Chapter 6 Pilbeam Finance and Financial Markets 4th Edition

Chapter 6
The Domestic and

International Bond
Market
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Learning Objectives

Different Types of Bonds
 Three types of bonds
 Domestic bond – bonds issued in the domestic currency by a domestic entity. For example, US
Treasury bills issued in dollars in the USA by the US government. A Corporate Bond issued by Dell
computers in the USA in dollars.
 Foreign bond – a bond issued in the domestic currency of the issuing country but by a foreign entity.
For example, a British company issues a bond in dollars in the USA – known as a Yankee. A bond issued
by a British company in yen in Japan is Samurai bond. A Japanese company borrows in Australian
dollars in Australia; known as a Kangaroo bond. A German company borrowing in pounds in London is
known as a “bulldog”. A British company borrows in euros in Spain; known as a Matador bond.

 Eurobond is a bond issued in a foreign currency to the country of issue. For example, a dollar bond
issued in London by either a British or American company is known as a dollar-denominated Eurobond.
A bond issued in yen in London by a domestic or foreign company is known as a yen-denominated
Eurobond. Note a US dollar bond issued in Asia is also a dollar-denominated Eurobond but is referred
to as a “Dragon bond”.

 Note the buyers of the bonds will be very international. The US government needs to sells its bonds to
Japanese and Chinese investors otherwise they would have to pay much higher interest rates to
encourage US citizens to buy them.

Introduction to Bonds
When lending funds the lender will want the principal to be returned (that
is the original sum of money lent) and to receive interest, at a rate that is
usually expressed as a percentage per annum of the principal loaned.

Factors that determine the interest rates:
 length of the loan
 perceived risk attached to the borrower of funds
 fundamental economic forces
 liquidity of the loan contact
 expected inflation during the period of the loan

Government Bonds
Government bonds are very important financial securities:

 Have a high degree of liquidity and lower transaction costs relative to
equities and corporate bonds
 Sometimes accorded special tax treatment to encourage investors to
hold them
 Trading in government bonds is restricted to certain licensed
institutions: In the UK trading is carried out on the London Stock
Exchange by gilt edged market makers (GEMMs)
 Government bonds provide a stream of regular income – coupon
payments and the payment upon maturity equal to the face value
 Held by a variety of financial institutions: pension funds, insurance
companies, banks, saving societies, etc.

Trading in Government Bonds
Trading in government bonds is restricted to certain licensed institutions:

In the UK trading is carried out on the London Stock Exchange by gilt
edged market makers (GEMMs)
 The GEMMs buy and sell both new and existing government stock and
have an obligation to provide continuous two-way prices (bid–offer) in
government bonds.
 If GEMMS could only sell stock that they actually held this would
severely restrict their ability to make a market.
 If they are short of bonds they can arrange to temporarily borrow bonds
from institutional investors via the services of inter-dealer brokers.
 Conversely, if they need funds to buy large amounts of bonds they can
borrow funds from the brokers.
Keith Pilbeam: Finance and Financial Markets 4th Edition

Principles of Government Bond Pricing
The basic principle underlying the price of any financial asset is that it should be
determined by the present value of the asset’s expected cash flow. By the expected
cash flow we mean the expected stream of cash payments over the life of the asset.
That is, assuming interest rates are known with certainty for periods 1, 2 . . . T to be
r1, r2 . . . rT respectively, the relevant formula for the price of a government bond is
given by:
where PB is the price of the security at time 0 with T periods to maturity; CF1, CF2
. . . CFT are cash flows at the end of periods 1, 2 . . . T; r1, r2 . . . rT are interest rates in
periods 1, 2 . . . T

Government Bond Pricing
Bond price
T
C M
PB   
t 1 1  r t 1  r T
M – the value of the bond upon maturity, C – the coupon,
T – the time to maturity, r – interest rate
 The bond price is higher the:
 greater the coupon payment attached to the bond
 greater the maturity value of the bond
 lower the interest rates
 The bond price is more volatile with respect to a change in interest rates the longer the
term to maturity of the bond
Par value
k  PB M
 k= 1: the bond is selling at par
 k>1: the bond is selling at a ‘premium’
 k<1: the bond is selling at a ‘discount’
Government Bond Pricing (example)
Calculation of a bond price

