Chapter

Appendix II: Developments in International Bond Markets

Author(s):
International Monetary Fund
Published Date:
July 1982
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Introduction

Private international capital flows have played an increasingly important role in the financing of payments imbalances and government deficits, the international reallocation of private savings and investment, and the arbitrage of yield differentials across national boundaries during the last decade. The international bond markets, however, have not expanded nearly as rapidly as have the international assets of commercial banks. This Appendix reviews developments in international bond markets in 1981 and considers—against the background of the experience of several years—why these markets have grown so much more slowly than international bank lending activity.

The issuer of international bonds generally has the option of utilizing an alternative domestic (e.g., domestic bond issuance) or foreign (e.g., international bank borrowing) source of credit. The choice of a particular type of financing has depended mainly on each instrument’s general risk and return characteristics. Official regulation affecting the purchasing or sale of foreign and domestic financial instruments has also been a factor, whose importance has fluctuated from period to period. Within the limits set by such constraints on capital movements, the more attractive the risk-return characteristics of a given instrument, the more likely it will be that investors or borrowers will seek to utilize it as a vehicle for the international transfer of capital. In addition to the volume of capital flows, the preferences of both issuers and investors will be important determinants of the instrument’s rate of interest, maturity, currency of denomination, and the proportion of interest rate and exchange rate variability risk borne by each party.

The increased activity in the foreign and Eurobond markets during 1981 did little to offset the extended decline in the importance of the international bond market as a source of long-term funds that took place during the last decade. This change encompassed not only a decline in the real size of new issue activity, but also a shortening of bond maturities, the emergence of higher real yield—especially at the long end of the market—and a redistribution of a portion of the risk of bond price variability from the investor to the issuer. These developments, in turn, reflected the responses of investors and borrowers in the international bond markets to higher inflation and interest rates, greater variabilty of exchange rates and interest rates, and the large capital losses experienced by bondholders during the late 1970s. A significant recovery in the real size of the international bond markets during the 1980s is therefore likely to take place only if there are fundamental improvements in the expectations of investors and borrowers regarding inflation and nominal interest rates, and the general stability of financial and exchange markets.

The remainder of this Appendix is in two sections. The first examines the conditions that prevailed in the foreign and Eurobond markets during 1981 and early 1982. Information is provided on interest rates, foreign and Eurobond sales, the currency composition of international bonds, bond maturities, and the types of bonds employed in the various financial markets. The second section considers the 1981 international bond market developments as part of a general deterioration of these markets as a source of long-term funds. There is an examination of the macroeconomic and financial market factors that have contributed to the weakening of these markets and what conditions must be improved if the international bond markets are again to be a major source of longer-term international credit.

The 1981 Experience

Even though 1981 was a period in which long-term international interest rates for some currencies rose to their highest in the postwar period—showing considerable variability in the process—international bond issuance recovered strongly from its depressed level in 1980. The use of U.S. dollars as the primary currency of denomination continued to expand, while the average maturity of most bonds was again reduced. The majority of international bonds was issued by entities from industrial countries and a continuing significant portion was issued on a floating interest rate basis.

Interest Rates

The interest rate movements that occurred in the major financial markets in 1981 are illustrated in Charts 8 and 9, and in Table 47. While domestic nominal interest rates declined slightly during March and April in some countries, there was generally a strong upward trend especially in long-term rates from April through August. In most markets it was not until September that nominal interest rates peaked and then declined until December. At the peak, interest rates were among the highest (nominal rates) experienced in most countries since the end of World War II. This general increase in interest rates reflected a number of factors including the presence of high and often increasingly variable rates of inflation, domestic monetary policy actions designed to slow inflation, and the prospect of large fiscal deficits. The pressure of these factors, and their intensity, varied from country to country. In some countries the upward pressure on their interest rates mainly reflected development in other countries such as the United States, given the extent of financial market integration.26

Chart 8.Domestic Short-Term Interest Rates, 1981

Source: Organization for Economic Cooperation and Development, Financial Statistics Monthly.

Chart 9.Domestic Long-Term Interest Rates, 1981

Source: Organization for Economic Cooperation and Development, Financial Statistics Monthly.

Foreign Bonds Versus Eurobonds

Despite the record high interest rates in several financial market countries, the nominal value of both foreign bonds27 and Eurobond issuances rose sharply in 1981, with much of the issuing activity concentrated in periods during which interest rates declined (Table 21). Foreign bond issues rose from $16.2 billion in 1980 to $19.4 billion in 1981, while new Eurobond issues increased by $6 billion, to $28.2 billion. Much of this issue activity took place during the last quarter of 1981 when $6.3 billion of foreign bonds and $10.3 billion of Eurobonds were marketed as interest rates declined from their September peaks (see Charts 8 and 9). The high level of issue activity continued during the first quarter of 1982, when an additional $6.5 billion foreign bonds and $12.7 billion Eurobonds were sold. The scale of bond sales during the last quarter of 1981 and first quarter of 1982 provides an example of the type of “window” for bond issuance that often opens after interest rates reach their cyclical peaks and should not necessarily be taken as indicative of a sustainable level of issues.

