International Financial Markets Prices and Policies

Second Edition ©2001 Richard M. Levich 14



McGraw Hill / Irwin

International Asset Portfolios: Bond Portfolios

Overview

 Dimensions of National Bond Markets  Bonds Outstanding by Market Location  Bonds Outstanding by Market Segment  Return and Risk in National Bond Markets  Calculating Unhedged Returns in US$ Terms  Calculating Currency-Hedged Returns in US$ Terms

14 - 2 McGraw Hill / Irwin



2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Overview

 Empirical Evidence on Return and Risk in Global Bond Markets  Returns on Unhedged Bonds  Returns on Currency-Hedged Bonds  The Efficient Frontier and Gains to International Bond Portfolios

14 - 3 McGraw Hill / Irwin



2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Overview

 Policy Matters - Private Investors and Institutions  Currency-Hedged Bonds: Is There a Free Lunch?

 Active versus Passive Currency-Hedging Strategies  Problems in Implementing an International Bond Portfolio  The Impact of EMU on International Bond Markets

14 - 4 McGraw Hill / Irwin



2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Overview

 Policy Matters - Public Policymakers  The Impact of EMU  Brady Bonds and Emerging Market Debt Issues

14 - 5 McGraw Hill / Irwin



2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Dimensions of National Bond Markets

14 - 6

 The total market size, as measured by the market value of outstanding bonds in 20 developed countries as well as the Eurobond market, has grown rapidly from under $4 trillion in 1981 to $29.9 trillion in 1999.

 This growth reflects:  the tendency of governments to run fiscal deficits and turn to bond financing, and  the rapid expansion of corporate borrowing

McGraw Hill / Irwin



2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Bonds Outstanding by Market Location

14 - 7

4 2 0 14 41.1% 12 10 8 6 17.6%

Composition of Global Bond Markets by Market Location

Total Outstanding Bonds at the End of 1999: $29.86 Trillion

15.6% 8.2% 3.1% 3.9% 2.0% 1.6% 1.0% 1.0% 0.8% 0.8% 1.0% 0.6% 0.5% 0.5% 0.6%

McGraw Hill / Irwin



2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Bonds Outstanding by Market Segment

14 - 8 The Composition of the Global Bond Market by Sector in 1999

foreign 3.7% Eurobond 15.4% others 1.0% corporate 26.2% government 53.7%

McGraw Hill / Irwin



2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Bonds Outstanding by Market Segment

14 - 9 The Composition of the Global Bond Market by Issuer in 1999

corporate 40.6%

McGraw Hill / Irwin

government 59.4% 

2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Return and Risk in National Bond Markets

 In general, the return on a foreign bond, as measured in US$ terms, has 3 components:  Interest income earned or accrued.

 The capital gain or loss on the bond, resulting from the inverse relationship between interest rates and bond prices.

 The foreign exchange gain or loss, applied to the above two items.

14 - 10 McGraw Hill / Irwin



2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Calculating Unhedged Returns in US$ Terms

14 - 11

Let

B t

be the initial purchase price of the foreign bond in foreign currency (FC) terms.

Let

S t

be the spot exchange rate, in $/FC terms, on the purchase date.

Then

B t S t

is the US$ purchase price of the bond.

McGraw Hill / Irwin



2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Calculating Unhedged Returns in US$ Terms

~ Let

B t

+1 ~

B t

 1 

B t

be the value of the bond after one month.

 

t

 1 

C t

 1 where

B



t t

 1

C t

 1 = the initial bond price = the price change over the month = accrued interest ~

B t

 1 ~

S t

 1 month in US$ terms.

14 - 12 McGraw Hill / Irwin



2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Calculating Unhedged Returns in US$ Terms

14 - 13

The continuous rate of return on the foreign bond ~

R

$,

U

measured in US$ and on an unhedged basis is:  ln( ~

B t

 1 ~

S t B t S t

 1 )  ln(

B t

 1 )  ln( ~

S t S t

 1 )  ~

B

FC  ~

S

US$, FC Note that the unhedged US$ return on the foreign bond has two pieces:  ~ the return on the bond in FC terms (

B

FC ), and  bond (

S

US$,FC ).

McGraw Hill / Irwin



2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Calculating Unhedged Returns in US$ Terms

14 - 14

The variance of the returns on the foreign bond reflects the variance of each term and the covariance between the returns on the foreign  bond and the returns on spot foreign exchange: 2 ( ~

R

$,

U

)   2 ( ~

B

FC )   2 ( ~

S

US$, FC )  2 Cov ( ~

B

FC ; ~

S

US$, FC ) Note that the covariance of bond returns and currency returns can be either positive or negative, and possibly changing over time.

