Chapter

IV International Bond Markets

Author(s):
John Lipsky, Peter Keller, Donald Mathieson, and Richard Williams
Published Date:
July 1983
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Introduction

Since the fourth quarter of 1981, international markets have witnessed historically high rates of bond issuance. During 1982, total international bond issues rose by 50 percent, with Eurocurrency bond issues increasing by over 75 percent and foreign bond issues by 18 percent.35 Investor demand for new issues was stimulated by the prospect of declining long-term interest rates, the reappearance of a positively sloped yield curve, and the continuance of high ex post real yields, especially on longer-term bonds. The supply of new issues was generated by the financing needs of the fiscal authorities in many of the industrial countries, the desire of private corporations to secure longer-term sources of finance, and the borrowing programs of the various multinational institutions. Most of the borrowers and lenders in the international bond markets were from the industrial countries, and the non-oil developing countries were generally absent from the bond markets, especially during the second half of 1982 and the first quarter of 1983.

The U.S. dollar continued to serve as the primary currency of denomination. Bond maturities did not change significantly in most markets; where some change was observed, however, it mainly took the form of a movement away from both short-term and long-term bonds into medium-term instruments. A number of new bond market instruments and new funding techniques appeared. Examples were interest rate swaps that involved the exchange between borrowers of fixed rate debt for floating rate debt, extendable bonds that offered the option of changing the maturity of the bond, and partially paid and deferred payment bonds. The latter appealed to investors expecting declines in nominal interest rates. These new instruments, along with the continued utilization of the traditional straight debt instruments, were all designed to further increase the attractiveness of longer-term bonds for investors and to give borrowers access to various national bond markets.

The higher level of bond market activity resulted in a significant increase in the real36 value of bonds issued and in the importance of bond financing relative to international bank lending. For the first time in almost a decade, the real level of bond issuance rose above the previous peak of $29 billion in 1976 to reach $35 billion in 1982. At the same time, the ratio of international bond issues to international bank lending rose from a low of 18 percent in 1980, and 22 percent in 1981, to 61 percent in 1982. To a large extent, this reflected an absolute decline in bank lending in 1982. During the first quarter of 1983, the total issuance of international bonds actually exceeded publicized international bank lending commitments.

The remainder of this section is composed of two major subsections. The first examines the state of the foreign and Eurobond market during late 1981 and 1982. There is a discussion of the behavior of interest rates, the levels of foreign and Eurobond issuance, the currency composition of international bonds, bond maturities, and the types of bonds employed in the various markets. The second subsection takes a somewhat longer-term perspective and compares the 1981–82 performance with that experienced during the 1970s. This includes an examination of the macroeconomic factors that led to the deterioration of the bond markets during the last decade and is followed by a discussion of whether conditions now exist for a continuation of the 1981–82 recovery of bond market activity.

The 1982 Experience

Following the issuance of $9.6 billion of international bonds in the last quarter of 1981, an additional $46.4 billion were marketed in 1982. Nominal interest rates declined in 1982, especially during the second half of the year (Chart 6). However, as inflation rates also fell by roughly the same extent, real interest rates in many countries remained high enough to attract considerable investor interest in bonds. In part reflecting the market’s response to the debt servicing problems of certain developing countries, the position of developing country issuers deteriorated noticeably. The majority of purchasers in the bond markets were from the industrial countries and consisted largely of institutional investors seeking relatively safe assets. Bond maturities did not change greatly, but several new types of bonds were issued.

Chart 6.Developments in International Bond Markets, 1979–82

1 Three-month deposits.

2 Bonds with remaining maturity of 7 to 15 years.

3 Prior to 1982 this type of bond represented only a small proportion of total bond issues.

Interest Rates

Charts 7 and 8 and Table 41 illustrate the interest rate movement that occurred in the major financial markets during 1982. While nominal interest rates did not show a definite trend in a number of short-and long-term markets during the first half of the year, they generally remained below the peak levels witnessed in 1981. From July 1982 onward, however, there was a downward trend in nominal interest rates that was most pronounced in the short-term markets. In the United States, for example, interest rates on three-month certificates of deposit fell from 15.5 percent in June 1982 to 9.5 percent in December 1982. In most longer-term markets, there were much more limited declines of from 2 to 3 percent leading to the reemergence of a positive yield curve. This decline in interest rates reflected a variety of factors, including the impact of lower rates of inflation, moves toward relatively less restrictive monetary policies in some industrial countries, and the low level of real activity in the world economy. As shown in Table 40, however, the declines in inflation generally matched or exceeded the reductions in interest rates, which kept ex post real interest rates at near record levels. Some possible explanations for the persistence of these high real rates is discussed in the second part of this section.

