Credit Risk: From Transaction to Portfolio Management

any shortfall needed to pay the investors. If funds are drawn down

during a particular period they will usually be repaid later if the

spread recovers.

Further reserve funds can be built up into separate ways. Either a

portion of the profits upon issuance is placed on deposit, or the excess

servicing spread is pooled (if any). These represent proceeds generated

from the difference between the incoming payments and the debt ser-

vicing payments.

1.8 International bonds

The International (often called the Eurobond) market is now one of the

largest and most important sources of capital. It continues to grow and

develop new structures in response to the varying demands placed

upon it by the investor community (Figure 1.22).

The International marketplace can only be used by a good credit

including some governments, large corporates and supranationals.

Investors are predominantly institutional but the private client is also

important, looking to invest in the Eurobond market due to a lack of

development within their domestic market. Indeed many instruments

are designed to be tax efficient specifically to appeal to the private

investor.

The distinguishing characteristic of the Eurobond is the nature of

issuance. They are placed across borders by an international syndicate

of banks. This method of issuance is distinct from the auction system

characteristic of government bonds. The bond is subsequently traded

OTC by the market participants in a number of international financial

centres. A further characteristic of the market is the lack of any one cen-

tral authority to provide regulation. They are, however, usually registered

on a national exchange enabling some types of institutional investor

access to the market who might otherwise be frozen out. Possibly because

of local legislation banning the holding of non-exchange traded assets.

30 Credit risk: from transaction to portfolio management

USD

GBP

EUR

Other

Figure 1.22 International bond volumes by country (May 2003). Source:

Deutsche Bank.

The major currencies of issuance are the dollar, euro, sterling and

yen. The term ‘euro’, originally used as a prefix, was coined to repre-

sent dollar deposits within Europe in the 1960s. These received a pref-

erential rate due to the perception of higher risk. Now we have a

situation where ‘euro’ refers to any currency on deposit outside of the

country of issue. For example sterling on deposit in Japan would be

called eurosterling. The currency of issuance does not necessarily

match the currency in which the borrower is domiciled, indeed the

currency will be chosen on the basis of how attractive that debt will be

perceived by the investor community within that currency.

Interest on Eurobonds is paid gross of any tax. They are bearer

bonds and have no central register. However, they are usually held in

a central repository for settlement purposes. These features were key

to the development of the market.

The majority of Eurobonds are conventional bullet structures with a

fixed coupon and maturity date. The latter typically from 5 to 10 years,

many bonds are considerably longer dated. This is particularly true of

the eurosterling market, thus meeting the considerable demand of

institutional clients which have long dated pension obligations.

The bond is typically unsecured and consequently depends upon the

borrower’s credit worthiness in order to appeal to the investor base.

The Eurobond market gave birth to the FRN. Here the coupon pay-

ment varies and is dependent upon a reference rate typically either

libor or euribor. There will be an additional spread, dependent upon

the credit quality of the issuer. For example borrowers with a poorer

credit than AA (which is representative of the swap market) will be

referred to as libor plus borrowers, conversely issuers with a better

credit than AA will be able to borrow at libor minus. Typically spreads

range from 10 to 200 basis points.

Common non-vanilla structures, especially within the sterling mar-

ket are perpetuals, which pay a regular coupon but do not mature,

and conventional bonds with an embedded call or step up feature. We

have discussed these arrangements and will not go into detail here.

Also important within the Eurobond market is the zero coupon bond

which pays no coupon but is issued at a discount to par. The effective

interest is implied by the return on the difference between par and

the issue price. This return is locked in so effectively represents an

income. However for tax purposes it is categorized as a capital gain

and taxed at a preferential rate. These bonds have correspondingly

become less important within the US and UK who have adjusted their

tax legislation. Correspondingly the return counts as income and not

capital gain. Table 1.4 illustrates a typical deal.

Fixed income credit 31