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The expanding Eurobond market: What is the market, and how has it grown?

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
September 1976
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Carlos J. Emanuel

The rapid growth of the Eurobond market during the past 15 years has evoked wide attention recently. This interest was sparked by the rather unexpected resurgence of the market in the face of relaxation of U.S. capital controls. Between 1958 and 1963 new issues of Eurobonds—largely by governments and official institutions—had amounted to about $0.4 billion, but in July 1963 the U.S. tax authorities introduced an Interest Equalization Tax (IET), which was formally enacted in September 1964, on foreign bonds and certain other assets purchased by U.S. residents. Borrowers in most western (or industrialized) countries, including Japan and the United States itself, then found it more convenient and economical to raise funds outside the United States, and by 1972 the annual volume of new Eurobond issues had risen to $6.4 billion. The IET and the subsequent U.S. capital control programs undoubtedly stimulated the very rapid growth of the Eurobond market. It was, therefore, widely expected that once these were abolished the Eurobond market would revert to its former subsidiary position. However, the experience following the dismantling of U.S. capital controls in January 1974, with Eurobond issues reaching new record levels, suggests that the Eurobond market has come into its own as part of the world capital market.

Investors and underwriters

Since institutional investors (pension funds, insurance companies, and similar institutions) are typically tied to domestic capital markets by a variety of rules and regulations, they play a much smaller role in the Eurobond market than in domestic bond markets. As most issues are publicly placed, an unusually large role is played by underwriting investment banks, which requires an active secondary market. The general pattern of Eurobond syndicates follows the traditional U.S. system with a three-tiered structure of managers, underwriters, and selling groups. Investment banks acting as co-managers select an underwriting group with contracts in a number of key countries, and selling agents, who are usually several times as numerous as under-writers, and have a wider geographical dispersion.

Borrowers in the Eurobond market

Source: World Financial Markets. Morgan Guaranty Trust Company of New York.

As a result of the large number of underwriters and selling agents normally engaged in Eurobond issues, there is a good deal of intermediary activity in the placement process that often makes it difficult to assess the market’s interest in a given bond. Bond offerings are usually sold to banks, security dealers, and professional investors before the issue is announced to the public. The underwriting cost (selling commission, management fee, and underwriting fee) in the Eurobond market is generally higher than the comparable U.S. cost. This is due to the comparatively loose organization of the Eurobond syndicates and the uneven sales performance on the part of underwriters and sales agents that entails the risk of having to sell bonds at less than par.

In the earlier phases of its development, the Eurobond market was primarily a market for loans to governments and official institutions. In the mid-1960s, however, private corporations entered the market as borrowers on a large scale. The share of private U.S. companies increased steadily from 1965 until 1968, when it reached $2.1 billion, or 59 per cent of the total, as U.S. balance of payments controls (the Foreign Direct Investment Program, in particular) induced them to raise funds for their foreign operations through the Eurobond and Eurocurrency markets. The share of governments and official institutions in total Eurobond borrowing nevertheless has remained relatively high, amounting to 40 to 50 per cent of the total in recent years.

With the declining attractiveness of convertible issues (reflecting mainly developments in the U.S. stock market), Eurobond placements by U.S. companies declined after 1968. After the U.S. balance of payments controls were lifted in early 1974, Eurobond placements by U.S. companies fell to $0.3 billion, or 3 per cent of the total in 1975, compared with $0.9 billion, or 21 per cent in 1973. On the other hand, the share of other private borrowers has remained fairly stable while that of government bodies, relying on straight bonds, has increased.

Long-term international bond issues—both Eurobonds and foreign bonds—by developing countries have been relatively small over the years, with their share in total international bonds amounting on average to slightly over 5 per cent during the past four years. This reflects the limited access of developing countries to the international capital markets and contrasts sharply with developments in the Eurocurrency market where these countries have been more noticeable and have recently taken a significant share of the credits.

Eurobond and foreign bond issues, selected years 1(In millions of U.S. dollars)
196319691972197319741975
Eurobonds21643,1566,3664,1932,1348,542
By category of borrower
U.S. companies1,0051,992874110268
Other companies258171,7591,3096402,884
State enterprises806821,1709475423,165
Governments535841,0506594821,633
International organizations668395404360592
By currency of denomination
U.S. dollar1021,7233,9082,4479963,733
Deutsche mark1,3381,1601,0253442,234
European unit of account629599174371
Other1,2986226202,204
By type of security Straight debt1442,0255,1463,5462,039
Convertible201,1311,22064795
Foreign bonds21,7632,1273,3303,5864,69811,071
Outside the United States(389)(827)(2,029)(2,626)(1,432)(4,624)
In the United States(1,374)(1,300)(1,301)(960)(3,266)(6,447)
Total international bonds21,9275,2839,6967,7796,83219,613
Of which issued by developing countries(…)(…)(642)(664)(603)(777)
Source: World Financial Markets, Morgan Guaranty Trust Company, New York.