Chart 7.Domestic Money Market Rates, 1982

(In percent)

Source: International Monetary Fund, International Financial Statistics.

Foreign Bonds Versus Eurobonds

International bond issues (i.e., the sum of foreign and Eurobond issues) increased by nearly 50 percent in 1982 following a 26 percent increase in 1981. Borrowers in industrial countries accounted for 80 percent of total issues, international organizations for 15 percent, and developing countries for 5 percent. The access of individual developing countries to the market is shown in Table 42. Most of these developing country issues took place during the first half of the year, and there was a significantly lower level of issuance in the August to December period. The major issuers during the year were Indonesia, Malaysia, Mexico, and South Africa. The continuing absence of developing country issues from the bond markets was amply demonstrated by the fact that, during the first two months of 1983, South Africa was the only developing country issuer (for $42 million) in the Eurobond market. During the same period, industrial country issuers marketed over $8 billion of bonds. The sharp increase in bond issues during 1981 and 1982 resulted in higher global net flows through the bond markets, after account is taken of redemptions. International bond issues, net of redemptions, rose from $28 billion in 1980 to $37 billion in 1981 and further to $58 billion in 1982. These increased net flows went primarily to industrial countries and international organizations, while net flows to developing countries remained basically unchanged at very low levels as redemption rose sharply in 1981 and 1982. Although data on redemptions are incomplete, on present trends, redemptions by developing countries are likely to exceed bond issues in 1983.

Chart 8.Domestic Long-Term Interest Rates, 1982

(In percent)

Source: International Monetary Fund, International Financial Statistics.

While foreign bond issues rose from $21.3 billion in 1981 to $25.1 billion in 1982, Eurobond sales expanded even more rapidly from $26.5 billion in 1981 to over $46.4 billion in 1982 (Table 17). The increased issuance activity took place throughout the year, but the highest levels of Eurobond issues took place in the second quarter ($13.4 billion) and for foreign bond issues in the third quarter of 1982 ($7.8 billion). Most foreign bonds were issued by industrial country borrowers ($17.0 billion) and international organizations ($7.4 billion). The proportion of foreign bonds accounted for by these two groups rose from 94 to 97 percent between 1981 and 1982. This change encompassed a fall in the share of bond issues for the industrial countries between 1981 and 1982 from 71 to 68 percent, and a rise in the share of issues by international organizations from 24 to 29 percent. In view of the market’s concern regarding the debt servicing difficulties of a number of developing countries, their share of foreign bond issues fell from 6 to 3 percent. The decline in foreign bond issuance by developing countries was especially sharp for the oil exporting countries (from $243 million in 1981 to $38 million in 1982.

Table 17.International Bond Issues and Placements, 1977-Second Quarter, 19831(In millions of U.S. dollars)
1983
1977197819791980198119821st qtr.2nd qtr.
Foreign bonds
Industrial countries10,15713,05712,30111,46515,02316,9926,0204,964
Developing countries1,6092,5841,6417731,213725279254
Oil exporting333571105462433837
Non-oil developing1,2762,0131,536727970687242254
Centrally planned economies2643
International organizations4,7485,7066,9595,7165,0257,4151,8182,055
Other9019616121817
Total foreign bonds——

16,610
——

21,543
——

21,105
——

17,956
——

21,279
——

25,149
——

8,117
——

7,273
Eurobonds
Industrial countries13,1679,83214,21416,93421,67340,13211,6149,144
Developing countries2,7923,1541,8851,3802,2462,923145341
Oil exporting4531,08232913270275
Non-oil developing2,3392,0721,5561,2482,1762,648145341
Centrally planned economies2743030
International organizations2,4122,7193,0641,7112,4873,2809892,648
Other1,040204344248010040
Total Eurobonds——

19,584
——

15,939
——

19,537
——

20,049
——

26,486
——

46,435
——

12,748
——

12,173
International bonds
Industrial countries23,32422,88926,51528,39936,69657,12417,63414,108
Developing countries4,4015,7383,5262,1533,4593,648424595
Oil exporting7861,65343417831331337
Non-oil developing3,6154,0853,0921,9753,1463,335387595
Centrally planned economies2803073
International organizations7,1608,42510,0237,4277,51210,6952,8074,703
Other1,130400505269811740
Total international bonds——

36,095
——

37,482
——

40,642
——

38,005
——

47,765
——

71,584
——

20,865
——

19,446
Sources: World Bank, Borrowing in International Capital Markets; and Organization for Economic Cooperation and Development, Financial Statistics Monthly.