Table 21.International Bond Issues and Placements, 1976-First Quarter 19821(In millions of U.S. dollars)
19761977197819791980198121982 1st Qtr.2
Foreign bonds
Industrial countries12,37910,15713,05712,3019,12712,1554,760
Developing countries9671,6092,5841,6681,0361,241357
Oil exporting33357110546242
Non-oil developing9671,2762,0131,563990999357
Centrally planned economies3643
International organizations5,1934,7485,7066,9595,9955,8781,286
Other405901961345113361
Total foreign bonds18,93416,61021,54321,10516,20919,4076,464
Eurobonds
Industrial countries10,99513,1679,83214,21417,63122,84410,963
Developing countries1,1252,6173,1831,8851,4252,2971,089
Oil exporting1774531,08232913267
Non-oil developing9482,1642,1021,5561,2932,2291,089
Centrally planned economies372249303050
International organizations3,0632,4122,7193,0642,9242,805640
Other1121,040176344144260
Total Eurobonds15,36819,48415,93919,53722,17928,20612,692
International bonds
Industrial countries22,37423,32422,88926,51526,75834,99915,723
Developing countries2,0924,2255,7673,5542,4613,5381,446
Oil exporting1777861,653434178309
Non-oil developing1,9153,4394,1143,1202,2833,1151,446
Centrally planned economies372256307350
International organizations8,2567,1608,42510,0238,9248,6831,926
Other5171,13037147719539361
Total international bonds34,31136,09437,48240,64238,38947,61319,156
Sources: World Bank, Borrowing in International Capital Markets; and Organization for Economic Cooperation and Development, Financial Statistics Monthly.

The country classifications are those used by the Fund.

Preliminary figures.

Excluding Fund member countries except Hungary, which became a member in mid-1982.

Sources: World Bank, Borrowing in International Capital Markets; and Organization for Economic Cooperation and Development, Financial Statistics Monthly.

The country classifications are those used by the Fund.

Preliminary figures.

Excluding Fund member countries except Hungary, which became a member in mid-1982.

In 1981 most foreign bonds were issued by industrial country borrowers ($12.2 billion) and international organizations ($5.9 billion). While the total proportion of foreign bonds accounted for by these two groups remained at approximately 93 per cent in both 1980 and 1981, the share of the industrial countries rose from 56 to 63 per cent, while that of international organizations declined from 36 to 30 per cent. The share of foreign bonds issued by developing country entities remained roughly constant at 6 per cent in the growing market, reflecting a greater issuance by oil exporters and little change in the level of issues by the non-oil developing countries. These proportions did not change significantly during the first quarter of 1982.

Industrial country issuers increased their share of Eurobonds from 79 to 81 per cent, and the share of developing countries rose from 6 to 8 per cent in 1981. As with foreign bonds, much of the issue activity took place in the last quarter of the year, when about one third of all Eurobonds were marketed. For the developing countries, the larger issuance of Eurobonds reflected somewhat smaller issuance by traditional oil exporters and much greater activity by other developing countries (especially Mexico). During the first quarter of 1982, the share of the industrial country issuers increased to 86 per cent and that of developing countries to 8 per cent.

The combination of greater foreign and Eurobond issues resulted in a 24 per cent increase in the total amount of international bonds issued in 1981. Industrial country borrowers accounted for almost three fourths of total issues, international organizations 18 per cent, and developing countries 7 per cent. The market access of individual developing countries is shown in Table 48. There was a sharp increase in the value of issues by Mexico and, to a lesser extent, by Venezuela and India. Developing countries with larger issue values in 1981 than in 1980 were Greece, Hong Kong, India, Indonesia, Korea, Mexico, Peru, and Venezuela. During the first three months of 1982, Malaysia and Mexico were the primary developing country issuers.

Currency Composition

As discussed in the final section of this Appendix, the currency composition of international bonds reflects the expectations of borowers and lenders regarding future interest and exchange rate developments. In recent years, these expectations have created strong incentives to denominate international bonds in U.S. dollars.

During 1981 the value of foreign bonds issued in the U.S. market almost doubled to $5 billion (Table 22). Almost one half of these bonds were issued during the fourth quarter of 1981, as interest rates declined. In the first quarter of 1982, only $0.7 billion foreign bonds were sold. As a result of this growth, and the appreciation of the U.S. dollar vis-à-vis other major currencies, foreign bonds denominated in dollars rose from 16 per cent of all foreign bonds in 1980 to 25 per cent in 1981, before declining to only 11 per cent in the first quarter of 1982. In the Eurobond market, the rise in the dollar share was even more pronounced (Table 23). The portion of all Eurobond issues denominated in U.S. dollars, increased from 62 per cent in 1980 to 82 per cent in 1981, although conditions in the United States and Eurobond markets did not differ much in 1981. By the first quarter of 1982, 84 per cent of Eurobonds used the U.S. dollar as a unit of account. The sharp rise in the dollar share in Eurobond issues seems to reflect the fact that investors in the Eurobond market were more attracted to the record high nominal long-run yields (over 17 per cent), the relatively long maturities for which these yields were offered (up to eight years), and the presence of some innovative features on new offerings (discussed below). It was also true that at times the interest rates on dollar-denominated Eurobonds lagged behind rising U.S. domestic bond rates. Although these periods were relatively brief and the differences were quickly arbitraged, they also witnessed greater issuance of dollar-denominated Eurobonds. The attractiveness of Eurobonds for investors was also influenced by the fact that while there is a withholding tax on U.S. domestic bonds, there is no such tax on Eurodollar bonds. As a result of these factors, it appears that during 1981 there were a number of instances when it was marginally less expensive to borrow in the Eurobond market than in the U.S. market.28