 Consider a five-year bond which has the following cash flows and assume
interest rates are known and projected with certainty to be 7% (r1 = 0.07) in year
1, 8% (r2 =0.08) in year 2, 9% (r3 =0.09) in year 3, 10% (r4 =0.10) in year 4, and
11% (r5 = 0.11) in year 5.
Year Coupon (C) Principal (M) Cash flow (CF)
1 7 0 7
2 7 0 7
3 7 0 7
4 7 0 7
5 7 100 107

Government Bond Pricing (example)
Solution:


Clean price
 the price of a bond excluding accrued interest
 the price quoted in the UK bond market (since Feb 1986)
 most commonly used benchmark price for the calculation of yields
Dirty price
 the full price of a bond including the total accrued interest to which the bond
holder would be entitled for holding the bond between the coupon payments
 increasingly exceeds the clean price as the next coupon payment becomes due
 on the day of payment of the coupon:

clean price = dirty price

Current Yield
The most basic measure of the yield is the current yield (coupon over
price) C
YC 
PB
YC – the current yield, C – the coupon payment,

PB – the current clean price of a bond
 a very imprecise measure

 takes no account of the potential capital gains or losses resulting from
the difference between the current market price of the bond and its
value upon maturity
 more useful for bonds with long term to maturity

Simple Yield to Maturity
 Takes into account capital gains and losses assuming that the capital
gain or loss on a bond occurs evenly over the remaining life of the bond
 Takes no account of the fact that coupon receipts can be reinvested and
hence further interest gained
 C 100  PB  / T 
YS      100
 PB PB 
YS – the simple yield to maturity, C – the coupon payment,
PB – the current clean price of a bond, T – the number of years to maturity
 The expression in the oval gives an approximation of the capital gain

from holding the bond!

Simple Yield to Maturity (example)
 Consider the same bond as in the current yield example, that is, paying a
coupon of $7 per annum with 5 years until maturity:
 The second expression in the brackets gives 1.56%

 That is the bond holder will make 7.54% per annum from the coupon
payment and 1.56% per year from a capital gain, given that the bond
holder that invests $92.78 today will receive $100 when the bond
matures in 5 years’ time.
 So the total return per year is 7,54% + 1,56% = 9.10% .

Yield to Maturity
 Yield to maturity – the rate of return on a bond expressed as a

percentage per annum if it is held until maturity
 Takes into account all coupon payments and any prospective capital
gains/losses as well as the term to maturity and assumes that future
coupon payments can be reinvested at the yield to maturity
 Most convenient to compare risk-free bonds with different coupon
payments, different maturities and different current prices
T
C M
PB   
t 1 1  y t 1  y T
y– the yield to maturity, C – the coupon payment,
M – the maturity value of the bond, T – the number of years to maturity,
PB – the current price of a bond

Yield to Maturity
 The yield to maturity (y) is calculated by a trial and error method

(iterative method).
 The formula develops to the following:
 It is therefore very hard to solve for y...

 Consider the previous example (C=7; PB=92.78; M=100, 5 years)
 Try 8%
 Try 9%
 Do interpolation!
Yield to Maturity Example
The relevant y is (0.088489 or 8.8489%). It can be calculated by using

interpolation or more easily by using the YIELD function supplied with
spreadsheets such as Microsoft Excel. In other words, the cash flows on the
bond represent an average return of 8.8489% over the remaining life of the
bond on the $92.78 invested, assuming the bond is held to maturity and
coupon payments are reinvested at the yield to maturity. The investor could
invest the $92.78 at 8.8489% for five years and it would become, with
accrued interest
$92.78 × 1.0884895 = $141.77

Yield to Maturity Example
This is identical to placing $92.78 in the bond and making a capital gain of
$7.22 upon maturity plus investing the $7 coupon payment at the end of the
first year, which will become $7 × 1.088489 = $7.62 by the end of the second
year.
The investor is then entitled to a further $7 coupon payment giving a total
$14.62 which would become $14.62 × 1.088489 = $15.91 by the end of the
third year.
The investor is then entitled to a further $7 coupon payment giving a total
$22.91 which would become $22.91 × 1.088489 = $24.94 by the end of the
fourth year, when the investor also receives a $7 coupon payment.
In the final year he has $31.94 which would become $31.94 × 1.088489 =
$34.77. Upon maturity he also gets a further $7 coupon payment. The total
from coupon payments with reinvestment interest is $41.77. Hence, in total,
the $92.78 bond investment increases by $7.22 + $41.77 to become $141.77.