Industrial country borrowers were the largest issuers of Eurobonds, and total issuance by this group nearly doubled during the year, rising from $21.7 billion in 1981 to $40.2 billion in 1982. This volume of issuance raised the proportion of Eurobonds accounted for by industrial country issuers to 87 per cent in 1982 from 82 percent in 1981. While the amount of Eurobonds issued by developing country borrowers rose from $2.2 billion in 1981 to $3 billion in 1982, almost two thirds of this activity took place in the first half of 1982. The share of developing countries in total bond issuance fell from 8 to 6 percent between 1981 and 1982. The share of international organization issues declined from 9 to 7 percent of the total market even though their total issues grew from $2.5 billion in 1981 to $3.3 billion in 1982.

Currency Composition

The currency composition of international bonds reflected, in part, the expectations of borrowers and lenders regarding the future movements in interest rates, inflation, and exchange rates. Throughout 1981 and 1982, prevailing expectations generally worked to create a strong preference by investors for Eurobonds denominated in U.S. dollars. While the movement toward denominating bonds in U.S. dollars can be observed in the recent data on the issuance of total international bonds, this trend primarily reflects developments in the Eurobond market rather than in the foreign bond markets.

In the foreign bond markets, the currency composition was strongly affected by the 20 percent decline in the issuance of foreign (Yankee) bonds in the United States (Table 18). In part, this was due to the fact that during the first and fourth quarters of 1982, a number of firms found it somewhat less expensive to issue in the Eurodollar bond market, because of strong investor demand for Eurodollar instruments. As a result, the proportion of foreign bonds denominated in U.S. dollars fell from 36 percent in 1981 to 24 percent in 1982. However, the importance of bonds denominated in Swiss francs in total foreign bond issues rose from 38 percent in 1981 to 49 percent in 1982, and the share of foreign bonds denominated in deutsche mark increased from 6 to 8 percent during the same period.

Table 18.Foreign Bond Issues and Placements by Market Country, 1977-Second Quarter 1983(In millions of U.S. dollars)
1983
1977197819791980198119821st qtr.2nd qtr.
Austria29100812952
Belgium431481616354456019
France622313652638922157
Germany, Federal Republic of1,5111,6772,2964,9521,1902,109867603
Japan1,3944,6872,9851,5432,7233,3011,117869
Luxembourg802062182001311402612
Netherlands182352466325485854297295
Saudi Arabia64524686123
Switzerland4,9597,5539,6377,4708,11811,3254,3692,988
United Kingdom551789131,12977266
United States7,6686,3594,6022,7367,5766,0251,2752,100
Other countries661892212
Total——

16,610
——

21,543
——

21,105
——

17,956
——

21,279
——

25,149
——

8,117
——

7,273
Sources: World Bank, Borrowing in International Capital Markets; and Organization for Economic Cooperation and Development, Financial Statistics Monthly.

In the Eurobond markets, in contrast, new issuance of U.S. dollar-denominated bonds rose from $21.3 billion in 1981 to $38.7 billion in 1982 (Table 19). The share of dollar-denominated bonds in total Eurobonds thus increased from 80 to 83 percent between 1981 and 1982. The first year in which issues of Eurodollar bonds surpassed the issue of U.S. domestic corporate bonds was also 1982. Many investors found Eurodollar bonds quite attractive. Aside from high coupon rates, this was prospect of capital gains reflecting expectations of future declines in U.S. interest rates. The prospect of these capital gains allowed borrowers to issue bonds at a somewhat lower relative interest cost in the Eurodollar market than in other bond markets. The general attractiveness of dollar-denominated bonds is illustrated by the fact that, for the sum of foreign and Eurobond issues, the share of dollar-denominated bonds rose from 60 to 62 percent between 1981 and 1982, despite a sharp decline in issuance of Yankee bonds. The share of dollar-denominated bonds in total international bonds thus increased from 37 to 62 percent between 1978 and 1982 (Table 43).

