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International Capital Market
THE INTERNATIONAL INVESTOR There are two types of international capital market investors, viz. the institutional investor and the individual investor. The institutional investor comprise big mutual and pension funds that diversify investments across the world and invest a small part of the portfolio in third world companies and stock markets. In addition to the diversification in different markets and currencies, the large institutional investors are faced with stagnant domestic economies in industrial countries. The faster growing developing countries attract them. The large institutional investors have global choices and perspectives, possess a long-term outlook and make research-based investments. The author is aware of several such investment institutions that are studying the Indian economy and the possibilities of portfolio investments for more than a decade. This should give some idea of the study and research of macroeconomic conditions that precedes investment decisions. The individual investor is the main instrument of the international bond market. In contrast to the institutional investor, he makes decisions more by perception than by analysis. As for the third world, his perceptions are derived from what flashes on his TV screen or his newspaper headlines. This includes news related to murders, natural disasters, manmade disasters and so on. At this moment, it is hard to convince him to invest in third world paper. In developing countries, only the large and professionally managed institutional investors can be approached through capital markets. It is in this background that we shall proceed to look at the different debt and equity instruments in the international capital market. THE INTERNATIONAL BOND MARKET The issue of international bonds to finance cross-border capital flows has a history of more than 150 years. In the 19th century, foreign issuers of bonds, mainly governments and railway companies, used the London market to raise funds. These days, international bonds are broadly classified under two heads: »The
so-called “foreign bonds” are floated in the domestic
market by non-resident entities. A lot of foreign bonds
are issued in the domestic markets of the United States,
UK, Germany, Japan, Netherlands, Switzerland, etc. Modern
jargons call them as Yankee bonds, Bulldog bonds, Samurai
bonds, etc. Yankee bonds are issued in the U.S. domestic
market. Bonds issued in the UK market are called Bulldog
Bonds, and bonds issued in the Japanese domestic market
are called Samurai Bonds. »Eurobonds:
The term “Euro” denotes a currency outside its home
country. Eurobonds are the bonds issued and sold outside
the home country. For e.g. a bond issued in Europe is
called Euro-dollar bond. Eurobonds are bearer securities. There is also a very active secondary market in the Eurobonds and the two best-known clearing and settlement agencies are CEDEL and Euroclear. The Eurobond market accounted for annual issues of $200 billion every year in the last 30 years. In domestic markets, the regulatory requirements with registration of an issue, disclosure of interest, credit rating, etc., are far more stringent than in the Eurobond market. The low level of regulatory requirements is an interesting of the Euro market. Regulatory requirements on private placement are less rigid as compared to a public invitation. These are professional institutional investors that are capable of making the risk assessment on their own and therefore not needing protection of stringent regulatory safeguards in the same scale as the public. INNOVATIONS Floating Rates One key innovation in the Eurobond market is the issue of medium-term securities carrying floating rate of interest. It is reset at regular intervals, say quarterly or half yearly on the basis of LIBOR. Bonds are fixed rate instruments. In the floating rate method, the interest rate risk can be transferred from the investor to the issuer of the bonds. These bonds are termed as floating rate notes (FRNs) or bonds. The term “bond” is used to denote long-term instruments. The term “term note” is used to denote short-term instruments. In the Eurobond market, interest payments on fixed rates are made at annual intervals. Interest payments on floating rate notes are made half-yearly or quarterly. Eurobonds are issued at fixed rate as well as floating rate. Collared/Inverse Floaters The so-called “collared floaters” are FRNs but with a floor and a cap to the interest payable for any half-year. These are also called minimax FRNs. Collared coupon floaters are issued in small quantities. For such issues, the applicable rate of interest for a particular half-year is expressed as a given number minus the prevailing LIBOR. When LIBOR falls, the rate of interest increases. Convertible Bonds Straight bonds and convertible bonds permit the holder to convert the bonds into the equity of the issuing, or its parent, company’s equity, at a pre-determined price. Convertible bonds and bonds that carry a warrant for the warrant holder to buy the issuer’s equity at a predetermined price, are very much in vogue. Perpetual Bonds One innovation, which failed to find root, was the issue of perpetual floating rate bonds. Perpetual Bonds do not any maturity. In the late-eighties, some banks issued such perpetual bonds in order to boost their capital-to-asset ratio. However, while initially some investors were attracted to such issues, the market proved short-lived and there was no issue of perpetual bonds thereafter. Dual Currency Bonds Another innovation some issuers introduced is the so-called dual currency bonds. When the bond is issued in one type of currency, the issuer can reimburse the principal in another currency. The conversion is done at the exchange rate fixed at the time of issue. The investor bears the exchange risk, and is compensated by a higher amount. Consequently, the investor writes down a currency option and the highest coupon is the fee he is paid for writing the option. Callable Bonds Another feature of some bonds is a “call option” in favor of the issuer, under which the issuer retains the option to prepay the bond before maturity but after a specified period from issue. The callable bonds carry coupons in higher quantities as compared to a straight bond. This helps the investor to cover the risk of early redemption when interest rates fall. Equity Index-linked Notes The debt issues carry a coupon, but the principle amount to be reimbursed on maturity is connected to an equity index. If the index is higher compared to a base level, the holder will get a correspondingly larger principal repayment. Equity Index-linked Notes exist in the U.S. domestic market. Asset-backed Securities These are bonds created to make secure and sell to investors specified groups of assets of the lender. The following assets secure the bonds: »A
pool of car loans »A
collection of credit card earnings »A
pool of housing loans, secured by property mortgages A ‘mortgage-backed security’ is a large market in the United States. The issues are estimated at over $1,500 billion currently. A few such securitizations also exist in India. Strips A government bond consists of a stream of cash flows: »Twenty
coupon payments on a ten-year bond; and »One
principal payment on maturity Stripping includes separating the two into interest only (IO) from the principal only (PO) instruments and then selling them to different investors. The advantage of stripping is that they are suitable to time horizons and interest rate risks. Strips have recently caught on in the French government bond market, and are expected to be introduced in the U.K. gilt market shortly. Related
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