Relationship between Yield and Bond Prices
 Negative convex relationship

between bond price and yield to
maturity
 Change in interest rates has a more
significant effect on prices of bonds
with longer term to maturity
 The volatility of the bond price has

two determinants:
(-) the coupon payments (the lower the
coupon, the greater volatility of price)
(+) the term to maturity (the greater the
term to maturity the greater the
volatility)

Bond Price Volatility

Macaulay Duration
 A commonly used measure of volatility: Macaulay Duration
 T C t M T 
D    T 
PB
 t 1 1  y  1  y  
t
D – Macaulay duration, y– the yield to maturity, C – the coupon payment,

M – the maturity value of the bond, T – the number of years to maturity,
PB – the current dirty price of a bond
It is the weighted-average term to maturity of the cash flows on a bond.

Note that for semi-annual basis the formula needs to be adjusted.
 The Macaulay duration for a coupon bond is less than term to maturity: D<T
 The longer the term to maturity, the greater the Macaulay duration and price
volatility
Macaulay Duration (example)

Macaulay Duration (example)

Modified Duration
 Modified duration D
Dmod 
1 y
Dmod – modified duration, D – Macaulay duration, y – the yield to maturity
Example
 measures the sensitivity of the price of a bond to changes in the rate of interest, in other words, it is
the slope of the price-yield curve
(Approximate change in bond value) = (-Mod Dur) x (Yield change in basis points)
PB   Dmod  y
 change in bond price: N

D p   wi Di
i 1
 modified duration for a portfolio of bonds:

A formula for Duration
 This is just an approximation

 This is because we assume linear
relationship but it is
CONVEX!
 Valid only for small changes in
interest rates of around 100 basis
points
 Will become increasingly
inaccurate as a predictor of bond
price changes the larger the change
in yield
 Since the relationship between bond
price and yield is convex, a linear
measure of duration
 under-predicts a price rise in bonds,
and
 over-predicts a price fall in bonds

Example of Modified Duration in Practice
Suppose yields increase from 8.00% to 8.50%. Yield change is 0.50% so we would
expect a price change of:
 − 4.0492 × 0.5 = −2.0246
According to modified duration measure, bond price can be expected to change

from 96.01 to 94.10 (that is, 96.01/1.020246). From Table 6.2 the actual price
change is to 94.09 and the actual percentage change is –2.03%.
Hence, for small changes in basis points the modified Macaulay duration measure
gives a good approximation of the percentage price change. In effect, the modified
duration measure gives the slope of the price–yield curve depicted in Figure 6.1.
From this, note that as yield increases duration will decrease. If we take an initial
yield y1 and then take another yield, y2, the approximation of duration analysis
will understate actual price change. Accuracy of the approximation is best for small
changes in yield and also depends on degree of convexity of price/yield
relationship.

Modified Duration (example)
An alternative method of obtaining the Modified duration
For example, our 5-year bond with par value $100 and one $7 coupon payment per year is currently
selling at $96.01 since the current yield is 8.00%.
If the yield is increased by 50 basis points the price would be $94.09.
If the yield is decreased by 50 basis points the price would be $97.98.
This means that we have the following values:
Initial price = $96.01
If yield rises to 8.50%, price= $94.09
If yield falls to 7.50%, price= $97.98

Modified Duration
The modified duration increases with three factors:

1. term to maturity of the bond
2. the lower the coupon payment
3. the lower the initial yield

Modified Duration
The modified duration increases with three factors:

1. term to maturity of the bond This accords with the fact that
2. the lower the coupon payment longer-term bonds fluctuate
3. the lower the initial yield more in price for a change in
yield than shorter-term bonds.

Duration of Portfolio of Bonds
 Modified duration of a portfolio

N
D p   wi Di
i 1
where
Dp is the modified duration of the portfolio
Di is the modified duration of the individual bond
wi is the weight of the individual bonds in the portfolio
N is the number of bonds in the portfolio

Duration of Portfolio of Bonds (example)
 A bond fund manager has a $100 million bond portfolio

invested 30% in 5-year bonds with a modified duration of 4
years, 25% invested in 10-year bonds with a modified
duration of 7 years and 45% in 20-year bonds with a
modified duration of 11 years.
 The yield curve is currently flat at 8% across all maturities
(5 year, 10 year and 20 year).
 The bond manager believes that interest rates are likely to
fall by 50 basis points to 7.5% and wishes to calculate the
likely rise in the value of the bond portfolio.