Table 19.Total Eurobond Issues and Placements by Currency of Denomination by All Countries, 1977-Second Quarter 1983(In millions of U.S. dollars; and in percent)
1983
1977197819791980198119821st qtr.2nd qtr.
Total amountPercentTotal amountPercentTotal amountPercentTotal amountPercentTotal amountPercentTotal amountTotal amountTotal amountPercentTotal amountPercent
Deutsche mark5,21526.86,53141.15,88130.13,45717.21,3745.23,2537.01,33910.51,54112.6
French franc1030.73741.98834.45332.0
Japanese yen1110.6790.51840.93011.54101.65981.31491.2
Netherlands guilder3631.93842.43081.65492.74171.66181.32992.3
U.S. dollar12,33663.37,64348.111,09556.813,29966.421,25280.238,67883.39,96378.29,49178.0
Composite currency units340.22351.54132.11000.57482.88351.85904.64503.7
European currency units2360.98231.85904.64503.7
European unit of account340.22031.33061.6800.41260.512
Special drawing right320.21070.5200.13861.5
Canadian dollar6543.34682.42701.46882.61,2002.62441.92442.0
Kuwaiti dinar1300.74813.03842.0260.13871.51610.3
Pound sterling2211.12871.82911.59764.95382.07981.71231.03643.0
Saudi Arabian riyal1030.5950.6
Austrian schilling800.4
Norwegian krone1010.5530.2310.1
Other currencies3171.6520.31390.77860.32630.6410.3830.7
Total——

19,484
——

100.0
——

15,890
——

100.0
——

19,537
——

100.0
——

20,049
——

100.0
——

26,486
——

100.0
——

46,435
——

100.0
——

12,748
——

100.0
——

12,173
——

100.0
Sources: World Bank, Borrowing in International Capital Markets; and Organization for Economic Cooperation and Development, Financial Statistics Monthly.

International bonds denominated in deutsche mark increased in relative importance during 1982, but did not return to the relative position they had held in the late 1970s. Foreign bonds denominated in deutsche mark almost doubled, rising from $1.2 billion in 1981 to $2.1 billion in 1982. Eurobonds in deutsche mark increased from $1.4 billion in 1981 to $3.3 billion in 1982, thereby raising the share of Eurobonds denominated in deutsche mark from 5 to 7 percent of total Eurobond issues. The share of bonds denominated in deutsche mark in total international bonds thus rose from 5 to 8 percent between 1981 and 1982. To some degree, developments in 1982 reflected the absence of informal actions taken at various times during 1981 to limit issuance of nonresident bonds denominated in deutsche mark when the German authorities regarded the current account position as weak. However, the share of bonds denominated in deutsche mark in total international bonds is still well below the 20–22 percent share achieved in 1978–80.

The relative share of foreign and Eurobonds denominated in Japanese yen, which had increased in 1981 to 6.6 percent of total issues, fell to 5.4 percent in 1982. This decline occurred despite the fact that issues of foreign bonds denominated in Japanese yen rose from $2.7 billion to $3.3 billion between 1981 and 1982, and Euroyen bonds increased from $4.2 billion to $6.2 billion. Much of this increased issuance activity was a result of the relatively low nominal interest rates on Japanese capital markets during much of 1982.

The use of other major currencies or various international units of account as the currency of denomination was much less significant. Only the relative share of bonds denominated in the Netherlands guilder rose from 1.9 percent in 1981 to 2.1 percent in 1982. The relative shares of bonds denominated in other currencies declined. Bond issues denominated in European Currency Units (ECUs) rose from $236 million in 1981 to $823 million, reflecting the strengthening of the general market acceptance for ECUs, including the emergence of a variety of instruments with different maturities and the establishment of an interbank clearing market for ECU instruments. The use of the ECU and Canadian dollar as currencies of denomination was most evident in the Eurobond markets as opposed to the foreign bond markets. In the Eurobond market, issues denominated in Canadian dollars represented 2.6 percent of total Eurobond issues and ECU-denominated instruments were 1.8 percent of total issues. While $408 million of Eurobonds denominated in SDRs were issued in 1981, there were no such issues during 1982, reflecting a general lack of investor interest.