In addition to somewhat different coverage, these figures differ from those in IBRD reports mainly because this table excludes international organizations’ private placements with monetary authorities.

Eurobonds are those offered for sale in more than one country, simultaneously, through international syndicates of underwriters and selling agents. Foreign bonds are those issued by a borrower in a foreign country and denominated in that country’s currency. International bonds, which include both Eurobonds and foreign bonds, refer to bonds floated in markets other than those of the issuing countries.

A dash indicates that the figure is zero; dots indicate that the figure Is not available.

Source: World Financial Markets, Morgan Guaranty Trust Company, New York.

In addition to somewhat different coverage, these figures differ from those in IBRD reports mainly because this table excludes international organizations’ private placements with monetary authorities.

Eurobonds are those offered for sale in more than one country, simultaneously, through international syndicates of underwriters and selling agents. Foreign bonds are those issued by a borrower in a foreign country and denominated in that country’s currency. International bonds, which include both Eurobonds and foreign bonds, refer to bonds floated in markets other than those of the issuing countries.

A dash indicates that the figure is zero; dots indicate that the figure Is not available.

Currency composition of issues

Until recently the Eurobond market was largely dominated by U.S. dollar issues, which, in the mid-1960s, reflected in part the heavy reliance on this market by U.S. corporations. However, since the late 1960s there has been a steady decline in the share of dollar-denominated Eurobond issues, from 89 per cent in 1967 to 47 per cent in 1974 and 44 per cent in 1975. While this development reflects the exodus of U.S. corporations from the market, as noted above, it may also be related to the dollar’s position in the foreign exchange markets; it is interesting, however, to note the contrast to developments in the Eurocurrency market, where the dollar has remained the dominant currency.

Although the question of exchange risk has come to the forefront of Eurobond operations, it appears that the limited success of composite currency bond issues—which aim at reducing the exchange risk for borrowers and lenders and have been marketed for some time—has been due not only to accounting difficulties but also to the absence of the dollar in these composites. In both respects, the recent issue of bonds denominated in special drawing rights (SDRs) seems to hold greater promise even if uncertainty over the future valuation of SDRs remains.

Taxation

An important feature of the Eurobond market is the flexibility that it allows investors in respect of taxation. While many countries impose “new issues taxes” or “stamp duties,” countries with major Eurobond centers (such as the United Kingdom and Luxembourg) either have no such taxes or have low rates of taxation. However, the withholding tax levied in many countries on interest paid to bondholders is of greater importance because Eurobond issues are generally not subject to a withholding tax. If such a tax is levied, agreements normally provide that the investor is to be reimbursed by the borrower to offset the tax. On the other hand, bonds issued in the United States by domestic or foreign borrowers, in addition to mandatory registration with the U.S. Securities and Exchange Commission, are subject to a 30 per cent withholding tax when coupons are cashed by nonresident investors. This holds unless there is a double taxation agreement with the United States or if bond issues have been floated through a “foreign source income company” (a company deriving 80 per cent or more of its income from foreign sources). U.S. corporations have often availed themselves of this exemption by forming financial subsidiaries in order to raise funds abroad. However, when substantial amounts of international bond proceeds are passed on to parent companies for domestic use in the United States, this exemption does not apply. Since the removal of U.S. capital controls, there has been some uncertainty about this, as the U.S. Internal Revenue Service also revoked its previous rulings under which the exemption was granted, but to date no new rulings have been forthcoming.

Emergence of the market

Although the issuance of foreign bonds is a long-standing practice in international finance, the Eurobond market had its beginnings in the late 1950s when some European banks, primarily in Belgium-Luxembourg, started organizing international underwriting and selling syndicates to offer foreign bonds to international groups of buyers.

With the imposition of the IET in the United States in 1963, European and Japanese borrowers turned increasingly to European capital markets, and especially to London, which had unique advantages over other financial centers in Europe because of its long history as an international financial center. The fact that it was already established as a major center for Eurocurrency operations also contributed to its role in the international bond market. These and other factors meant that the costs of placing a foreign issue were substantially lower in London than in most other financial centers.