Duration of Portfolio of Bonds (example)

Formula for Duration
 Duration formula:
y – the bond yield, c – the annual coupon yield on issue,

T – the number of periods left on the bond

Usefulness of Duration
Duration extensively used by dealers & investment managers.

Useful for bond portfolio management as duration measure can
be combined across an entire portfolio.
Investment managers use duration analysis to measure interest
rate risk & can adjust duration of their portfolio to increase
expected returns from anticipated changes in interest rates.
For example, if interest rates expected to rise, that is, bond
prices are expected to fall, an investment manager may try to
decrease the duration of her portfolio so that the impact of any
bond price falls will be limited.
Conversely, if interest rates are expected to fall and bond prices
rise, it will pay to be in long-term bonds which will rise
proportionately more in price than short-term bonds.
Corporate Bonds
 Corporate bond – a bond issued by a company to investors, with the yield

depending in part on the credit rating of the company
 issued by the corporations that wish to raise funds for various purposes
 are of substantial size ($50-$300 million are typical)
 attract investors such as insurance companies, pension funds, foreign investors
and investment funds
 many types and forms: medium-term notes, high-yield bonds (junk bonds),
serial bonds, etc.
 usual maturities are 10–20 years
 Associated risks
1. common with Treasuries: interest rate risk, reinvestment risk, inflation risk
2. credit risk (bond issuer may default on its debt-servicing obligations)
3. call risk (fall in interest may make it worthwhile for the bond issuer to exercise a call
provision)
4. event risk (some dramatic unexpected event may occur that will undermine ability of
issuer to service the debt)

Credit Rating
 Debenture bond – a bond secured against company assets giving bond

holders the legal right to sell company assets in case of default
 Call provision – a clause giving the issuer of a security the right to redeem the
security prior to maturity
 Credit rating agencies keep a careful watch on companies’ balance sheets, cash
flows and activities
 high-grade company: has low credit risk, that is, a high probability of future repayment
 low-grade company: has high credit risk compared to high-grade companies
 Credit risk of companies is vital in determining the rate of interest they will be
expected to pay on their bond issues
 difference in the yield between two issues that are identical in all respects except
for the quality rating of the companies is known as quality spread
 in times of recession this spread increases with a flight to quality – investors sell
risky securities and use the proceeds to buy what are regarded to be safer
securities; this raises the quality spread

Credit Rating Systems on Corporate Debt

Credit Rating Systems on Corporate Debt
• Change from Aaa to Aa adds around

32 basis points to borrowing costs
• Change from Aa to A rating adds a

further 32 basis points to borrowing
costs
• Change from A to Baa adds a further

46 basis points to borrowing costs
• The spread varies according to market

conditions

Default Rates on Corporate & Sovereign Bonds

Corporate Bonds Innovations
 Motivated initially by the greater volatility of interest rates following the collapse of Bretton
Woods system (1971)
 Convertible bond – bond that can be converted into either shares or some other
asset at some point
 can be used to attract investors if a firm regards its stock undervalued, reduces coupon payable
 Warrant – medium- or long-term option attached to a bond that gives the holder the
right to buy or sell the security at a given price
 warrants can be detached from the bond and traded separately from the bond
 different from other options – warrants have longer maturities
 attractive to the issuer because the possibility of capital gain may mean that the firm is able to raise finance
more cheaply than would otherwise be the case; reduces the coupon
 Putable bond – bond that allows the holder to force the company to repurchase the
bond at par usually on certain fixed dates
 ensures that the bond will stay above its par value and the bondholder will have some protection if the
credit rating of the company deteriorates
 Floating rate note – bond that has a variable coupon or rate of interest
 e.g. usually expressed as percentage above LIBOR and will fluctuate according to changes in LIBOR
 enables corporation to raise long-term finance at a cost of short-term interest rates
 can suit finance companies that use funds raised to make loans at a variable rate
Junk Bonds
 A junk bond is a high-yield bond issued by a corporation that has a relatively low credit
rating of less than BBB.
 In order to compensate investors for the higher risk of default the bonds have to be issued
at significantly higher yields than other corporate bonds.
 The junk bond market was relatively small in the mid-1970s at roughly $15 billion.
 However, in the 1980s, it grew enormously; was estimated to be worth some $200 billion
by the end of the 1980s.
 Junk bonds enable companies to raise long-term funds in circumstances where banks
would only be prepared to lend funds on a short-term basis.
 In some cases, funds raised by junk bonds have been used to finance acquisitions, mergers,
working capital and retirement of debt from previous mergers & acquisitions.
 Default can involve complete loss of capital invested in the bond, although holders of
defaulted bonds frequently recover 30 per cent or more of the capital invested.
 Key question is whether holding a portfolio of junk bonds in which defaults can be expected
provides sufficient excess return above Treasury bonds to compensate for additional risks
involved.
 Academic studies have provided mixed results depending on the methodology employed,
companies studied, time period considered and other factors.
International Capital Market
International capital market has grown astonishingly since the 1960s.
 Domestic bond – bond issued in the domestic currency by a domestic entity
 Foreign bond – bond issued in the domestic currency of a country by a foreign