McGraw Hill / Irwin



2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Calculating Unhedged Returns in US$ Terms

14 - 15 Combinations of Currency Market and Bond Market Returns

Bond Market Returns

Negative Positive

Currency Market Returns

Negative Positive

FC interest rates Spot FX

 

(A) FC interest rates



Spot FX



(D) FC interest rates



Spot FX



(C) FC interest rates Spot FX

 

(B)

McGraw Hill / Irwin



2001 by The McGraw-Hill Companies, Inc. All rights reserved.

14 - 16

Calculating Currency-Hedged Returns in US$ Terms

 One possible hedging strategy is to sell all the future coupon payments as well as the final return of principal forward in exchange for US$.

 The return on this swapped-bond should be nearly identical to a US$ bond of the same maturity.

McGraw Hill / Irwin



2001 by The McGraw-Hill Companies, Inc. All rights reserved.

14 - 17

Calculating Currency-Hedged Returns in US$ Terms

 A less extreme strategy is to sell a one-month forward currency contract for an amount equal to next month’s estimated value of the bond with accrued interest.

 Then the return consists of:  the return from the predicted price change in the bond in FC terms,  the forward premium (or discount) on the foreign currency used to buy the bond, and  the unpredicted price change in the bond that is valued at a future uncertain spot exchange rate.

McGraw Hill / Irwin



2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Performance of Unhedged National Bond Markets & World Portfolios January 1978 - September 1989

14 - 18

Portfolio

U.S. dollar Canadian dollar German mark Japanese yen British pound Swiss franc Dutch guilder French franc Nondollar portfolio (value weighted) World portfolio (value weighted) World portfolio (equal weighted)

McGraw Hill / Irwin

Return

10.1

% 10.4

8.9

13.6

11.3

6.4

9.4

9.5

11.3

10.6

10.0

Risk

11.0

% 13.6

16.2

17.3

18.3

16.1

15.3

14.2

Return/Risk (Return-R F )/Risk

0.92

0.76

0.55

0.79

0.62

0.40

0.61

0.67

0.11

0.11

0.00

0.27

0.13

-0.15

0.04

0.05

3 13.8

0.82

0.18

10.2

12.0

1.04

0.83

0.16

0.10



2001 by The McGraw-Hill Companies, Inc. All rights reserved.

14 - 19

Performance of Currency-Hedged National Bond Markets & World Portfolios January 1978 - September 1989

Portfolio

U.S. dollar Canadian dollar German mark Japanese yen British pound Swiss franc Dutch guilder French franc

Return

10.1

% 9.9

11.3

12.8

10.4

9.9

11.2

9.8

Risk

11.0

% 11.5

5.8

6.4

10.4

4.1

5.7

5.9

Return/Risk (Return-R F )/Risk

0.92

0.86

1.95

2.00

1.00

2.41

1.96

1.66

0.11

0.09

0.42

0.62

0.15

0.26

0.41

0.16

Global portfolio (equal weighted) 10.7

5.5

1.95

0.34

McGraw Hill / Irwin



2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Efficient Frontiers of Unhedged and Currency-Hedged Global Bond Portfolios 1977 - 1990

14 - 20 McGraw Hill / Irwin

0.120

0.115

Global Portfolio 0.110

0.105

Global Portfolio 0.100

Unhedged Portfolios

0.095

0.090

Hedged Portfolios

Dollar Portfolio 0.085

0.05

0.08

0.11

Risk: Standard Deviation of Returns 

2001 by The McGraw-Hill Companies, Inc. All rights reserved.

14 - 21

Policy Matters - Private Enterprises

Currency-Hedged Bonds: Is There a Free Lunch?

 By simultaneously increasing return and reducing risk, currency-hedged bonds seem to offer a “free lunch” to investors.

 The return pickup could be an artifact of the sample period.

 The International Fisher Effect suggests that the interest differential should offset exchange rate movements, implying that any passive strategy should produce the same level of returns in the long run.

McGraw Hill / Irwin



2001 by The McGraw-Hill Companies, Inc. All rights reserved.

14 - 22

Policy Matters - Private Enterprises

Active versus Passive Currency-Hedging Strategies

 An investor who adopts a

passive strategy

routinely follows the same policy toward currency risk month after month.

