from one form into another. In euromarket usage, the conversion

is into ordinary shares at a specied 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.

In recent years, many other forms of securities have developed. These have included

oating rate eurobonds and dual currency bonds. Floating rate eurobondsare popular

with investors seeking the protection of capital. Interest rates are re-xed every three

or six months, removing the threat to capital value posed by very volatile interest

rates. Thus, most oating 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, oating

rate eurobonds generally have their coupons set in terms of a percentage margin

over LIBOR or another basis rate.

Issues of oating rate eurobonds (oaters) grew greatly during the 1980s, largely

due to the increased need for banks to buy assets with low credit risk as other lend-

ing, notably sovereign lending to developing countries, became more risky. At the

same time, many borrowers have found oaters 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 nal maturity. Many variations on oating

rate eurobonds have developed, including ip-op optionswhich allow the investor

to switch from undated perpetuals into a four-year oater paying a lower rate of

interest while maintaining the right to switch back again into the perpetual issue.

Dual currency bondsare 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$0.74, an exercise price of 76 cents and a coupon rate of

7 per cent against the 4 per cent available on an ordinary one-year bond. If, at the

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