entity, for example:
 Yankees (US dollar bonds), Bulldogs (sterling bonds)
 Samurais (yen bonds), Kangaroos (Australian dollar bonds)
 Eurobond – bond that is sold by a domestic or foreign entity (government,

institution or company) in a currency that is different from the country where the
bond is issued, for example:
 a dollar bond issued in London is a dollar-denominated Eurobond
 a yen bond issued in Luxembourg is a yen-denominated Eurobond
 A Euro bond issued in London is a euro-denominated Eurobond

Motivation behind International Capital Flows
Trade financing motive:

Much trade financed by borrowing on international capital markets
Borrowing or lending motive:
Many capital flows simply motivated by desires of savers to get the best possible
return on their money, while borrowers are merely seeking to obtain the lowest
possible interest rate (Eurobond market is especially strong in this respect)
Speculative motive:
Much borrowing or lending is due to the taking of speculative positions based on
profiting from prospective exchange/interest rate changes
Hedging motive:
Some borrowing and lending is motivated by a desire to hedge positions, that is, to
avoid losses resulting from prospective exchange/interest rate changes
Capital flight motive:
Many movements of capital motivated by desire to protect investors’ funds from
penal taxation, possible seizure by the domestic government, restrictions being
imposed on convertibility or political risk
Eurobond Market
 Origins and development
 First Eurobond issued in 1963
 Market has grown substantially especially since the 1980s
 Interest Equalization Tax (tax to US citizens that held dollar bonds by foreign
entities in the USA) & withholding taxes on foreign citizens that held US bonds –
so much better to have Eurobonds
 Nowadays, the value of outstanding Eurobonds issued significantly exceeds the
issue of domestic corporate bonds
Main incentives
 Interest equalization tax on US citizens holding dollar bonds issued by foreign entities (until
1974)
 Withholding tax on foreign citizens that held US bonds (until 1984)
 Lower cost finance for well known companies
 Less stringent regulatory and disclosure requirements on the corporate issuer
 Financial innovation is crucial, enables issuers to raise finance in a variety of innovative ways
that are more suited to their funding requirements

Typical Eurobonds
 Most popular form of issue are dollar and euro-denominated Eurobonds

 Most undertaken by very highly rated issuers (around 75% of them AAA/AA)
 Most medium-term contracts (5–7 years)
 Frequently issued in bearer form when a bond is not registered by the issuer
and the bearer is taken to be the owner and entitled to the attached coupons
 Some issuers raise finance in currencies different than they actually require as
part of a swap deal
 Yield at which borrower obtains funds depends primarily on market conditions
and credit rating of the issuer and any special features
Most common types:

 straight – a bond with a fixed periodic coupon payment
 floating rate note – a bond that has a variable coupon or rate of interest

Eurobonds are issued free of withholding tax
Withholding tax is a tax based on foreign holders of a security.

For example Germany suspects that Franz holds a UK issued Eurobond receiving
€50 coupon which he is not paying tax at 40% in Germany (i.e. €20) because he
does not put the income on his tax form.
Germans would like the UK to impose a 20% withholding tax on Franz (i.e. €10),
which he will be able to claim back from the UK once he has paid his €20 in
Germany.
Germany feels Franz is more likely to reveal his foreign income in Germany if the
UK has imposed a €10 tax on him, as he will fear the UK handing over his details
to the tax authorities in Germany.
UK is not keen to impose the withholding tax as it fears the Eurobond business
will shift elsewhere, for example to Hong Kong, where no withholding taxes are
imposed.
Also the UK does not get to keep the withholding tax.
The UK argues that the Germans should impose sufficient penalties on Franz so as
to induce him to make an honest tax declaration in Germany.