Table 22.Foreign Bond Issues and Placements by Market Country, 1976-First Quarter 1982(In millions of U.S. dollars)
1976197719781979198019811982 1st Qtr.
Austria382910081
Belgium431481615222
France76622313659489
Germany, Federal Republic of1,3091,5111,6772,2963,4961,604614
Public offerings5392986994181,9001,269
Private placements7701,2139781,8781,596335
Japan2871,3944,6872,9851,7312,562995
Public offerings2191,1613,3781,5151,0682,182
Private placements682331,3091,471663380
Luxembourg378020621815912322
Netherlands692182352466325539253
Saudi Arabia2956452468621
United Kingdom56178803
Switzerland5,4444,9597,5539,6377,4888,1203,133
Public offerings1,4951,6012,7793,3763,3083,835
Private placements3,9493,3584,7746,2614,1804,286
United States10,6327,6886,3594,6022,6374,959700
Public offerings6,5275,5334,8264,1022,3764,945
Private placements4,1052,1551,53350026114
Other countries12466189557665
Total18,93416,61021,54221,10516,20919,4076,404
Sources: World Bank, Borrowing in International Capital Markets; and Organization for Economic Cooperation and Development, Financial Statistics Monthly.
Sources: World Bank, Borrowing in International Capital Markets; and Organization for Economic Cooperation and Development, Financial Statistics Monthly.
Table 23.Total Eurobond Issues and Placements by Currency of Denomination by All Countries, 1976-First Quarter 1982(In millions of U.S. dollars; and in per cent)
1976197719781979198019811982, 1st Qtr.
Total amountPercentTotal amountPercentTotal amountPercentTotal amountPercentTotal amountPercentTotal amountPercentTotal amountPercent
Deutsche mark2,82118.45,21526.86,53141.15,88130.14,25419.21,0553.77966.3
French franc620.41030.63741.91,0024.55131.8
Japanese yen1110.6790.51840.93011.45351.93002.4
Netherlands guilder4673.03631.93842.43081.67923.64531.6870.7
U.S. dollar9,99965.112,33663.37,64348.111,09556.813,66461.623,02481.610,71684.4
Composite currency units1030.7340.22351.54132.11000.58182.91140.9
European currency units2650.91020.8
European unit of account1030.7340.22031.33061.6800.41450.5120.1
Special drawing right320.21070.5200.14081.4
Canadian dollar1,4509.46543.34682.42701.26492.34583.6
Kuwaiti dinar3042.01300.74813.03842.0260.1260.1670.5
Pound sterling2211.12871.82911.51,0894.98262.91541.2
Saudi Arabian riyal1030.5950.6
Austrian schilling2351.1
Norwegian krone1000.5780.3
Other currencies1621.03171.6520.31390.73461.62290.8
Total15,368100.019,484100.015,890100.019,537100.022,179100.028,206100.012,692100.0
Sources: World Bank, Borrowing in International Capital Markets; and Organization for Economic Cooperation and Development, Financial Statistics Monthly.
Sources: World Bank, Borrowing in International Capital Markets; and Organization for Economic Cooperation and Development, Financial Statistics Monthly.

The use of bonds denominated in deutsche mark declined in both the foreign and Eurobond markets. In the German market, there was only $1.6 billion in foreign bonds issued during 1981, in comparison with $3.5 billion during 1980. Similarly, in the Eurobond market, the share of bonds denominated in deutsche mark declined from 19 per cent ($4.2 billion) in 1980 to 4 per cent ($1.1 billion) in 1981. This reduction reflected domestic monetary policy considerations, the weakness of the deutsche mark relative to the dollar early in 1981, and informal actions taken at various times to limit issuance of nonresident bonds denominated in deutsche mark.

Early in 1981, the German monetary authorities began to tighten monetary policy to deal with inflationary pressure and weakness of the deutsche mark relative to the dollar. As part of an attempt to reduce exchange market pressure on the currency, a gentlemen’s agreement between the banks and the supervisory authorities restricted issuance of deutsche mark bonds by nonresidents during the first three months of 1981. Even after March, the authorities requested that the banks be prudent in bringing additional bonds to the market. It was not until late in that year that an improvement in Germany’s current account position, inter alia, reversed the exchange market pressure on the deutsche mark29 and downward movements in U.S. interest rates facilitated a decline in German interest rates. As a result, issuance of foreign bonds in the German market during the last quarter of 1981 ($0.8 billion) equaled more than 90 per cent of the bonds issued during the first nine months of the year. An additional $0.6 billion bonds were sold during the first quarter of 1982.

The Swiss franc share of foreign bonds declined slightly from 46 per cent in 1980 to 42 per cent in 1981 despite the fact that $0.6 billion more foreign bonds were issued in 1981 than in 1980. In the first three months of 1982 this share recovered to 49 per cent. The Swiss market was able to approximately maintain its relative position because the tightening of domestic monetary policy, designed to fight higher inflation, raised yields enough to attract investors who focused mainly on newly offered public issues. In contrast, activity in privately placed notes, where Japanese convertible issues had been quite important, was relatively subdued, especially late in 1981 after a decline of Japanese equity prices.

The Japanese yen was one of the few currencies other than the U.S. dollar to increase its share in both the foreign bond and Eurobond markets. In the foreign bond market, its share rose from 11 per cent in 1980 to 13 per cent during 1981, whereas in the Eurobond market its share rose to a lesser extent, from 1.4 to 1.9 per cent. During the first quarter of 1982 there were additional increases in the shares for foreign bonds (to 15 per cent) and Eurobonds (to 2.4 per cent). The increased volume of financing reflected, inter alia, terms that were quite attractive to foreign borrowers in view of the relatively low Japanese interest rate costs. To Japanese investors, nonetheless, these foreign issues offered a higher yield than those available on new domestic offerings.