 An

active strategy

allows the investor to accept currency risk at some times but to hedge it at others.

 The currency and interest rate risk dimensions of an international bond portfolio are

separable investments

.

McGraw Hill / Irwin



2001 by The McGraw-Hill Companies, Inc. All rights reserved.

14 - 23

Policy Matters - Private Enterprises

 An investor who holds foreign bonds on a currency hedged basis is exposed essentially only to foreign interest rate risk.

 An investor who holds foreign bonds without currency hedging faces both foreign interest rate risk and foreign exchange risk.

McGraw Hill / Irwin



2001 by The McGraw-Hill Companies, Inc. All rights reserved.

14 - 24

Policy Matters - Private Enterprises

The Expanded Opportunity Set of National Bond Markets Currency Risk and Interest Rate Risk Dimensions

Interest Rate Risk

United States EMU Japan US$

U.S.

Treasury Bond German Bund: Currency hedged to $ JGB: Currency hedged to $ Currency Risk

€

U.S. T-Bond: Currency hedged to € German Government Bond (Bund) JGB: Currency hedged to €

¥

U.S. T-Bond: Currency hedged to ¥ German Bund: Currency hedged to ¥ Japanese Government Bond (JGB)

McGraw Hill / Irwin



2001 by The McGraw-Hill Companies, Inc. All rights reserved.

14 - 25

Policy Matters - Private Enterprises

 However, if currency risk and interest rate risk depend upon each other, then the performance of the currency will have implications for the performance of the foreign bond markets, and vice versa.

 Active currency hedging requires a timing decision based on the probability of negative currency returns.

McGraw Hill / Irwin



2001 by The McGraw-Hill Companies, Inc. All rights reserved.

14 - 26

Policy Matters - Private Enterprises

Problems in Implementing an International Bond Portfolio

 The costs of operating an international bond fund are greater than those for a domestic bond fund, especially for a US$-based investor.

 Managers also face other risks:  The error introduced by optimizing a portfolio on the basis of estimated returns and variances of returns is referred to as

estimation risk

.

 The

peso problem

refers to the situation where there is a small probability of a large, unexpected exchange rate change.

McGraw Hill / Irwin



2001 by The McGraw-Hill Companies, Inc. All rights reserved.

14 - 27

Policy Matters - Private Enterprises

The Impact of EMU on International Bond Markets

 The fundamental change was the transfer of monetary policy making authority to a single European Central Bank (ECB).

 The government bonds of the eleven EMU nations now bear credit risk, since the national central banks could not print domestic money (if necessary) to redeem their bonds in full.

 As a result, the market sets different prices and yields on different EMU government bonds.

McGraw Hill / Irwin



2001 by The McGraw-Hill Companies, Inc. All rights reserved.

14 - 28

Policy Matters - Private Enterprises

 With fewer central banks in the world exercising monetary policy, investors also have fewer opportunities to diversify their exposure to central bank risk.

McGraw Hill / Irwin



2001 by The McGraw-Hill Companies, Inc. All rights reserved.

14 - 29

Policy Matters - Public Policymakers

The Impact of EMU

 European financial markets remain somewhat physically segmented, although electronic trading systems and cross-border financial mergers are leading to some consolidation of trading activity.

 The EMU bond market will expand as more nations enter EMU and issuers turn to the bond market to raise capital.

McGraw Hill / Irwin



2001 by The McGraw-Hill Companies, Inc. All rights reserved.

14 - 30

Policy Matters - Public Policymakers

Brady Bonds and Emerging Market Debt Issues

 The Brady Plan entailed a restructuring of nonperforming LDC (less-developed country) bank debt into various uniform bond issues that could be sold to a wide spectrum of investors.

 Usually, the principal of the new debt is collateralized or guaranteed in some manner.

 Annual turnover in Brady Bonds peaked at $2.5 trillion in 1997, before dropping off following the Asian and Russian financial crises.

McGraw Hill / Irwin



2001 by The McGraw-Hill Companies, Inc. All rights reserved.

14 - 31

Policy Matters - Public Policymakers

 The combination of Brady Bonds, sovereign loans, and corporate bonds issued by firms in emerging markets comprise an emerging market for debt.

 Outstanding emerging market bonds totaled $1.2 trillion at year-end 1999.

 Innovative contract design has enabled the market to grow in popularity, even though these securities face substantial credit risk.

McGraw Hill / Irwin



2001 by The McGraw-Hill Companies, Inc. All rights reserved.