Characteristics of Eurobonds
• Eurobond market is primarily a
medium-term borrowing market with
the vast majority of issues
(approximately 80 per cent) being for
under 10 years, with many typically in
the range 5–7 years.
• Contrasts with domestic bond market
which is generally speaking a longer-
term market.
• Most Eurobonds are issued at fixed
rates of interest and others are issued
at floating rates of interest or are
equity-related.
• Many issues are sold at short notice to
take advantage of what are perceived to
be favourable market conditions.

Features of Typical Dollar Eurobond Issue

Eurobond Market
 Control and regulation of Eurobonds

 Comply with regulations set by Association of International Bond Dealers
 Eurobonds are generally exempt from the rules and regulations that govern
the issue of foreign bonds in the country (prospectus, withholding tax, etc.)
 Government means of control
 Most clearance of funds in Eurobonds done through the clearing system of
the domestic banking system of the currency of issue. Thus national central
banks and authorities can effectively prohibit the issue if they wanted to
 Governments can exert pressure on both domestic and foreign investment
banks not to participate in Eurobond issues

Why does World Bank raise money on international capital
markets?
To use its AAA credit rating to raise the finance cheaper than
South Africa can and the funds can then be used for approved
finance projects in South Africa
World Bank South Africa

AAA BBB
World Bank raise funds at 6%

and lends them to South Africa
at 6.1% saving South Africa
2.9% per year !
Can raise $500 million Can raise $500 million

at 6% at 9%

Bullet Form vs Non-bullet Form Bond
 Cash flows on 5-year Corporate Bond

End of year 1 2 3 4 5
$70 $70 $70 $70 $70
+$1000
+$1070
In the above bond the principal comes all at once at the end and is known as “bullet form.” This is typical of most bonds.

 Cash flows on early repayment of principal Corporate Bond

$60 $60 $60 $60 $60
+$300 +$300 +$400
$360 $360 $460

In the above bond the principal is paid back in three instalments prior to maturity. This means the coupon payable is lower
than in the “bullet form” bond, in this case $60 rather than $70. It is also less risky due to early repayment of the principal.

Fixed Principal vs Variable Principal Bond
Cash flows on 5-year Fixed Principal Corporate Bond
 End of year 1 2 3 4 5
 $70 $70 $70 $70 $70
 +$1000
 +$1070
In the above bond the principal is fixed at $1000.
The Bond may have an “indenture” or “covenant” (clause in the bond contract). Which specifies that if the S&P500 stock
index which currently reads 1000 is above 1500 then a bonus of $200 will be payable on the bond on expiration.
This means there are two possible routes the bond may take:
 Scenario 1 the S&P500 is less than 1500 on expiration
 End of year 1 2 3 4 5
 $60 $60 $60 $60 $60
 +$1000
 +$1060
 Scenario 2 the S&P500 is greater than 1500 on expiration
 End of year 1 2 3 4 5
 $60 $60 $60 $60 $60
 +$1200
 +$1260
The idea is if the US economy is strong the stockmarket will do well and the company will do well and be able to afford the
increased cost of finance. If however the economy does poorly the stock index does poorly but the company has a lower cost
of finance – a coupon of only $60 rather than $70.

Straight vs Floating Rate Note (FRN)
A Straight has a fixed coupon.

 $70 $70 $70 $70 $70
 +$1000
 +$1070

A Floating Rate Note (FRN) has a variable coupon.
The coupon will be variable for example it might be set at 2% (i.e. 200 basis points) above
$LIBOR
End of year 1 2 3 4 5
 $80 $50 $70 $80 $1060
$LIBOR 6% 3% 5% 6% 4%
Most companies prefer a fixed borrowing cost so that they know their borrowing cost. However, a
finance company might be happy to borrow at a floating rate if it is making loans at a floating rate
of say $LIBOR plus 5% so that it can lock in a 3% gross spread.

Asset-backed Eurobond (1)
In this example, a bank with a lot of

Using existing cash flows illiquid outstanding loans to the
value of $600 million generating
$36 million of interest plus

principal repayments needs to
raise cash urgently.
Barclays Bank $500 million

$600 million of loans Asset-backed Eurobond It can use cash flows from these
existing assets to create an asset -
Average yield of 6% Yield 6.5% backed security to the value of say

$36 million interest per year $32.5 million interest per year $500 million with a yield of 6.5%
implying interest of $32.5 million
per year. The bond is a lot safer
than an unsecured bond!
In this case the Eurobond is “over collateralized” there is more than enough interest and
principal ($36 million interest and $600 million principal) to pay off the Eurobond investors
($32.5 million interest and $500 million principal).
The net effect is a package of illiquid loans that have been turned into cash through
the process of “securitization”.

