Eurobonds market rules

Eurobonds are bonds which are often issued in several European countries simultaneously. Issuers are often large international institutions, companies, and sometimes public authorities. The prefix "Euro" simply refers to the bond's location of issue (Europe). It does not refer to the nationality of its issuer or the currency of issue. A Eurobond can therefore very easily be issued by a Japanese company in US Dollars.

Alongside the Eurobonds market, the national or domestic bond market also exists. These bonds are only issued in the country of their issuer, e.g. a bond for General Motors would be issued in the US. Keytrade Bank negotiates exclusively in Eurobonds.

Issuing bonds (primary market)

An issuer such as a multinational wishing to issue bonds in order to raise finance for its company will contact a specialist banker who will take care of all the necessary formalities. Furthermore, a certain number of factors need to be defined. The most important of these are: the bond's issue size, period, currency, coupon and subscription price.

• Issue size: this is the total amount that the issuer would like to raise on the primary bond market. A routine issue size on the Eurobonds market would be EUR 100 million.
• The life span of the bond is determined by the issuer. This period more often than not varies between 3 and 10 years.
• Currency: although most bonds are issued in euros, a Eurobond can actually be issued in any currency that exists.
• Coupon: the periodic interest (often paid annually) that the investor will receive on the nominal value of the investment.
• Subscription price: a percentage of the nominal value; the bond is issued against this percentage on the primary market.

For example: General Motors wishes to issue a Eurobond. It will be agreed with the investment banker that the issue on the primary market will have the following characteristics:

• Issue size: EUR 150,000,000
• Life span: 7 years
• Currency: Euro
• Coupon: 5.25%
• Issue price: 101%

During a defined period called the subscription period (which often lasts 4-6 weeks) investors can sign up to the bond issued by General Motors (subscription on primary market). For a nominal investment of EUR 10,000, the investor will have to pay EUR 10,100 (101%). Every year for 7 years, this bond will yield a return of EUR 525 (5.25% of EUR 10,000) on the coupon date, before deductions are made for withholding tax. On the maturity date (after 7 years) the investor will be paid back the EUR 10,000 capital investment.

The secondary Eurobonds market.

Once the subscription period for the bond issue has closed, it is no longer possible to sign up for the bond at the original price. The bond is then no longer listed on the "primary market".

This does not mean that an interested investor has missed their chance to buy the bond.

The day after the subscription period closes, the bond issue in fact moves from the primary market to the secondary market.

The secondary Eurobonds market is simply a market for existing bonds. Buyers and sellers are continuously active on this market.

This is why market pricing constantly comes into play. An investor who buys a bond on the primary market can in principle always sell it on the secondary market. An active investor can go to the secondary market to acquire bonds listed at very attractive prices.

Contrary to the situation on the equity markets, the majority of trades in Eurobonds take place directly between professionals such as bankers or stockbrokers, etc. rather than via stock exchanges.

Though Eurobonds are often listed on the stock markets (mostly on the Luxembourg stock exchange), the majority of trades are carried out "over-the-counter" (between professionals) for reasons of limited liquidity. This means that unlike the stock markets, the Eurobonds market is a true professionals' market.

Keytrade Bank offers its customers access to this secondary professionals' market via its Eurobonds trading platform.

The basics of investing in Eurobonds

Why should I invest in bonds? How secure is an investment in bonds? How can I choose a good bond, and what do I need to look out for?

We have tried to provide answers to these questions in the points that follow. We hope they will help you to understand some of the introductory principles of investing in bonds.

The conflict between risk and return

Naturally, every investor is always looking for that impossible combination of "high level of security" and "high yield" for all of their investments. But unfortunately, security rarely equates with a high return. A high return is more often than not coupled with a high level of risk. This universal rule applies throughout the financial world, and this includes on the bond market.

• Quality and rating The quality of the issuer is often expressed through its rating, which gives an indication of its level of solvency. The following question then arises: how can the bondholder (the investor) be sure that the issuer will honour all of his commitments? In addition to making regular interest payments, the issuer must be in a position to repay the nominal value of the bond upon maturity. There are several rating agencies all pursuing the same objective, which is to assess the solvency of issuers on the bond market. The most well known of these are Standard & Poors (S&P) and Moody'sFollowing an in-depth analysis of the issuers, these agencies award them a credit rating, which is an indication of the issuers' level of solvency.