The use of the other major currencies as a unit of account has remained much more limited. For example, the share of Eurobonds denominated in pounds sterling declined from 5 per cent in 1980 to 3 per cent in 1981. From October to December 1981 and January to March 1982, use of the Canadian dollar in the Eurobond market increased, as Canadian borrowers found the cost of borrowing in this market lower than in the domestic market. Foreign investors were attracted by the high coupon levels (up to 18 per cent) in what appears to have been regarded as an unduly depressed currency. Issues denominated in Kuwaiti dinars were resumed late in the year. Since the coupon rates on new issues were subject to official ceilings, new issues were placed under par while the number of new issues was also restricted.

In the Eurobond market, the utilization of the SDR as a unit of account increased during 1981 in contrast to 1980. In 1980 only 0.1 per cent of all Eurobonds was denominated in SDRs, whereas in 1981, 1.4 per cent of these bonds ($408 million) was SDR denominated. During 1981 most SDR-denominated issues were floating rate notes, and they included issues by Red Nacional de los Ferrocarriles Espanoles (Spain), Ente Nazionale per l’Energìa Elettrica (Italy), Pechiney Ugine Kuhlmann (France), Azienda Autonoma delle Ferrovie Dello Stato (Italy), and the Scandinavian Investment Bank.

Combining the issuance of foreign bonds and Eurobonds shows that the proportion of international bonds issued in U.S. dollars increased from 43 per cent in 1980 to 59 per cent during 1981, reaching 65 per cent during the last quarter of 1981 and 60 per cent during the first quarter of 1982 (see Table 49). The deutsche mark share declined equally dramatically, from 20 per cent in 1980 to 6 per cent in 1981 before recovering to 7 per cent in the first three months of 1982. Even the Swiss franc share declined modestly from 20 per cent in 1980 to 17 per cent in 1981, mainly reflecting a depreciation of the Swiss franc vis-à-vis the U.S. dollar. The Japanese yen share rose moderately from 5 per cent in 1980 to 7 per cent in 1981 and the first quarter of 1982.

Type of Bond Issued

Although complete information on the type of securities issued is not available for the second half of 1981, there are a number of important characteristics which are evident in the first-half-year data. In the foreign bond markets, the dominant form of debt issue continues to be the straight debt bond30 (Table 24), which has constituted between 85 and 90 per cent of foreign bonds throughout the period between January 1978 and June 1981. The share of floating rate notes is small and has not grown noticeably. In several financial markets nonresident issues of floating rate notes are effectively not permitted. In the Eurobond market, however, the share of floating rate notes rose from 19 per cent in 1980 to 24 per cent during the first six months of 1981, whereas the proportion of straight issues declined from 64 to 61 per cent.

Table 24.International Bonds, by Type, 1977-June 1981(In millions of U.S. dollars; and in per cent)
1981
1977197819791980Jan.-June
Total foreign bonds16,61021,54321,10516,2099,139
Convertible and warrant2268342,1241,121721
Percentage share1.43.910.16.97.9
Floating rate notes6714013610288
Percentage share0.40.60.60.61.0
Straight15,69018,93517,83714,0907,538
Percentage share94.487.984.586.982.5
Special placements347801756570597
Percentage share12.03.73.63.56.5
Other and unknown280833252326195
Percentage share1.73.91.22.02.1
Total Eurobonds19,48415,93919,53722,17911,427
Convertible and warrant1,1731,3081,6172,5941,325
Percentage share6.08.28.311.711.6
Floating rate notes1,8402,5534,2174,2352,779
Percentage share9.416.021.619.124.3
Straight15,71511,08612,85914,2436,922
Percentage share80.669.665.864.260.6
Special placements724844844993401
Percentage share3.75.34.34.53.5
Other and unknown33148115
Percentage share0.20.95.2
Source: World Bank, Borrowing in International Capital Markets.
Source: World Bank, Borrowing in International Capital Markets.

Bond Maturities

As shown in Table 25, the average maturities in the foreign bond and Eurobond markets have displayed somewhat divergent patterns. The average maturity in the former market declined from roughly 10.4 years in 1978 to 8.6 years in 1980 before rising to slightly more than 9 years during the first half of 1981. In the Eurobond market, in contrast, the decline in the average maturity was more modest but has continued. The average maturity fell from 7.8 years in 1978 to 7.3 years in 1980 and to 6.9 years in the first half of 1981. As these changes are best explained in terms of a general trend that has existed since the early 1970s, the next section examines the factors which have contributed to the secular decline in bond maturities.

Table 25.Maturity Structure of Foreign Bonds and Eurobonds, 1978-June 1981
Foreign BondsEurobonds
19811981
197819791980Jan.-June197819791980Jan.-June
Over 1 year up to 5 years21.921.621.329.627.624.225.440.1
Over 5 years up to 7 years13.719.318.58.616.318.125.521.5
Over 7 years up to 10 years18.819.239.835.029.534.328.419.7
Over 10 years up to 15 years26.819.39.314.223.522.018.714.7
Over 15 years16.119.08.210.50.70.61.72.8
Unclassified2.71.62.92.12.40.80.51.2
Source: World Bank, Borrowing in International Capital Markets.
Source: World Bank, Borrowing in International Capital Markets.

