Foreign Currency Bonds

Today, corporations, governments and their entities utilize a variety of options to raise capital. In addition to issuing bonds in domestic markets and local currencies, governments and companies can also issue bonds in other markets and different currencies. Since interest rates may differ from country to country, issuers may choose to take advantage of these opportunities.

Corporations domiciled outside of the United States may decide to issue and register their bonds in the United States, in the U.S. dollar – referred to as Yankee bonds. On the other hand, U.S.-based corporations may decide to go outside the United States to issue bonds. Hence, it is possible for General Electric to (1) issue and register bonds in the United States in the U.S. dollar (domestic issue); or (2) issue bonds in multiple markets, in addition to the U.S. market in the U.S. dollar (global issue); (3) issue bonds outside of the United States in the U.S. dollar (Eurodollar issue); or (4) issue bonds outside the U.S. in a foreign currency, such as Japanese yen (foreign currency issue).

Similar options involving different markets and different currencies exist for other issuers seeking access to capital. For example, the Kingdom of Sweden and a Brazilian oil company, Petrobras, have issued bonds in local currency both inside and outside of their respective countries. They have issued Yankee bonds, and Eurodollar bonds. Bond offerings can be denominated in different currencies, such as euros (EUR), U.S. dollars (USD), British pounds (GBP), etc. The risks associated with investing in foreign bonds, in part, depend on the types of markets and currencies in which they are issued.

Securities issued in the United States are usually registered with the U.S. Securities and Exchange Commission. Most bonds issued outside of the United States are not registered for purchase by individual U.S. investors.

Raymond James facilitates foreign currency bond trades in sovereign debt of certain AAA-rated countries with a foreign exchange (FX) occurring at the time of the trade. As with any investment, foreign securities should fit within an investor’s stated objectives and risk tolerance, and should be allocated accordingly.

Types of Bonds

Sovereign bonds are bonds issued by a national government. These bonds are usually denominated in the currency of the issuing government; however, some governments may issue bonds outside of their countries and in other countries’ currencies.

Corporate bonds are bonds issued by a corporation. Although they carry their own credit ratings, these offerings are generally impacted by the ratings of their sovereign countries. Corporate bonds may be registered and issued in different countries and currencies.

Other classes of issuers that do not fit into either category include bonds of local authorities (municipalities, states and provinces), agencies and supranational organizations.

Investment Considerations

Currency risk and its effects on principal and interest – Purchasing foreign currency bonds involves conversion from U.S. dollars into a foreign currency and is subject to exchange rates. The exchange risk can account for a significant portion of a bond’s risk and return. Therefore, it is crucial to understand the volatility of the base currency in which the bond is issued, as well as its relationship to the U.S. dollar. Even though the purchase is confirmed and settled in U.S. dollars, the principal and interest payments remain at risk due to currency fluctuations. This means that even if held to maturity, the proceeds may be more or less than the stated par value after the currency conversion. The same applies to coupon payments during the life of the bond.

For example, an investor wishes to purchase £100,000 face value of a five-year U.K. Treasury Note paying 5%. The current price in the foreign currency is 100% of face value. Let us assume that the currency exchange rate at the time of trade is $1.65 (as of July 27, 2009) for every British pound (£1 = $1.65). So the cost of the trade in U.S. dollars is $165,000. The client holds the bond to maturity and receives all interest and principal due, paid in British pounds. Let’s assume that, on the maturity date, the prevailing exchange rate is £1 = $1.50. The client receives $150,000, thereby losing $15,000 of invested principal. The same risk applies to the coupon payments. (This example does not include commissions and/or fees that an investor may incur.)

Interest rate risk – As with all fixed income investments, investors must understand the inverse relationship between price and yield (i.e., when interest rates rise, the price of an existing bond falls because its coupons become less attractive to potential buyers and vice versa). If the bond is paying a higher coupon rate than the current rates available on new issues of similar-quality bonds, it is likely the market price would increase because other investors would be willing to pay more in order to earn higher interest. Conversely, if the bond is paying a lower coupon than is generally available, other investors would expect to pay less and the market price could decline. If the bond is sold prior to maturity, a realized gain or loss could result.

Credit quality – Moody’s Investors Service and Standard & Poor’s often rate foreign bonds. However, investors should be aware that accounting and reporting standards vary by country, which may make it difficult to ascertain the issuers’ financial strength. Since foreign currency risk is a major consideration, foreign corporations often carry the debt rating that reflects both the credit quality of the company and the country. Note that credit actions by either rating agency, as with any rated bond, may affect the investment. As a rule of thumb, in addition to estimating return on investment, yield calculations reflect the market perception of risk. When a bond yields more than its comparable counterparts, the market perceives it to carry a higher overall risk. A credit rating is not a recommendation to buy, sell or hold securities and may be subject to review, revision, suspension, reduction or withdrawal at any time by the assigning rating agency.

Liquidity – The foreign currency market is dominated by institutional buyers and sellers and can become very illiquid for individual investors. It should also be noted that U.S. investors need to be aware of the time differences and the possibility of limited access to foreign markets from the United States. The market of issuance and size of initial offering affect the liquidity of an issue.

Lack of price transparency – The secondary market on foreign currency debt is predominantly over-the-counter. Therefore, opaque markets and limited liquidity may impede investors from determining the fair-market value of the foreign investment.

Political instability risk – Investors in foreign bonds should also understand the risk of political instability and its effect on the value of investments. This includes the potential for a complete loss of principal and/or all rights and privileges in the most extreme cases of unrest. Rapidly occurring world events and current economic news should also be considered before investing in foreign bonds. Foreign investors may not have an enforceable legal claim in the event of default.

Local market risk – Another important risk to address is that of the local market. A foreign bond investor should be aware that the regulations, liquidity and actions taken by foreign market participants may vary substantially from those in the United States. Certain countries may use different calculations for interest payments than those used in the United States.

Yield calculations and returns – In continuation with the currency risk stated above, additional consideration must be given to overall currency fluctuations and the bid/ask spread of the foreign currency itself. When an investor buys a foreign currency bond, bid dollars are converted into the underlying currency at the ask price. Upon redemption or maturity, the underlying currency is converted into dollars at the bid price.

Tax considerations – There may be additional tax consequences related to foreign bonds depending on the agreements in place between the United States and the country of issuance. Professional tax advice must be sought for additional information.

Depending on individual risk tolerance, certain investors may want to include an international component in their asset allocation models. Foreign currency bonds carry additional risks to which domestic bonds are not subject. Therefore, for most investors, it may be prudent to use professional management through mutual funds or individual money managers that specialize in foreign markets.

Billing and Account Statements

Raymond James will confirm foreign currency trades in the U.S. dollar equivalent. All account holdings and price evaluations will be in the U.S. dollar. Upon initial inquiry, quotes given will represent the percentage of face value in the foreign currency followed by an indication of the exchange rate. Exchange rates fluctuate constantly and may be dependent on the size of the trade and market volatility. Final money will only be confirmed at the time of the trade, including the actual exchange rate and the net money spent, inclusive of accrued interest, if any. Subsequent maturity and interim coupon payments, when received, will be converted into U.S. dollars at the current exchange rate. Trade confirmations will indicate the price in the foreign currency, the exchange rate at which the trade was executed, and the total amount of the trade in U.S. dollars. It will also highlight some of the risks mentioned above that are associated with this type of investment.

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