Eurobonds

What are “Eurobonds”?

Eurobonds are the bonds denominated in a currency other than that of the country in which they are issued. A bond denominated in Japanese Yen and issued in the UK, or a bond denominated in US dollars and issued in France or the UK are examples of Eurobonds. London is the preeminent market for Eurobonds along with other types of bonds.

Many companies borrow in the international capital markets via Eurobonds and other types of fixed-income securities. Investors purchase such bonds from foreign issuers, in addition to buying bonds from domestic issuers to gain exposure to international markets. Eurobonds should not be confused with bonds that are issued in a foreign country but in the same currency as the investor. For example, a yen-denominated bond sold by a non-Japanese issuer (such as a French company) in Japan, or a US dollar-denominated bond sold by a German company in the US.

Eurobonds – Regulation and Features

Eurobonds are mostly traded on the London Stock Exchange (LSE), though they can be traded on various other exchanges too. Such bonds are issued outside the home country of the issuer and are sold to investors in various countries or markets simultaneously (i.e. to investors around the world). They can also be issued through an international syndicate (for example, a US company’s Eurobond can be underwritten by a British syndicate and float the issue in London).

Eurobonds account for approximately 30% of the global bond market. Such bonds can be issued with fixed or floating interest rates. These bonds have medium to long-term maturities. The issuer of the same can choose between a significant range of maturities usually 3, 5, 7, and 10 years – although some Eurobonds have maturities ranging from 15 to 30 years.

Large companies (multinational companies and supranational organizations) and countries prefer international capital markets and tend to issue Eurobonds denominated in the currency (for example, the US dollar) that offers the most attractive interest rate at a given time. They seek to borrow money at the cheapest rate to finance their global operations. Issuers of Eurobonds tend to prefer issuing such bonds in stable markets (such as the US), where the regulatory landscape is in accord with their needs. Issuers also tend to look at the market depth and the economic cycle, when considering which country to issue Eurobonds in. Eurobonds are generally issued by companies or governments that require secure long-term funds.

Eurobonds denominated in dollars (known as Eurodollars) are the largest component of the Eurobond market. A large pool of investors might prefer to purchase dollar-denominated Eurobonds, due to relatively favorable dollar interest rates, compared to other currencies. Most Eurobonds are issued either in US dollars or the Japanese yen.

Advantage of Eurobonds

An advantage of Eurobonds is that they are easy to sell, relatively low risk, and a fairly safe investment alternative (as they are usually underwritten by financial institutions – for example, investment banks). Further, Eurobonds tend to be low-cost investments, given that they usually have small par (or face) values.

Eurobonds are usually highly liquid i.e. they can easily be purchased and sold. The liquidity of such bonds tends to be higher if they are issued in a country whose economy and currency are strong. Issuers can also avoid some currency risk (i.e. foreign exchange risk) by issuing Eurobonds.

Disadvantage of Eurobonds

A disadvantage of Eurobonds is that they usually have lower rates of return (i.e. conservative returns for an investor) than other investments that are considered riskier. Further, in recessions, some Eurobonds have also been known to have issued a negative rate of return to investors.

Eurobonds are usually bearer bonds i.e. holders of such bonds do not have to disclose who they are, in order to receive interest and capital from investing in such bonds. The only requirement is that holders of such bonds must have the same in their possession.

An attractive feature about Eurobonds is that interest on such bonds is paid without any deduction of tax i.e. it is paid gross, rather than being subject to an interest withholding tax (such as in the case of most domestic bonds).

The organization, International Capital Markets Association, a self-regulatory body, does impose certain rules, restrictions, and standardized procedures on the issuing and trading of Eurobonds. These remain outside the purview of official regulation of the country of the currency in which they are denominated.

Eurobonds – Zero Coupon and Floating Rate Eurobonds Example

Given below is a workout of a zero-coupon Eurobond. These are usually sold at a deep discount to the face (or par) value and there are no scheduled periodic interest payments.

In this example, the 3 Eurobonds were issued by Company A and Company B (denominated in US dollars and issued in the UK), and a floating rate Eurobond issued by Company C (denominated in US dollars and issued in the UK).

In the workout, the compounded annual interest yield has been computed for each of the zero-coupon bonds. The formula for the same is:

Compounded Interest Annual Interest Yield = (Face Value / Issue Price) ^ (1 / Years To Maturity) – 1

In Excel, there is a function known as ‘Rate’, through which this yield has been calculated in the workout. Further, in Excel, the issue price is expressed as a negative number. Whether you use the formula, or the ‘Rate’ function in Excel, you should get the same answer.

The floating rate Eurobond (denominated in US dollars and issued in the UK) where the interest paid by the issuer (Company C) for the first three months has been computed. In a floating rate Eurobond, the coupon or interest rate is reset at regular intervals – which is usually  3 months, 6 months, or one year. The interest rate is equal to LIBOR or a money market rate plus a ‘margin’ which is best described as the ‘additional’ yield that reflects the issuer’s creditworthiness.

The coupon rate paid in the first three months by Company C equals the LIBOR rate at the time this bond was offered to investors (in this instance, 3.1%) + the ‘margin’ (60 bps or 0.6%). Following the first three months, the interest rate on such bonds is periodically reset or updated at the end of a specified period (for example, at the end of 3 or 6 months) to reflect the current LIBOR rate (for example, the 3 or 6-month Libor Rate) for US dollars.

Thus we can calculate the compound annual interest yield for each Eurobond. Download the accompanying Excel files for the question & answer.