Developments in the Last Decade

While a comparison of 1980 and 1981 illustrates the short-run changes that have occurred in the structure of the international bond markets, it does not provide any indication whether these changes are a continuation of recent trends or a sharp break with past behavior. An understanding of the factors that have dominated secular developments in these markets is especially important in order to identify the conditions that could lead to stronger international bond markets during the years ahead. This section reviews the factors that have led to a decline in the real size of the international bond markets and the shortening of average bond maturities in the 1970s and early 1980s. Broadly, these developments have reflected the responses of market participants to the large capital losses experienced by bondholders in the late 1970s, the increasing variability of both exchange rates and interest rates, and the persistence of high rates of inflation.

In general, the demands and supplies of foreign bonds and Eurobonds interact to determine not only the quantity of bonds issued and the market rate of interest that will prevail on each type of bond but also the bond’s maturity, currency of denomination, and risk sharing characteristics. Each bond therefore represents a bundle of characteristics which strongly influences the risk and return associated with holding or issuing this financial instrument. These bond characteristics are constantly being changed in attempts to help minimize the cost of issuing bonds for the borrower and to raise the return to the bond purchasers. This means that macroeconomic factors which adversely affect bond purchasers and suppliers will have an impact not only on the real volume of bond issues and bond interest rates but also on the risk, maturity, and currency denomination characteristics of the bonds. The remainder of this subsection therefore examines the impact of high inflation and interest rate and exchange rate variability on the international bond markets in terms of the changes that have taken place in some of the key characteristics of these international financial instruments.

Level of Real Activity in the Bond Market

While the real size of the net issuance of international bonds can be measured in a number of ways, all these measures portray approximately the same picture: a sharp decline in real net bond issuance from 1976 to 1980 followed by a recovery in 1981 that offset only a small proportion of the decline in the earlier period. In addition, the bonds issued in 1981 generally had less favorable characteristics for the borrower (e.g., shorter maturities and higher real cost) than those issued in the early or mid-1970s. Table 26 presents three measures of real activity in the international bond market. As the net issuance of international bonds is measured in terms of U.S. dollars, the nominal value of such issues could increase as a result of a general rise in the price level without any corresponding increase in the real resources raised via these markets. To remove the effects of the general increase in the price level, item 1 in Table 26 presents the results of deflating the nominal value of net bond issues by the U.S. GNP deflator. This suggests that, measured in terms of 1975 prices, net international bond issuance reached a peak in 1976 of $29 billion, and declined to $20 billion in 1980 before recovering slightly to $23 billion in 1981. An alternative procedure is to compare net bond issuance with some other broadly defined measures of international trade and financial transactions. Items 2 and 3 of Table 26 measure net international bond issues against the nominal value of world trade (as given by the U.S. dollar value of world imports) and net international bank lending. Net international bond issues declined from 3.8 per cent of world trade in 1975 to 1.5 per cent in 1980. Similarly, these bond issues fell from the equivalent of 50 per cent of the value of net international bank lending in 1975 to only 18 per cent in 1980. While the higher level of bond activity in 1981 raised ratios of bond issues to imports and bank lending from their 1980 values, they were still well below the earlier peak ratios in 1975.

Table 26.Measures of Real Size of Bond Market, 1974–81
1974197519761977197897919801981
(In billions of U.S. dollars at 1975 prices)
Bond issues (net)1
1. Deflated by U.S. GNP deflator1220292825252023
(In percent)
2. As ratio to world imports in U.S. dollars1.43.83.22.92.42.01.51.9
3. As ratio to international bank lending (net)22.050.044.345.633.325.617.521.8
Sources: International Monetary Fund; Orion Royal Bank, Ltd. (London); and Bank for International Settlements.

New international bond issues less redemptions and repurchases.

Sources: International Monetary Fund; Orion Royal Bank, Ltd. (London); and Bank for International Settlements.

New international bond issues less redemptions and repurchases.

This fall in the real value of bond issues during the late 1970s was just one aspect of the overall decline in the importance of the international bond market as a source of long-term funds. Other signs of this change included higher real borrowing costs, shorter maturities, and fundamental changes in the types of financial instrument issued in the market. A brief summary of the most important factors that have contributed to this decline may be useful. A basic cause of the deterioration of both domestic bond and Eurobond markets during the 1970s was the experience with world inflation. In some of the countries with the largest bond markets, the 1970s witnessed increasingly erratic but generally rising rates of inflation. This, in turn, has often been reflected in, and accompanied by, greater variability and uncertainty regarding movements in nominal interest rates and exchange rates. As interest rates rose in the late 1970s, partly in response to the increases in uncertainty over future movements in inflation, interest rates, and exchange rates, bondholders suffered large capital losses on their long-term, fixed interest rate securities. As a result, it is likely that investors began to demand historically high real returns on any long-term commitment of funds and to show a much stronger preference for shorter maturity assets. To market their bonds successfully, borrowers developed a series of new financial instruments designed to transfer part of the risks associated with greater interest rate variability away from the investor and to allow them to take greater advantage of any distinctions in national tax codes between the treatment of interest and capital gains income. The continual shift toward denominating bonds in currencies that have shown a tendency to appreciate over time also reflects the attempts to make them more attractive to investors. This involved a relative shift toward the deutsche mark and Swiss franc in the mid-1970s and toward the U.S. dollar in the early 1980s.

