Best Bonds to Buy: Overview of International Bond Types & Why to Buy
International Bond Instruments
International Business contracts typically involve foreign exchange risk. Buyers desire agreements denominated in their own national currency. Sellers, contrarily, prefer to strike terms in domestic denominations. When currency exchange rates fluctuate, the value of contracts denominated in foreign currency carries risk of devaluation. Especially in very large contracts – exactly the kind that most likely are signed one day and delivered for payment months or years afterward – the risk may be sufficiently high to pose a danger to the ability of a multinational corporation (MNC) to remain in business. For this reason, sellers and buyers both purchase market instruments which will fluctuate counter to any foreign exchange (FX) rate changes. In the marketplace, this is called hedging. Today, the investment and hedge market offers many international bond instruments to service the needs of contracts involving FX.
The Two Basic Categories of International Bonds
The first type of bond is a foreign bond. A foreign bond is one sold by a borrower in one nation to buyers (investors) in the marketplace of another nation to raise capital, and is denominated in the currency of the foreign nation. An example of this type of bond is an American company selling Yen-denominated bonds on the Japanese bond market. These bonds often have slang terms to describe them: A Yankee bond sells in dollars, in the U.S., but is sold by a foreign nation like Japan, the UK, or Germany. A Samurai bond sells in Japan, for Yen, but is sold by Americans, Germans, and others. A Bulldog bond is sold in England, in pounds sterling, by Canadians, Americans, French, and other MNCs.
The second bond instrument is called a Eurobond. The name can mislead. This is not a bond sold in Europe; these bonds sell in one nation, but are denominated in the currency of another nation. The Eurobond is a bond sold in a denomination differing from that of the country in which it is sold. For example, a German MNC may sell bonds denominated in Euros, but sold in Switzerland, where the Swiss Franc is used. Eurobonds are almost always bearer bonds (Eun & Resnick, 2009).
Bearer Bonds or Registered Bonds
A bond is either tracked (registered), or ownership is maintained by possessing the bond itself. When a bond is issued to the hand of the buyer, and no registration is made of ownership, this is a bearer bond. Bearer bonds are paid at maturity to the bearer of the bond. The anonymity of bearer bonds makes possible tax evasion, and this type of bond typically yields a smaller return- because the savings on taxes avoided more than compensates for the lower return (but adds the risk of audit and revenue service penalties).
Straight Fixed-Rate Issues
The most common of all bonds is the straight fixed-rate bond. These bonds are sold at a discount and mature to face value over the life of the bond. In addition to the difference between purchase and sale prices, straight fixed-rate bond holders are also compensated with semiannual coupon payments.
These are typically issued by large corporations or governments. This bond type, for the seller, is more similar to a line of credit than to a traditional, lump-sum loan. These bonds can be sold only as funds are required. As such, they have an advantage similar to a line of credit; monies that are not required are not raised. This saves the bond issuers when they do not have to make bond payments on capital they did not require.
The European Union maintains an €80 billion medium-term note issue to fund the European Atomic Energy Community, and to provide lines of credit to member nations (Bloomberg, 2012).
Floating Rate Notes
Floating-rate bonds (FRNs) are most often a medium-term bond with coupon payments. Rather than a constant rate to calculate fixed coupon payments, as with a euro medium-term note, FRNs fluctuate according to an index stipulated in the bond. The most common index is LIBOR, the London Interbank Offered Rate. For example, Landwirtschaftliche Rentenbank of Germany plans to offer a 3-year FRN totaling $500 million (Bloomberg, 2012). The note will be indexed to LIBOR, plus 25 basis points over the three month rate (LIBOR +0.25). FRNs have an advantage over straight fixed-rate bonds in that fluctuations in payments vary much less.
The first of two kinds of equity-related bonds has an equity warrant. An equity warrant gives the holder the right to purchase a pre-stated number of the issuer’s business shares at a pre-determined price, during a pre-determined time span. The second kind of equity-related bond is the convertible bond. Convertible bonds have two potential values. A set minimum value, the floor value, is its value as a straight fixed-rate bond. The second value is based on the ability of the holder to exchange the bond for shares in the company that issued it. On the secondary market, these bonds sell for the higher of the two values, plus a premium based on market demand and conditions.
Zero Coupon Bonds
As the name implies, these bonds have no coupon payments. This makes the price of maintenance (sending payments and tracking holders as well as management fees) lower. These bonds are typically purchased by investors who can save money taxwise because of local tax laws.
Japanese investors, for example, pay tax on coupon payments, but not on the profit of the matured bond. Zero coupon bonds are therefore more attractive to Japanese investors. Japanese wives, who typically manage household finances, invest in zero coupon bonds (Economist, 1997).
A dual-currency bond pays in two currencies. Coupon payments are denominated in one currency. The maturity price is paid in another denomination. For example, a dual-currency bond sold in the United States may give coupon payments in Yen, and the maturity value in dollars. The maturation value, most often, includes an allowance for the strengthening of the stronger currency. This bond is similar to a long-term forward contract. If one currency strengthens, the holder makes up the loss in the appreciation of the other, either the coupon payments or the maturation value.
International Bonds Provide for Various Investor Needs
The needs of international finance to hedge contracts involving FX risk are met with a variety of bond instruments. Dual currency bonds mimic a long term forward contract. Straight fixed-rate bonds provide an instrument for MNCs to raise funds for acquisition and expansion. Medium-term notes provide a kind of line of credit as large corporations sell off the bonds as funds are required. Zero coupon bonds have tax advantages for investors working within certain tax codes which treat coupon payments and value gains different. The needs of foreign exchange contracts to protect against risk of exchange rate variations are met with a mix of different kinds of international bond instruments.
Bonds: Fixed Income Investments
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