Type of Bond

Table 20 and Chart 6 provide some information on recent evolution of the type of bond utilized in international bond markets. In the Eurodollar market, there has been a notable increase in the use of the traditional straight debt instrument during recent.37 After accounting for only 53 percent of all Eurodollar bonds in 1980, the share of this type of issue increased to 68 percent in 1982. Although floating rate are still one of the primary Eurobond instruments, their share in total Eurodollar bond issues declined from 36 percent in 1979 to 29 percent in 1982. Convertible issues,38 which represented 14 percent of all in 1980, constituted only 3 percent of total bond in the most recent period. The increasing importance of straight debt issues reflects, in part, the fact these instruments produce the most significant captial gains during periods of declining nominal interest. In addition, the role of straight debt issues has enhanced by the high level of bond issuance by sovereign borrowers and international organizations, Which typically have preferred these instruments. If expectations of further declines in interest rates persist straight debt issues will continue to be quite attractive to investors during 1983. Given the strengthening of activity and prices in the equity markets in many major countries, there also may be more convertible bond issuance in 1983 than in 1982.

Table 20.International Bonds, by Type, Selected Eurobonds, 1979–82(In percent of total)
1979198019811982
Eurodollar bonds
Straight57535768
Floating rate notes36333329
Convertibles714103
Swiss franc bonds
Foreign straight and floating rate notes858587
Foreign convertibles151513
Eurodollar bonds issued by U.S. borrowers
Straight65718390
Floating rate notes29898
Convertible62182
Eurodollar bonds issued by Canadian borrowers
Straight100889287
Floating rate notes712
Convertible581
Source: Salomon Brothers, Inc., International Bond and Money Market Performance.

Bond Maturities

The recovery of bond issuance during 1981 and 1982 has not been accompanied by a significant increase in bond maturities (Table 21). In most markets, the percentage of bonds having a maturity of more than ten years declined or at best remained unchanged between 1981 and 1982. There was also some movement out of shorter-term (less than five years) maturities into medium-term (six years to ten years) instruments. As will be discussed later, the absence of greater maturity transformation reflects investors’ preferences in view of many uncertainties regarding future movement in exchange rates, interest rates, and inflation.

Table 21.Maturity Profile of International Bonds in 1981–82(In percent)
0-5years6-10 yearsOver 10 years
Currency of Denomination198119821981198219811982
U.S. dollar252054592121
Canadian dollar3521587970
Deutsche mark1211828168
Japanese yen0224697629
Pound sterling41322275741
Swiss franc3236646044
Netherlands guilder373935482813
Source: Salomon Brothers, Inc., International Bond and Money Market Performance.

Bond Market Developments in 1970s and the 1981–82 Bond Market Recovery

The record levels of bond market issuance during late 1981 and 1982 were part of a recovery from almost a decade-long decline in the real level of activity in international bond markets during the 1970s. This section first briefly summarizes the reasons for this development in bond market activity, especially in the late 1970s, and then examines the reasons for the upturn during 1981 and 1982. There is also a discussion of factors likely to influence future bond issuance activities.

Developments in 1970s

As noted in Appendix II of last year’s report,39 the typical borrower’s decision to issue international bonds as opposed to using an alternative source of domestic or foreign credit reflects the risk-return characteristics of different types of instruments, as well as official regulations affecting certain types of capital flows. During the late 1970s, in particular, high levels of inflation, greater variability of interest rates, exchange rates, and inflation, and large capital losses on fixed interest rate securities made holding of many type of financial assets less attractive. In the international bond markets, this was reflected in a decline in the real volume of bond issuances, higher real interest rates, declining bond maturities, and a redistribution of a portion of the risk of interest rate variability from the investor to the issuer through instruments such as floating rate notes.