Bond Investors’ Experience with Inflation, Interest Rates, and Exchange Rates During 1970s

The willingness of investors to acquire and hold international bonds has been conditioned, in part, by their experience with inflation, interest rate movements, and exchange rate variability in the recent past, as well as by their expectations regarding the future behavior of these variables. Table 50, summarizes the developments in some of the major industrial countries, which also have significant domestic bond markets and/or whose currencies are used in the Eurobond markets, with respect to the level and variability of inflation, short- and long-term interest rates, and exchange rates during the first and second half of the 1970s.31 Although experiences varied, it generally was true that the second half of the 1970s witnessed greater variability of exchange rates and long-term nominal interest rates, higher levels of real short- and long-term interest rates, and, in the United States and United Kingdom, increased inflation and higher interest rates than in the first half of the 1970s. These developments undoubtedly increased uncertainty regarding the future levels of these variables which adversely affected the public’s willingness to hold bonds as well as other financial assets.

Real Rates of Return on International Bonds

While the data in Table 50 indicate that the second half of the 1970s generally witnessed a rise in real short- and long-term interest rates, they do not indicate the extent of the resulting capital losses experienced by bondholders. To indicate the size of these capital losses and their impact on the real rate of return obtained by bondholders, Table 27 illustrates the experiences of representative U.S. and German nationals with purchases of either U.S. dollar or deutsche mark Eurobonds with a ten-year maturity.32 The top line of each table represents the initial year of purchase, and the column refers to the year of sale. The figures without brackets are the annualized ex post real rates of return taking into account interest paid on the bond, reinvestment of interest income, the capital gain or loss resulting from the sale of the bond, the gain or loss due to exchange rate movements between time of purchase and time of sale, and the change in the real value of the preceding gains or losses due to the rise in the cost of living in the investor’s country. The figures in parentheses give the effect on the annual rate of return of the capital gain or loss associated with only the difference between the initial purchase price and sale price of the bond.33

Table 27.Real Return on Bond Holdings, 1975–80(In per cent per annum)
Purchased on 1/1:197519761977197819791980
U.S. Investor Holding a U.S. Dollar Eurobond
Sold on 1/1:
197611.10
(7.13)1
19775.900.62
(2.76)(-1.10)
19782.59–1.90–5.12
(0.17)(-2.89)(-5.18)
1979–0.54–4.44–7.99–12.98
(-2.46)(-4.86)(-7.50)(-11.34)—
1980–1.25–4.86–7.11–9.77–8.69
(-3.80)(-5.43)(-6.86)(-9.06)(-8.73)
1981–0.44–3.41–5.41–6.77–5.31–3.64
(-2.63)(-4.48)(-6.15)(-7.54)(-7.49)(-7.68)
U.S. Investor Holding a Deutsche Mark Eurobond
Sold on 1/1:
197627.73
(22.85)
197729.2527.31
(25.91)(26.42)
197825.1520.5310.87
(23.10)(21.10)(13.60)
197917.6512.272.99–5.47
(16.85)(14.20)(7.01)(-0.39)
19807.481.74–5.69–13.52–23.72
(6.90)(3.12)(-2.56)(-10.10)(-20.91)
19813.33–0.14–7.56–11.87–16.34–11.80
(2.52)(-0.61)(5.55)(-9.43)(-14.78)(-11.58)
German Investor Holding a Deutsche Mark Eurobond
Sold on 1/1:
197617.62
(11.67)
197717.8418.39
(12.27)(14.10)
197813.2511.033.16
(7.16)(6.11)(-0.67)
19798.475.54–1.43–6.88
(2.66)(1.23)(-4.07)(-8.22)
19806.232.74–2.50–6.28–7.19
(0.23)(-1.74)(-5.13)(-8.18)(-10.03)
19815.812.69–2.10–3.05–1.793.82
(-0.16)(-1.64)(-4.60)(-4.67)(-4.12)(1.19)
German Investor Holding a U.S. Dollar Eurobond
Sold on 1/1:
19762.27
(-2.62)
1977–2.15–6.44
(-6.73)(-10.75)
1978–4.73–8.40–11.74
(-9.31)(-12.83)(-17.11)
1979–5.80–8.70–11.49–14.24
(-10.10)(-12.63)(-15.76)(-18.28)
1980–2.10–4.11–4.08–1.7611.09
(-7.25)(-8.82)(-9.07)(-7.09)(3.80)
19811.580.250.734.1614.0013.44
(-4.59)(-5.31)(-5.22)(-2.38)(5.35)(5.67)
Sources: Orion Royal Bank, Ltd., The Orion Royal Guide to the International Capital Markets (Euromoney Publications Limited, London, 1982); the Organization for Economic Cooperation and Development; and the International Monetary Fund, International Financial Statistics.

Capital gain (or loss) includes effect of both gain or loss on sale of bond and movement in exchange rate between initial purchase and final sale.

Sources: Orion Royal Bank, Ltd., The Orion Royal Guide to the International Capital Markets (Euromoney Publications Limited, London, 1982); the Organization for Economic Cooperation and Development; and the International Monetary Fund, International Financial Statistics.

Capital gain (or loss) includes effect of both gain or loss on sale of bond and movement in exchange rate between initial purchase and final sale.

For the U.S. investor, the real return on Eurodollar bonds was very much dependent on the initial year of purchase, although any bond purchased after 1976 would not have yielded a positive real return. The basic problem is that the large capital losses which began to be experienced in 1978–79 wiped out the effects of interest income. The worst performance was for those who purchased their bonds at the beginning of 1978.