An AAA rating awarded to an issuer by Standard & Poors is an indication that this issuer is very solvent indeed. The equivalent of the S&P AAA rating is the Aaa rating from Moody's. Bonds with a rating of lower than BBB (S&P classification) or Baa3 (Moody's classification) are generally considered to be speculative grade bonds.

Of course, a bond issued by a very good debtor (with a high rating such as AA or A2) will produce a lower yield than a bond with the same characteristics but whose issuer is in financial difficulty and consequently has a rating of B or B2, for example.

So it is essential to always pay attention to the ratings given to bonds when comparing their yields.

• Life span In normal market circumstances, a long-term bond offers a higher yield than a short-term bond. However, a long-term bond is inherently riskier than a short-term bond, since one can never predict the future. The likelihood that the issuer will fail is obviously greater over a longer period of time compared to a short period.
• Currency Certain bonds can present a very attractive yield to the investor without there necessarily being any link to a bad debtor. The reason for this could simply be that the bond was issued in a high-yield currency. Yet it must not be forgotten that exchange rates change and that therefore, a risk is present. If you do not wish to take any risks at all, you should only invest in euros. The yield of a bond issued in euros may be smaller than those issued in certain other currencies (e.g. the Hungarian Forint), but you will not incur any foreign exchange risk. If you would prefer to speculate, for example on the rise of the US Dollar, it would be a worthwhile investment to buy bonds in US Dollars.
• Interest rate and coupon The coupon is the periodic payment of interest that you receive as the holder of bonds. Ordinarily, Eurobonds pay a fixed annual coupon, but twice-yearly or quarterly coupon payments are also possible.The coupon amount is obtained by multiplying the nominal interest rate by the nominal value of the bond.For example: A bond has a nominal interest rate of 5.25% per annum. An investor buys EUR 10,000 at a cost of EUR 10,400. Every year, this investor will receive a coupon amounting to 5.25% of EUR 10,000: 5.25% x 10,000 = EUR 525.As well as fixed rate bonds, there are also floating rate bonds. The interest rate for these bonds is modified periodically throughout the life span of the bond, and is often adjusted quarterly. These floating interest rates are often linked to a benchmark rate such as the Euribor rate. In the jargon, these bonds are often also called "Floating Rate Notes".For example: a "Floating Rate Note" has a life span of 4 years and pays a quarterly coupon linked to the 3 month Euribor rate + 0.50%..A type of bond also exists that we call "zero-coupon bonds" or "zero bonds". As their name would suggest, these bonds do not pay periodic coupons. But this definitely does not mean that a zero bond is not a worthwhile investment. The main feature of a zero bond is that this bond is issued "under par value". This means that if an investor buys a zero bond, he/she will pay less than the bond repayment amount. The investor's profit is constituted by the difference between the bond repayment (often 100% of the nominal value) and the price the investor paid.For example: a zero bond has a life span of 5 years and is listed at 75%. The repayment is for 100%. The investor will receive no coupons for 5 years, but his/her investment of 75% will be repaid at a rate of 100% after 5 years.
• Price and yield In the example cited above, the investor receives an annual coupon of 5.25%. This coupon is calculated against the nominal value of the bond he/she bought (EUR 10,000), not the price paid (EUR 10,400).As a consequence, the yield the investor obtains on the investment is less than 5.25%! The investor's "direct yield" only amounts to 525/10,400 = 5.05%. Thus we can say that the higher the price of the bond, the lower the yield it deliversProfessional investors almost never refer to the idea of direct yield, but instead to what we call the "actuarial yield".The actuarial yield is the annual yield of a bond which not only takes into account the coupon, but also other aspects such as coupon date, maturity date, current price and the bond repayment. We will return to the example given above. Let us assume that the investor bought this bond just one year before its maturity date. The buyer would have paid 104% (EUR 10,400 for a nominal value of EUR 10,000) and will receive a 100% repayment (EUR 10,000) after one year. After one year, the investor does the accounts: he/she will receive a coupon of 5.25%, but will lose 