Table 22 presents three measures of the level of real activity in international bond markets during the period Since 1975. Since the net issuance of international bonds is measured in current U.S. dollars, the nominal value of bonds must be adjusted for the general rise level in the in order to capture the real level of activity. The first item in Table 22 represents the results of deflating the U.S. dollar value of net bond issues by the U.S. GNP deflator. Measured in terms of 1975 prices, Eurobond issuance declined almost continuously from $29 billion in 1976 to $20 billion in 1980. There was a recovery of real activity during the next two years, with net real bond issuance rising to $24 billion in 1981 and $35 billion in 1982. An alternative approach is to compare net international bond issues with other broadly defined measures of international trade or financial transactions. The second item in Table 22 indicates that, by 1982, the importance of net bond issuance relative to the value of international trade had returned to the same value evident in 1976, even though this ratio has more than doubled since 1980. The data in Table 22 indicate that, although the current recovery in the bond markets has raised the real value of net international bonds issued, it has not yet caused the international bond markets to grow significantly relative to the real size of international trade over the period after 1975. As the last item of Table 22 shows, however, the recovery of bond market activity, combined with the reduction in new international bank lending, led to a sharp increase in the importance of bond issues relative to international bank lending. In 1982, net bond issuances equaled 61 percent of international bank lending. This was the first time since 1975 that this ratio had risen above 50 percent. This trend could continue in 1983; during the first quarter of 1983 there were more international bond issues (gross) than publicized international bank lending commitments.

Table 22.Measures of Real Size of Bond Market, 1975–82
19751976197719781979198019811982
Billion U.S. dollars at 1975 prices
Bond issues (net)12030313033283758
Deflated by U.S. GNP deflator2029282525202435
Percent
As ratio to world imports in U.S. dollars2.53.22.92.42.11.51.93.2
As ratio to world imports in U.S. dollars2.53.22.92.42.11.51.93.2
Sources: International Monetary Fund; Orion Royal Bank, Ltd. (London); and Bank for Internationa l Settlements.

The decline in the level of real activity in international bond markets during the late 1970s reflected in part investors’ experiences with inflation, interest rate movements, and exchange rate volatility (Table 44).40 In general, during the late 1970s, investors saw greater variability of exchange rates and long-term interest rates, rising real short-and long-term interest rates, and, in many countries, higher rates of inflation than experienced during the first half of the 1970s. One major aspect of this development was the emergence of capital losses experienced by bond investors, especially during the late 1970s (Table 23). Reflecting the exchange rate and interest rate movements that occurred during certain periods, real bond values, as measured in the domestic currency of the investor, declined by up to 20 percent in a single year. These developments reduced the attractiveness of financial assets in general, and fixed interest rate bonds in particular.

Table 23.Real Return on Bond Holdings, 1975–811(In percent per annum)
Purchased in December of:1975197619771978197919801981
U.S. Investor Holding a U.S. Dollar Eurobond
Sold in Dec. of:
197611.32
19775.930.48
19782.59–2.00–5.18
1979–0.66–4.65–8.23–13.42
1980–1.32–4.97–7.22–9.91–8.55
1981–0.40–3.41–5.38–6.72–5.00–3.09
19821.35–1.05–2.13–2.281.226.2717.27
U.S. Investor Holding a Deutsche Mark Eurobond
Sold in Dec. of:
197628.02
197729.2927.12
197825.1420.3810.80
197917.4211.942.68–5.95
19807.371.59–5.80–13.65–23.61
19813.37–1.42–7.54–11.82–16.10–11.30
19822.95–0.99–5.69–9.28–10.23–4.413.71
German Investor Holding a Deutsche Mark Eurobond
Sold in Dec. of:
197617.64
197717.8618.40
197813.2210.983.07
19798.425.48–1.50–6.94
19806.162.66–2.59–6.37–7.32
19815.802.67–2.12–3.04–1.764.05
19826.283.69–0.06–1.461.656.9110.35
German Investor Holding a U.S. Dollar Eurobond
Sold in Dec. of:
19762.29
1977–1.07–6.41
1978–1.58–4.21–11.79
1979–1.46–2.91–5.78–14.33
1980–0.43–1.04–1.39–0.94–10.94
19810.260.050.171.387.0213.68
19820.620.600.982.266.3310.1224.78
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.