The U.S. investor’s experience with Eurobonds denominated in deutsche mark illustrates the impact of both interest rate and exchange rate movements on the real rate of return. Until 1979 the U.S. investor made high real rates of return on deutsche mark Eurobonds primarily because of the effect of an appreciation of the deutsche mark relative to the U.S. dollar (by approximately 33 per cent between the first quarter of 1975 and the fourth quarter of 1979) and a rise in bond prices as deutsche mark interest rates declined. During 1976 and 1978, for example, these exchange rate and bond price movements combined to create a nominal rate of return of between 20 and 25 per cent per annum on deutsche mark bonds for the U.S. investor. In contrast, U.S. investors holding deutsche mark bonds experienced substantial losses from 1979 to 1981 as the U.S. dollar appreciated relative to the deutsche mark and interest rates on deutsche mark bonds rose (thereby lowering the prices of bonds with low coupon rates of interest).

While the German investors who purchased their deutsche mark Eurobonds either early (1975–76) or late (1980) would have earned a positive real rate of return throughout the period, those who purchased in the intervening years suffered negative real returns. The worst experience has been for those who purchased their bonds in 1978 just prior to the rise in deutsche mark interest rates. Eurodollar bonds have yielded an attractive return for the German investor only since 1979. Prior to that period, the appreciation of the deutsche mark and the rise in Eurodollar interest rates created negative real returns on Eurodollar bonds for the typical German investor.

Taken together, these examples imply that, although there have been periods of positive returns on Eurobonds for both U.S. and German investors, there have also been extensive periods of highly negative real returns caused by capital losses owing to interest rate increases and exchange rate movements; and these returns have been highly variable. While these ex post real returns may not be indicative of the ex ante real returns that investors had anticipated, the results nonetheless suggest that there were certain periods where bondholders suffered large losses and this most likely contributed to a desire to avoid future purchases of financial assets that would be vulnerable to those types of capital losses. The next two subsections discuss the impact of the investor experience on Eurobond maturities and the types of financial instruments used in these markets.

These results also have some implications for the issue of the currency of denomination of bonds. The choice of the currency of denomination plays an important role in determining the ultimate return that an investor obtains from holding a given bond (as measured in the investor’s domestic currency) and also the long-run cost of issuance to the borrower. During the late 1970s and early 1980s, the currency of denomination of Eurobonds has generally shifted toward appreciating currencies (initially the deutsche mark and later the U.S. dollar). The results in Table 27 suggest that, at least on the basis of ex post real returns, U.S. and German Eurobond holders would have earned their highest returns by holding deutsche mark bonds during the period when the deutsche mark appreciated relative to the U.S. dollar and Eurodollar bonds during the period when the dollar appreciated. This implies that the initial interest rate differentials on Eurodollar and Euro-deutsche mark bonds were not sufficient to offset the impact of the actual exchange rate movements which took place.

Changes in International Bond Maturities

One response to the investor’s experience with large capital losses has been a movement toward shorter maturity bonds whose prices are less strongly affected by interest rate movements than are longer maturity instruments. As shown in Chart 10, the average maturities in both the foreign and Eurodollar bond markets declined throughout the 1960s and 1970s. Two aspects of Chart 10 are important to note. First, although Interbond data indicate that there was a secular decline in maturities in the Eurodollar bond market throughout the 1960s and the early 1970s, Interbond and World Bank34 data indicate that Eurobond maturities have generally fluctuated within a range of six to ten years without a clear trend since 1975. This represents, in part, the advent of short-term to medium-term floating rate notes as a major instrument, especially in the Eurodollar sector of the bond markets. These instruments, which have a relatively short maturity (five to seven years) and a variable coupon rate, almost eliminate the possibility that their holders could suffer capital losses because of interest rate increases and thus reduce pressures to further shorten maturities. It has been estimated that between 1975 and the end of July 1981 there were almost 290 dollar floating rate note issues, totaling $16.4 billion, with over three fourths of these issued by banks.35 Banks are able to minimize the effects of potential interest rate uncertainty on the cost of funds when issuing floating rate notes to the extent that they can match the medium-term funds raised through floating rate notes with floating rate medium-term loans.

Chart 10.Average Maturities in Foreign and Eurodollar Bond Markets, 1963–80

1 As measured by Interbond and reported in Orion Royal Bank, The Orion Royal Guide to the International Capital Markets (Euromoney Publications Limited, London, 1982).

2 World Bank, Borrowing in International Capital Markets. These bonds include dollar-denominated foreign (Yankee) bonds issued in the U.S. market.

A second aspect of Chart 10 is that the differences between average maturities in the foreign and Eurodollar bond markets are becoming much smaller. This reflects the fact that average maturities in the foreign bond market have fallen by almost 40 per cent from 1974 to 1980. By 1980 the World Bank data implied an average maturity for foreign bonds of 8.6 years and for Eurobonds of 7.3 years. As shown in Table 24, a much greater proportion of foreign bond than Eurobond sales has continued to involve straight debt issue. In foreign markets, shorter maturities have thus been a way of protecting bondholders from capital losses.