Asset-backed Eurobond (2)
In this case, Arsenal is

Using prospective future cash flows using prospective future
gate receipts to borrow £80

million to finance the

£80 million building of a new stadium.
Arsenal Football Club There is still a risk to
6-year Asset-backed Eurobond
investors that Arsenal does
£100 million gate receipts
Yield 7% not get enough gate receipts
1/5 set aside to pay bond holders because the team performs
$5.6 million of interest per year
poorly and is relegated, so
£20 million per year
The other £14.4 million will be used gate receipts are much
to fund principal repayments lower than forecast. But this
(6 x £14.4 million = £86.4 million)
is highly unlikely! 
The effect of creating an
asset-backed Eurobond is
to reduce the annual
coupon payable as it makes
the Eurobond safer than an
unsecured Eurobond by the
same issuer.
Letter of Credit
A letter of credit is simply a promise by a bank such as Goldman

Sachs or JP Morgan to make repayments on behalf of the issuer should
the issuer of the bond fail to make payments for any reason including
bankruptcy.
This makes the bond more secure and hence investors will accept a
lower annual coupon, for instance, $65 rather than $70.
The investment banks earn a fee by writing a letter of credit but they
must not issue too many letters of credit as it may risk their
own credit rating. For example, if an investment bank writes too
many letters of credit then it would be vulnerable to a downturn in the
economy and defaults by the companies whose debt it has written
letters of credit on.
Special Features – Call-back Feature
Cash flows on 5-year corporate bond non-callable

 End of year 1 2 3 4 5
 $70 $70 $70 $70 $70
 +$1000
 $1070

Cash flows on 5-year corporate bond callable after Year 3
End of Year 1 2 3 4 5
 $80 $80 $80 $80 $80
 +$1000
 $1080
The bond is callable at the end of year 3 when it can be redeemed with a principal repayment of $1000 and
the $80 coupon. So bondholder will not get $80 coupons in years 4 and 5.
A bond may be called back prior to maturity if interest rates fall sufficiently to make it profitable for the
issuer to call back the bond and reissue new debt for the remaining two years at a lower rate of interest.
To compensate investors for risk of bond being called back prior to maturity investors will require a higher
coupon on a callable (e.g. $80) than on non-callable bond (e.g. $70).

Special Features – Warrant Attached to Eurobond
Cash flows on 5-year corporate bond without a warrant

 End of year 1 2 3 4 5
 $70 $70 $70 $70 $70
 +$1000
 +$1070
A warrant is a long-term call option that gives the holder the right to buy shares in a
company.
For example Exxon shares trade at $100 today and the warrant gives the bondholder the
right to buy 10 shares at $130.
Cash flows on 5-year Exxon Corporate Bond with a warrant

 End of year 1 2 3 4 5
 $50 $50 $50 $50 $50
 +$1000
 +$1050

Special Features – Warrant Attached to Eurobond
If shares remain below $130 then warrant cannot be exercised and
investor will just collect $50 coupons per year (less than the $70 on
a Eurobond without a warrant attached).
If share prices rise to $180 then investor will be happy as he will
exercise the right to buy 10 shares at $130 and can then resell them
at $180 making a capital gain of $500.
The possibility of the $500 bonus means the investor is prepared to
take a lower coupon ($50 on a Eurobond with a warrant while $70
of the bond does not have a warrant attached).
Note the warrant can be detached and sold off to other investors.
For example if the price of the bond reached $150 at the end of year
2, then the warrant can be sold for at least $200 ($150-$130) x 10
shares.

Top Ten Lead Managers

Special Features – Convertible Bond
Convertible Eurobond can be converted into equity once predetermined
price is met. E.g. Exxon shares trade at $100 today and the warrant gives
the bondholder the right to convert the bond into 10 shares at $140 any
time after year 2.
Cash flows on 5-year Exxon Convertible Corporate Bond
$50 $50 $50 $50 $50
 +$1000
 +$1050
If share price is below $140 during life of the bond, bondholder will just
hold onto the bond and receive the above cash flows.
Special Features – Convertible Bond (2)
However, if some time in year 3 share price hits $140 , bond holder will convert bond into
equity : 10 shares@$145 per share=$1450.