Even with the re-emergence of London as an international capital market, considerable difficulties had to be overcome so that European capital markets could fill the financing gap left by New York. Unlike New York (or London in earlier days) postwar London was essentially an entrepôt market with no substantial amounts of domestic savings to be tapped by foreign borrowers. On the other hand, France and the Federal Republic of Germany—two countries with larger national savings than the United Kingdom—lacked some of the institutional prerequisites for the development of international capital markets. The emerging practice of floating bonds simultaneously in various European countries was therefore aimed at overcoming these difficulties. Furthermore, since the domestic currencies of most of the countries where funds could be mobilized for international investment were not held widely enough to serve as a monetary yardstick for international loans, the practice of issuing bonds denominated in composite currency units was developed.

In the early 1960s, for example, the first Eurobonds denominated in the European unit of account (EUA) were issued. While this denomination did not constitute a means of payment, it reduced some of the risk of exchange rate changes by fixing principal and interest payments in terms of a set of specified currencies. Among other composites introduced as units of account in bond issues in recent years are the EURCO in 1973, representing a basket of the nine EEC currencies, the ARCRU in 1974, based on the movement of twelve Arab currencies, and the SDR in 1975.

Growth of Eurobond market and foreign bond market in the United States, 1964-75

(New issues, in billions of US dollars)

Source: World Financial Markets. Morgan Guaranty Trust Company of New York.

Contraction

After five years of very rapid growth, 1969 brought the first period of contraction in the volume of new Eurobond issues. The market that had initially attracted mostly governmental bodies as borrowers had meanwhile become an important source of finance for a wide variety of private corporations. Tight monetary conditions in the United States, however, induced very high Eurodollar deposit rates that substantially exceeded long-term Eurobond rates, so that a yield differential that was adverse to bonds appeared. As a result, some investors tried to liquidate their Eurobond investments to take advantage of short-term rates. The contraction of the Eurobond market was compounded by the slump in the U.S. stock market. During the 1968 stock market boom underwriters had introduced a substantial number of convertible Eurobonds that amounted to more than half of the volume of new issues in that year. As the prices of these bonds were severely affected by the U.S. stock market reversal of 1969 and 1970, convertible issues fell sharply.

Some institutional problems had also accumulated during the previous years of rapid growth that may have contributed to the market adjustment at this time, in particular, long delays in Eurobond settlements and deliveries. These problems in clearing Eurobond transactions and some other weaknesses of the secondary markets in general, prompted the introduction of new clearing arrangements (EUROCLEAR and CEDEL) and, in particular, a degree of standardization of practices under the auspices of the Association of International Bond Dealers (AIBD) established in 1969.

Recent developments

Eurobond activity gradually recovered from the 1969 setback and reached a record volume of new issues of $6.4 billion in 1972. The easing of world money markets induced by the reversal of monetary conditions in the United States in late 1970 seems to have been the major factor behind the recovery. Moreover, the activities of the AIBD in the first few years after its inauguration inspired new confidence in the secondary markets and the operation of the new clearing systems greatly improved settlements and deliveries.

The 1971-72 boom, however, was short-lived. As U.S. monetary conditions became increasingly tight from early 1973 until late 1974, and the demand for bank loans to finance large balance of payments deficits intensified, the differential between Eurobond yields and short-term rates moved against bonds. In addition, the announcement in February 1973 that U.S. capital controls were to be terminated caused widespread concern about the long-term viability of the Eurobond market. Since the Eurobond market had clearly been a substitute market for New York in the mid-1960s, its decline was generally expected once U.S. capital controls were terminated.

These capital controls were eliminated in January 1974, and following the withdrawal of U.S. companies from the market, Eurobond issues did, in fact, decline, from the record $6.4 billion in 1972 to $4.2 billion in 1973 and to $2.1 billion in 1974. But this decline probably had less to do with the abolition of U.S. capital controls than with other developments in 1973-74, such as the emergence of an interest rate differential adverse to bonds that induced investors to seek the higher returns offered by short-term deposits. In addition, borrowers were unwilling to commit themselves to bond rates that seemed high in the light of longer-term expectations. Exchange rate uncertainty and inflation further complicated the picture. More recently, and particularly following the restoration of the yield differential in favor of bonds and some abatement in the rate of inflation, the Eurobond market has experienced a sharp increase in issue activity, with new bond issues in 1975 amounting to $8.5 billion, against $2.1 billion in 1974. The market’s resurgence has also reflected Eurobond investments by OPEC countries, with their banks becoming important in international issuing syndicates and the ARCRU being added to the list of currency composites.

The experience suggests that rather than being primarily a substitute for the U.S. foreign bond market, the Eurobond market—mainly because of its wider geographical distribution and absence of centralized official regulation—has become a vital part of the world capital market.

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