Under these circumstances, borrowers found that they could only attract purchasers to the bond market by offering high real yields and by altering the maturity and risk-sharing characteristics of the financial instruments used in international bond markets. In a number of major financial markets, real yields, which were relatively low during 1977–78, rose sharply during 1979–80 and remained high through 1982 (Table 40). The changes in risk bearing involved a number of innovations in the financial markets. For example, there was a move toward denominating bonds in currencies expected to undergo extended appreciations. Bonds denominated in deutsche mark thus increased in popularity in the late 1970s, and the use of U.S. dollar-denominated bonds expanded in the early 1980s. There was also a clear preference for bonds with shorter maturity. In the Eurodollar bond market, average maturities declined from a range of 12–15 years in the early 1970s to one of 7–10 years in the late 1970s. Shorter-term instruments proved to be especially popular in the periods immediately following those in which holders of longer-term instruments suffered large capital losses because of rising interest rates. During these periods, the use of floating rate instruments increased significantly, with many floating rate notes issued by large banks to improve their funding. To a certain degree, banks tried to match the extension of floating rate medium-term loans with the issuance of floating rate notes.

In addition to the floating rate note, there also came on the market a variety of other instruments that were designed to shift a portion of the risk associated with interest rate and exchange rate variability from the bond purchaser to the issuer of the bond. One example was the multiple-tranche (tap stock) bonds where only a portion of an issue was sold initially (the first tranche). Subsequent tranches would then be issued at the option of the issuer on a best-effort basis at prices reflecting market conditions. The issuer gained the advantage of greater flexibility in determining the amount and timing of subsequent tranches, but at the cost of some uncertainty regarding the exact yield that would have to be paid on the future tranches. Another instrument that offered the investor better protection against interest rate variability was the fixed rate bond with variable terms. This involved issuing a bond with a fixed coupon rate that was convertible into another bond at the same nominal value but with a longer maturity. The investor was therefore allowed to choose, within limits, the maturity of the instrument he held.

Another means of attracting investor interest was the attempt to create a situation where the yield on a bond would be represented by capital gains income instead of ordinary interest income payments. The objective was to take advantage of the differences in the income tax rates applicable to capital gains and interest income that existed in a number of major industrial countries. This innovation involved the use of deep discount or zero coupon bonds, which carried either a low or zero coupon rate of interest. These were issued at prices below their face value and the implicit interest yield was the appreciation of the price of the bond between the date of issuance and maturity. In many cases, however, the fiscal authorities in the major industrial countries ruled that such gains would not necesarily be taxed at the capital gains tax rate, but treated as current interest income. In other cases, the authorities did not permit the issuance of such instruments.

The 1981–82 Recovery

As already noted, late 1981 and 1982 witnessed a strong, sustained recovery in the issuance of international bonds. While this recovery involved record numbers of new issuances, even when adjusted for price changes, it was also a period of high real interest rates and little, if any, lengthening of bond market maturities. One of the fundamental factors of the recovery in the international bond market has been the high real yields that bond purchasers have been able to obtain in recent years. During 1981 and 1982, ex post real interest rates on both short-and long-term financial instruments were considerably above comparable rates that had prevailed during either the first or the second half of the 1970s (Table 44). In the United States, for example, the ex post real return on U.S. Treasury bills was in excess of 4 percent per annum and, on U.S. Treasury bonds, at over 5 percent per annum during 1981 and 1982.

The real rate of return that individual investors obtained was strongly influenced also by the currency of denomination of the bond and relative exchange rate movements. As shown in Table 23, the real return seen by German and U.S. nationals on bonds denominated in U.S. dollars or deutsche mark differed considerably. The real return earned on these two different types of bonds depended on the initial year of purchase. In general, investors earned a high real rate of return by buying bonds denominated in deutsche mark between 1975 and 1977 and the U.S. dollar-denominated bonds in the early 1980s. In 1980–82, U.S. dollar-denominated instruments became especially attractive, owing to an appreciation of the U.S. dollar relative to the deutsche mark and the presence of high nominal interest rates. Table 23 shows that German investors who bought U.S. dollar-denominated instruments at the end of 1981 and sold these at the end of 1982 earned an annual real rate of return of almost 25 percent.

Investors were also attracted to longer-term instruments by the emergence of a positively sloped yield curve in many major financial markets. As portrayed in Chart 9, the 1980–82 period witnessed a movement from a flat or negatively sloped yield curve to a positively sloped curve in the United States, the United Kingdom, and the Federal Republic of Germany. This was also true for other financial market countries, for example, Japan and Switzerland. This change helped to restore the relative attractiveness of longer-term instruments.