Recent Innovations in Financial Instruments

A second aspect of the bond investor’s desire to avoid capital losses and reduce the impact of interest rate and exchange rate uncertainty has been a fundamental change in the types of securities utilized in the international bond markets. During the early 1970s many Eurobonds were straight debt issues with average maturities of 10–15 years. These instruments placed the risk associated with interest rate movements solely on the bond purchaser. As interest rate and exchange rate uncertainty increased in the 1970s, bond issuers found that they could more readily market their bonds if they were willing to utilize new financial instruments which shifted some of those risks from the bond purchaser to the bond issuer and to be more flexible in allowing bond purchasers to extend payment over a period of time. These innovations have included the emergence of the following new instruments. Multiple tranche (tapstock) bonds have only a portion (usually one third or one half) of an issue sold initially (the first tranche). In some cases, subsequent tranches are then issued at the option of the issuer on a best-effort basis at prices reflecting market conditions. The issuer gains the advantage of greater flexibility in determining the amount and timing of subsequent tranches, while having to pay conventional issue commissions on only the first tranche. In other cases, the buyer has the option to purchase additional tranches at fixed interest rates even if market interest rates decline. These advantages for the buyer are obtained by having the borrower accept greater uncertainty regarding interest cost.36

Another instrument has involved the use of floating rate notes with a fixed rate conversion option. This allows the investor to convert his floating rate note into a fixed rate note if market interest rates decline to some specified conversion interest rate. During a period of declining interest rates, this gives the investor the possibility of capital gains if interest rates decline below the conversion rate. This increased protection for the investor is naturally obtained by having the issuer assume greater interest rate risk.

Another instrument designed to offer the investor better protection against interest rate variability has been the fixed rate bond with variable terms. This involves issuing a bond with a fixed coupon rate that is convertible to another bond of the same nominal value with a longer maturity. The investor can then speculate that, before the maturity of the shorter bond is reached, interest rates will fall below the level of the interest rate on the longer-term bond, giving rise either to a new investment possibility or to a short-term capital gain.

The instruments that played a significant role in Eurobond activity in the fourth quarter of 1981 and early 1982 were the deep discount and zero coupon bonds. These bonds carry a low or zero coupon rate of interest and the return to the investor reflects the fact that they are sold at a large discount relative to their ultimate redemption value. One of the main attractions of these bonds is that they guarantee the reinvestment rate of interest on the implicit yearly income from the bond. With a normal straight debt coupon bond, the investor cannot be certain that, over the life of the bond, he can reinvest the annual interest income at the same interest rate as initially applied to the bond at the time of purchase. With a zero coupon bond, in contrast, the implicit rate of reinvestment is virtually guaranteed for the life of the bond, as the issuer would have to pay the final maturity price if the bond were recalled earlier.

These bonds are also quite attractive if interest rates are expected to decline, as one can obtain larger capital gains than on ordinary fixed interest rate straight debt which carries coupon rates of interest closer to market interest rates. In addition, in some countries, it is possible that the increase in the bond’ value over its lifetime would be taxed as capital appreciation (with a relatively low tax rate) rather than interest income (with a relatively high tax rate). A number of tax authorities have recently indicated, however, that such favorable tax treatment is unlikely. These bonds are best viewed as another part of the ongoing evolution of financial instruments in the Eurobond markets that are designed to increase the attractiveness of bonds to investors during a period of high inflation and considerable uncertainty regarding interest rate movements.

An assessment of what these nominal interest rate movements implied for the real rate of return on bond holdings is discussed in the following subsection.

Foreign bonds are issued by a borrower who is of a nationality different from the country of the single capital market in which the bonds are issued. Such issues are usually underwritten and sold by a group of banks of the market country and are denominated in that country’s currency. In contrast, Eurocurrency bonds are those under-written and sold in various national markets simultaneously, usually through international syndicates of banks.

Quite apart from fees charged for issues in the two markets.

Culminating in a 5.5 per cent revaluation of the deutsche mark vis-à-vis the currencies of the European Monetary System’s other members.

A straight debt bond can be defined as a negotiable certificate of indebtedness sold by an issuer promising to pay the holder its face value plus fixed amounts of interest at future dates.

The variability of each variable is measured by its standard deviation.

In calculating the real rates of return in Table 27, the following assumptions were made: (1) The bond is assumed to be purchased on January 1 of the year at the top of the table. (2) All interest on the bond is paid on December 31 of each year and the initial coupon rate of interest is taken as equal to the prevailing market interest rate. (3) Principal is repaid only at maturity. (4) Bonds are sold on the first day of January of the year given at the side of the table at a price which ensures that the bond yields a return to maturity equal to the prevailing (January) interest rate. (5) All coupon interest received is assumed to be continuously reinvested in three-month Eurocurrency deposits (at the prevailing Eurocurrency deposit rate) in the same currency as the interest rate payments and bonds are denominated. (6) In calculating the real return on bonds not denominated in the domestic currency, the accumulated interest income and bond sale proceeds are converted at the prevailing exchange rate, and any exchange gain or loss is included in the calculation of the real return. (7) The real return is calculated using the consumer price index in the investors’ home countries. (8) The bonds are those issued by private corporations.

The calculations ignore the transaction costs the investor would incur when buying and selling the bond.

The World Bank data for all Eurobonds (including Eurodollar bonds) are not portrayed in Chart 10 but show an average maturity structure that is only slightly lower than that for Eurodollar bonds.

Orion Royal Bank, Ltd., The Orion Royal Guide to the International Capital Markets (Euromoney Publications Limited, London, 1982), p. 38.

Closely related to the tapstock bonds are deferred purchase bonds. With this instrument only a relatively small portion (e.g., 20 per cent) is payable on issue, with the balance being due in one or more installments of, for example, six months.

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