“International Finance and Payments” Lecture IX “International Bond Market” Lect. Cristian PĂUN URL: Academy of Economic Studies Faculty of International Business and Economics

General Situation Countries Weight Developed Countries96,1 % Asia2,3 % South America0,8% Eastern Europe + Africa0,7% International Bond Market Types of Bonds Bonds Weight T BondsPeste 50 % Corporate Bonds30 % Foreign Bonds10 % Euro Bonds20 %

Situation by Issuing Institutions International Bond Market Issuing InstitutionWeight GovernmentOver 50 % - Public Companies30 % Banks10 % Private Companies20 % International Institutions12,4 % ValueLead ManagerMaturityCoupon 225 bil USDMerill Lynch19999,75 % bil ¥Nomura Securities19995,20 % bil ¥ Nomura Securities20015,05 % 600 mil DMCredit Suisse20027,75 % Romanian Experience on International Bond Market

International Bond Market Bonds Fixed Rate Notes53 %63 %70 % 71,2%71,3% Floating Rate Notes41 %11 %10 % 25,1% Convertible Bonds4 %9 %3 % 3,5%3,4% Bonds with warrant2 %17 % 0,1%

Bond Issuing Mechanism - IPO Beneficiary Underwritting Group Co - managers Lead Manager Bank Coordination and/or guarantee group Selling group Private Investors Step VI Step III Step II Step I Private Investors Step VI Step IV Tombstone

IPO description: Step 1: Contacting a lead manager bank and this bank will create the coordinating group (if the amount is too important) Step 2: Creating the Underwriting group that will sign up for 70% from the total bond’s quantity with the condition of including the unsold bonds in their own portfolio; Step 3: Creating the Selling group that will try to sell in advance the remaining 30% from the total bonds; Step 4: Selling the bonds to private investors Step 5: Listing the bonds on capital markets, starting the secondary market, closing operation (tombstone) If the private investors will be not interested for IPO of bonds: - Redesigning the bonds conditions (issuing price, call price) - Road Show (promoting the IPO at the level of private investors) - Guarantee for IPO granted by lead bank (the unsubscribed bonds will be included in its own portfolio)

Bond Definition - Bond = a security that is issued in connection with a specific borrowing arrangement -Bond indenture = the contract between the issuer and the borrower - Main elements of the contract: - Face value - Coupon rate - Issuing price - Bond premium - Bond classification: - T-Bonds - Municipal Bonds - Corporate Bonds

Types of Corporate Bonds 1.Call Provisions on Corporate Bonds: -allows the issuer to repurchase the bond at a specific call price before the maturity -The call price is above par value according with maturity (it falls as time passes); -Usually offers a higher coupons rates then noncallable bonds. 2.Convertible Bonds: -Give to the bondholders an option to exchange each bond for a specified number of shares of common stock of the firm; -The Conversion Rate = Number of Bonds / Number of Stock -The Conversion Premium = Bond Par Value x Number of Bonds – Current Stock Price x Number of Stock

Types of Corporate Bonds 3. Puttable Bonds: -Allows the bond holder to extend or to sell bond at a specific date (call date) -The holder is interest to extend the bond life when the bond current yield exceeds current market yields; -When the coupon rate is too low the holder will reduce the holding period 4. Floating Rate Note: -Make interest payments that are tied to some measure of current market rate (T-Bill rate adjusted with 4%) -Major risk: changes in the company’s financial strength (if the financial situation will be worse the price of the bond would fall because the investor’s will require a greater yield premium than the security can offer).

Innovation in the Bond Market Reverse Floater Bonds: the coupon rate falls when the general interest rates rises (the benefit of the investors is double when the rates falls – higher price and higher interest rate); Asset - Backed Bonds: - issuing a bond with a coupon rate connected to the financial performance of several firms from the same group (example: Walt Disney, David Bowie) Catastrophe Bonds: - issuing a bond with a final payment that depended on whether there a catastrophe will be produced (example: Electrolux and a possible earthquake in Japan). Indexed Bonds: - make payments that are tied to a general price index or a particular commodity price (example: Mexico issued a bond tied to the price of oil).

Indexed Bonds: Example Par Value15USD Number100Bonds Coupon5% TimeInflationPar ValueCouponRepaymentsAnnuity % % % Nominal Return=(Interest+Price Appreciation)/Initial Price Real Return=(1+Nominal Return)/(1+Inflation) TimeNominalReal %5.00% 28.15%5.00% 36.05%5.00%

Bond Value and Bond Price

Bond Yields – Yield to Maturity Bond Yields – Current Yield YTM = 6 %

Bond Yields – Yield to Call YTM = 6.23 %

Determinants of Bond Safety 1.Coverage Ratios: ratios of company to fixed costs Times – interest – earned ratio (EBIT/Interest Obligations) Fixed Charge Coverage Ratio (EBIT/(Interest+Lease) 2. Leverage Ratio (Debt-to-Equity Ratio) 3. Liquidity Ratios: Current Ratios = Current Assets / Current Liabilities Quick Ratios = (Current Assets – Inventories) / Current Liabilities 4. Profitability Ratios ROA = EBIT / Total Asset 5. Cash Flow to Debt Ratio (Cash Flow to Outstanding Debt)

Financial Ratios by Rating Classes US Industrial Long Term DebtAAAAAABBBBBB EBIT interest coverage ratio EBITDA interest coverage ratio Funds Flow / Total Debt Free operating cash flow / Total Debt Return on capital Operating Income / Sales Long Term Debt / Capital Total Debt / Capital Source: Bodie, Kane, Marcus “Investment”, page 437, McGraw-Hill Irwin, 2003