Chart 9.Yield Curves in Federal Republic of Germany, United States, and United Kingdom

Sources: Bank of England, Quarterly Bulletin; Deutsche Bundesbank, Monthly Report; and U.S. Treasury, Treasury Bulletin

Although high real yields allowed borrowers to find a ready market for their bond issues, the recovery in issue activity was not accompanied by a significant lengthening of bond market maturities. The absence of an increase in maturities and the continuance of high real interest rates reflected the impact of considerable uncertainty regarding the future movements of inflation, interest rates, and exchange rates. This uncertainty created a situation where investors were willing to place their funds at long term only if they could earn a significant premium over the returns that could be earned on short- and medium-term instruments. Since real yields on even medium-term issues were historically high, bond issuers have generally not found it profitable to pay the extra premium required on longer-term debt. Most bond maturities are thus concentrated in the medium-term range.

Another element in the recent recovery was the introduction of a variety of new instruments at the same time that the traditional straight debt instruments were once again becoming important. In a number of respects, these developments reflected attempts to improve the attractiveness of bonds for borrowers during a period of declining nominal interest rates. Among the important innovations in 1982 were interest rate swaps involving the exchange of fixed rate debt for floating rate debt, extendable bonds, partially paid or deferred payment bonds, and warrant bonds. As already mentioned, many interest rate swaps involved the issuance of a fixed rate bond by a major international bank, which then swapped this obligation with a nonbank entity for floating rate debt. By engaging in this transaction, banks were able to raise funds on much more favorable terms than in the Eurodollar interbank or floating rate note markets. Typically, a wellknown bank would be able to issue fixed rate debt, while a lowerrated or less well-known corporation would borrow the equivalent amount at a floating rate from a bank at the London interbank offered rate (LIBOR) plus a margin. The two borrowers would exchange (swap) the interest obligations on their debt, with the firm paying the charges on fixed rate debt plus a spread over LIBOR, while the bank borrower would pay only LIBOR or less. This was more favorable than funding with a margin in interbank lending. This type of swap transaction was possible only because market participants in the fixed rate market and the floating rate market had different relative perceptions of the creditworthiness of major international banks and certain corporate entities. As long as the volume of these interest rate swaps remained limited, banks were able to profitably arbitrage the differences between the cost of funds in these two markets.

Other new instruments included extendable bonds that allowed investors to extend the maturity of their bonds, usually at a prespecified, fixed coupon rate. This permitted investors the freedom to redeem their bonds at various intervals prior to final maturity. Partially paid bonds and deferred payment bonds enabled investors to purchase at a given price, but then to make actual payment over an extended period. Such Eurodollar bonds were especially attractive to bond purchasers who anticipated declining U.S. interest rates and possibly (for non-U.S.-based investors) a declining U.S. dollar exchange rate relative to the other major currencies. During periods when there has been the prospect of stable or rising interest rates, these bonds have been much less attractive.

Just as with the extendable and partially paid bonds, the increased utilization of the more traditional straight debt issues reflected the borrowers’ desire to increase the attractiveness of their bonds during a period of somewhat erratic declines in interest rates. By offering investors the prospects of capital gains as well as interest income, they were able to minimize the current cost of borrowing funds. However, lenders often protected themselves by making provision for an early redemption of bonds should there be an unexpectedly sharp decline in interest rates.

Warrant bonds became increasingly popular during 1982 and appeared in a variety of forms. Some of these bonds were designed to attract investors expecting declining interest rates by offering floating rate bonds with attached warrants that enabled the holder, within a specified period, to buy medium-term fixed rate instruments. Other warrant bonds, aimed at those investors who thought interest rates would rise, carried fixed interest rates but offered warrants that allowed the purchaser to switch to a floating rate note in the future. Warrant bonds typically carried lower interest rates than either straight debt or floating rate instruments of similar maturity and quality.

Foreign bonds are issued by a borrower who is of a nationality different from the country 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 underwritten and sold in various national markets simultaneously, usually through international syndicates of banks.

The real value of bonds issued equals the nominal value of bond issues adjusted for the increase in the general price level.

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.

This a bond convertible at the holder’s option into shares in, or owned by, the issuing company or shares in a related company.

International Monetary Fund, International Capital Markets: Developments and Prospects, 1982, Occasional Paper No. 14 (July 1982).

For a detailed discussion of these factors see Appendix II of International Monetary Fund, International Capital Markets: Developments and Prospects, 1982, Occasional Paper No. 14 (July 1982).

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