Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

the probability that investors experience losses when default occurs, the expected return on junk bonds

is generally well below the promised return (the yield to maturity).

Bonds are essentially unmarketable without a rating. After a bond is rated, the rating is not changed

unless the likelihood of the company’s defaulting on the bond issue changes. It is perhaps surprising that

bond issuers themselves pay the ratings companies to issue ratings on newly issued bonds. Additionally,

in its discussions with the rating agency the issuing company can communicate sensitive information

privately to the rating agency. This information can then be usefully reflected via the bond rating without

being directly disclosed to competitors.

14 -3f INTERNATIONAL CORPORATE BOND FINANCING

Companies can sell bonds internationally by tapping the Eurobond or foreign bond markets. Both of these

provide established, creditworthy borrowers the opportunity to obtain large amounts of long-term debt

financing quickly and efficiently, in their choice of currency and with flexible repayment terms.

Eurobonds

A Eurobond is issued by an international borrower and sold to investors in countries with currencies other

than the currency in which the bond is denominated. A dollar-denominated bond issued by an Australian

company and sold to European investors is an example of a Eurobond. Australian and New Zealand banks

have been very active in this market during the period 2000–15. The Eurobond market first developed

in the early 1960s, when several European and US borrowers discovered that many European investors

wanted to hold dollar-denominated bearer bonds. Investors wanted bearer bonds because they would both

shelter investment income from taxation – because coupon interest payments were made to the bearer

of the bond and names were not reported to tax authorities – and provide protection against exchange-

rate risk.

Until the mid 1980s, blue-chip US corporations were the largest single class of Eurobond issuers,

and many of these companies were able to borrow in this market at interest rates below those the US

government paid on Treasury bonds. As the market matured, issuers were able to choose the currency

in which they borrowed. Later, the Eurobond market became much more balanced in terms of the

mix of borrowers, total issue volume and currency of denomination. Australian currency bonds grew

in volume, to rank in some years as the second-most common currency for Eurobond issues; but the

volume was still well below that of the US dollar. Most Eurobond issues, in fact, were executed as

part of a complicated financial engineering transaction known as a currency swap, wherein companies

headquartered in different countries issue bonds in their home-country currencies and then exchange

principal and interest payments with each other.

Foreign Bonds

In contrast to a Eurobond, which is issued by an international borrower in a single currency (frequently

dollars) in many countries, a foreign bond is issued by a foreign borrower in a host country’s financial

market and in the host country’s currency. An Australian dollar-denominated bond issued in Australia

by a US company is an example of a foreign bond, sometimes called a Kangaroo bond. Other examples

are a US dollar-denominated bond issued in the US by a German company (a Yankee bond) and a yen-

denominated bond issued by an American company in Japan (a Samurai bond). The three largest foreign

bond markets are Japan, Switzerland and the United States.

Can the yield to maturity on a

company’s junk bonds be higher

than the expected rate of return

on its shares?

thinking cap
question

Eurobond

A bond issued by an

international borrower and

sold to investors in countries

with currencies other than the

currency in which the bond is

denominated

bearer bonds

Bonds that pay interest

to the bearer and both

shelter investment income

from taxation and provide

protection against exchange

rate risk

foreign bond

A bond issued in a host

country’s financial market, in

the host country’s currency, by

a foreign borrower