$50 $50 $1450 … ...
Exxon
share price $100 $130 $145
Once shares are converted then the bond holder no longer receives coupons. Bond holder can
receive dividends as a shareholder or are of course free to sell the shares at the prevailing
market price.
Possibility of a profitable conversion means coupon will be lower, e.g. $50, than for a bond
without conversion rights, e.g. $70. Shareholders like the cheaper cost of finance if the
company is not doing so well and the share price is stagnant. But profits will be divided
between more shareholders and the cost of finance is higher if the company does well.
Therefore shareholders need to approve convertible bonds and warrant provisions.
Selling Eurobonds
The Lead Manager(s) There are three groups involved in

or Book runner(s)
Goldman Sachs and Credit Suisse selling Eurobonds – approximately
Advise on issue and ensure an orderly 50% are sold to wealthy individuals
secondary market in the bonds once
the bond has been issued. (the archetypal investor being the

so called “Belgian Dentist”) and
50% to institutional investors.
The Underwriting Group

Typically made up of 10 to 20 banks they will pick up
any unsold part of the issue.
The Selling Group

Typically made up of 10 to 50 banks who will try to sell the issue
around the world to wealthy individuals and institutional
investors using a “grey market” prospectus.

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Chapter 6 Pilbeam Finance and Financial Markets 4th Edition

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Chapter 6

The Domestic and

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Government bonds are very important financial securities:

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Trading in government bonds is restricted to certain licensed institutions:

Keith Pilbeam: Finance and Financial Markets 4th Edition

Keith Pilbeam: Finance and Financial Markets 4th Edition

Calculation of a bond price

Year Coupon (C) Principal (M) Cash flow (CF)

Keith Pilbeam: Finance and Financial Markets 4th Edition

Keith Pilbeam: Finance and Financial Markets 4th Edition

Keith Pilbeam: Finance and Financial Markets 4th Edition

 on the day of payment of the coupon:

Keith Pilbeam: Finance and Financial Markets 4th Edition

YC – the current yield, C – the coupon payment,

 a very imprecise measure

Keith Pilbeam: Finance and Financial Markets 4th Edition

 The expression in the oval gives an approximation of the capital gain

Keith Pilbeam: Finance and Financial Markets 4th Edition

 The second expression in the brackets gives 1.56%

 So the total return per year is 7,54% + 1,56% = 9.10% .

Keith Pilbeam: Finance and Financial Markets 4th Edition

 Yield to maturity – the rate of return on a bond expressed as a

Keith Pilbeam: Finance and Financial Markets 4th Edition

 The yield to maturity (y) is calculated by a trial and error method

 It is therefore very hard to solve for y...

The relevant y is (0.088489 or 8.8489%). It can be calculated by using

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

 Negative convex relationship

 The volatility of the bond price has

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

 A commonly used measure of volatility: Macaulay Duration

D – Macaulay duration, y– the yield to maturity, C – the coupon payment,

It is the weighted-average term to maturity of the cash flows on a bond.

Keith Pilbeam: Finance and Financial Markets 4th Edition

Keith Pilbeam: Finance and Financial Markets 4th Edition

 change in bond price: N

Keith Pilbeam: Finance and Financial Markets 4th Edition

 This is just an approximation

Keith Pilbeam: Finance and Financial Markets 4th Edition

 − 4.0492 × 0.5 = −2.0246

According to modified duration measure, bond price can be expected to change

Keith Pilbeam: Finance and Financial Markets 4th Edition

Keith Pilbeam: Finance and Financial Markets 4th Edition

The modified duration increases with three factors:

Keith Pilbeam: Finance and Financial Markets 4th Edition

The modified duration increases with three factors:

Keith Pilbeam: Finance and Financial Markets 4th Edition

 Modified duration of a portfolio

Keith Pilbeam: Finance and Financial Markets 4th Edition

 A bond fund manager has a $100 million bond portfolio

Keith Pilbeam: Finance and Financial Markets 4th Edition

Keith Pilbeam: Finance and Financial Markets 4th Edition

y – the bond yield, c – the annual coupon yield on issue,

Keith Pilbeam: Finance and Financial Markets 4th Edition

Duration extensively used by dealers & investment managers.

 Corporate bond – a bond issued by a company to investors, with the yield

Keith Pilbeam: Finance and Financial Markets 4th Edition