Why eurobonds are so popular across the world

Written by Sunil K Parameswaran | Updated: Nov 6 2012, 08:41am hrs
The global bond market is an active arena for borrowing and lending. Borrowers like multinational corporations, governments and national as well as supranational financial institutions are active borrowers of medium-term and long-term funds. High networth investors (HNIs) find such instruments to be suitable vehicles for making internationally diversified investments.

One of the most popular types of global bond issues are what are termed as eurobonds. A eurobond is a bond that is denominated in a currency, or a basket of currencies, other than the currency of the country in which it is being issued.

The nationality of the issuer is not a factor in such cases. For instance, consider US dollar-denominated bonds being issued in South Korea. These would be categorised as eurobonds, irrespective of whether they are issued by an American corporation like Ford or a Korean company like Hyundai. This is because the bonds are denominated in dollars whereas the local currency in Korea is the Won.

Another category of global bonds is what is termed as foreign bond. A foreign bond is denominated in the currency of the country in which it is being issued, but is sold by a foreign entity. For instance, if IBM were to issue bonds denominated in Korean Won in South Korea, it would be classified as a foreign bond.

A bond that is issued by Hyundai in Won in the Korean market, obviously, belongs to neither of these two categories and would be classified as a domestic bond. Thus, we have three types of bond issues local currency-local issuer bonds known as domestic bonds; local currency-foreign issuer bonds known as foreign bonds; and foreign currency-any issuer bonds known as Eurobonds.

Foreign bonds are known by nicknames. In the US, they are known as Yankee bonds; in the UK as Bulldog bonds; in Japan as Samurai bonds; and in Australia as Kangaroo bonds.

Eurobonds are largely unregulated. For instance, to issue US dollar bonds in the Japanese market, its not necessary to seek SEC approval. Consequently, they can be brought into the market quickly and with minimum disclosure.

This is vital from the standpoint of an issuer who is seeking to take advantage of favourable market conditions, for, if the time gap between planning and implementation of an issue is long, a potential issuer may miss the market.

Such bonds are issued in bearer form, which means that there is no record of ownership. Thus, like in the case of currency notes, the only proof of ownership is physical possession of the securities. These securities are, consequently, easy to transfer from one investor to another, and offer holders an opportunity to avoid and even evade taxes if they so wish. Since the transactions are anonymous, holders can receive cash flows in the form of interest payments without revealing their identity.

Interest on such securities is free from withholding taxes or what we, in India, call tax deduction at source (TDS). Those of us who invest in domestic bonds, such as RBI bonds, will know that when the semi-annual interest is paid out, 10% of the amount is automatically deducted by the issuer and paid directly to the government as a tax payment on behalf of the bondholder.

As a consequence of these desirable features, holders of eurobonds are willing to accept lower yields on such bonds compared to other securities, which carry comparable risk, but do not have such features.

Eurobonds are usually listed on a stock exchange, which is typically London or Luxembourg. This is done not so much from the standpoint of facilitating trading, but due to a technicality. In some countries, entities like pension funds, which are big investors in debt securities, are proscribed from investing in unlisted securities. Thus, eurobond issues are listed to facilitate investments on the part of such investors. Like in the case of domestic bond issues, most eurobonds are traded over-the-counter (OTC).

The origin of the eurobond market is interesting. There was a legislation called Regulation Q in the US, which required banks to impose a ceiling on interest paid to depositors and also maintain a high percentage of deposits in the form of reserves. Thus, American banks were operating with a high net interest margin (NIM), characterised by low deposit rates and high loan rates.

Overseas issuers, consequently, found America to be a fertile ground for offering dollar-denominated or Yankee bonds, which carried higher coupons compared to domestic investment alternatives.

Transnational diversification allows securities holders to carry out the risk-reduction process a step further.

However, holders of securities denominated in foreign currencies face an additional dimension of risk compared to those who choose to invest in domestic securities.

This is nothing but foreign exchange risk. For, if the domestic currency were to appreciate, the cash inflows will stand reduced when payments denominated in a foreign currency are translated to the domestic currency.

The writer is the author of Fundamentals of Financial Instruments, published by WILEY India