4% of the investment (which was bought at 104% but is repaid at 100%). The investor's net yield, therefore, is only 1.25%. We will now imagine that the investor bought the bond two years before its maturity date, again at 104% of its value. At the end of this period, the investor calculates the yield again: he/she receives 2 coupons of 5.25%, so 10.50%, and loses 4% of the investment. After two years, the net yield achieved is 10.50% - 4% = 6.50%, so approximately 3.25% per year.This method of calculating the yield produces a more precise picture of the actual yield of an investment in a bond than the simple direct yield idea. Professionals calculate this actual yield using the techniques of actuarial mathematics (the example above has been simplified considerably)! This is why we use the term "actuarial yield".
• Particular forms of repayment Generally, the majority of bonds are repaid in cash equivalent to their nominal value. However, this is not always the case. Some bonds are automatically repaid in stock, and in other cases, the investor has the choice of receiving payment at maturity in stock or in cash. Another possible scenario is that the bond repayment is linked to a stock market index.
• Guarantees/hierarchy It is generally recognised that bonds are reasonably safe investments. The risk of non-repayment of a bond issued by a good debtor is fairly low. Should an issuer face bankruptcy, the creditors of this issuer will be repaid in a particular order. Certain priority lenders will be repaid in the first instance (e.g. the government, mortgage lenders, etc.) Unsecured creditors are repaid next (the majority of bondholders fall into this category). The final group of creditors is then paid. These include shareholders, holders of subordinated bonds, and so on. Before purchasing a bond, it is therefore crucial that the guarantees and hierarchy of commitments in the event of bankruptcy are established in advance.
  • Guarantees :
    • Unlike secured bonds, unsecured bonds are issued without offering any specific guarantee.
    • In the case of multinational companies, bonds issued are often guaranteed by the parent company (called the "company guarantee", or "bank guarantee" in the case of a banking group)
    • Some bonds issued are "asset backed". This means that a specific fund is ring-fenced in order to guarantee repayment of the bond.
  • Hierarchy:
    • In the event of bankruptcy, a subordinated bond is paid after all the other bondholders, directly before the shareholders are paid.
    • A "senior bond" is a common form of bond situated above the bottom of the hierarchy, meaning it is more secure than an unsecured bond.
• Interest due The majority of Eurobonds pay an annual coupon. In principle, the investor receives 1/365 of this annual coupon for every day he/she holds a bond.We will now imagine that the investor buys a bond on a secondary market, and that the bond's annual coupon will be paid in 7 months. In other words, 5 months have passed since the last coupon was paid. The bond has therefore already produced interest over 5 months. This interest is due to the seller of the bond, and must therefore be paid by the buyer of the bond. The buyer will receive the entirety of the coupon on its payment date (in the next 7 months).The interest due is calculated by applying a fraction to the coupon amount, as follows: the fraction numerator is equal to the number of days' interest due, and the denominator equals the number of days in one year. This fraction (also called the "accrual basis") may vary from one bond to another. The most common types of accrual basis are :
  • ACT/ACT : the numerator is equal to the number of effective days between the date of the last coupon payment and its settlement date. The denominator is the number of effective days in one year (365 or 366).
  • ACT/360 : the numerator is equal to the number of effective days between the date of the last coupon payment and its settlement date. The denominator is set on the basis of 360 days.
  • 30/360 : it is agreed that every month contains 30 days
  For example: A bond has the following characteristics :
  • Its last coupon was paid on 23 February 2003
  • The annual coupon is 6%
  • The accrual basis used is ACT/ACT
  An investor buys EUR 10,000 of this bond with a settlement date of 19 September 2003. The exact number of days between 23 February 2003 and 19 September 2003 is 208. The seller of this bond is therefore entitled to 6% x 10,000 x 208/365 = EUR 341.92 in payable interest. The buyer will therefore have to pay this sum to the seller. The buyer will receive the entirety of the coupon on 23 February 2004 (the date of the following coupon payment).