Question

Russia’s Alternative Currency Bonds.

On March 17, 2018, the Russian Federation issued USD 4bn in eurobonds (what are they?) with an unusual provision. The issuer reserves the right pay bondholders principal and interest in EUR, GBP, or CHF should the Russian Federation be unable to make payment in USD for “for reasons beyond its control..”

Working for the chief investment officer (CInvO) of NoNaCaPa (No-Name Capital Partners), a prominent hedge fund, you are analyzing the bonds to determine what their risk and rewards are.    Your company is USD based but not averse to taking on foreign currency risk to enhance a position’s return potential. Your starting point is the attached Financial Times article which you supplement by your own research. In particular, you wonder about the alternative-currency clause in the indenture (debt contract) and how it might affect the investment performance of the bonds.

(a) Research dual- or multiple-currency debt securities which are typically issued in the eurobond market.

• What do they consist of?   How can you unbundle the bonds into its constituent parts?

• What are eurobonds?

(b) In comparison to multiple curency bonds, what does the alternative currency payment provision effectively amount to?

(c) What motivates the alternative currency payment provision and how does it affect the pricing of the bonds?

(d) What risk factors do investors face?   Present the risks in tabular form distinguishing between financial from nonfinancial risks which obviously translate into financial risks at a later stage. Identify each risk’s origin and nature,who bears it, its impact on bond pricing, and whether and how investors can hedge or not against it.

(e) What investment recommendation would you give to your CInvO? Explain your advice and motivate your investment thesis, i.e., the rationale why or why not you should participate in the transaction.

Answer 1

(a). A dual currency bond is a debt instrument in which the coupon and principal payments are made in two different currencies. The currency in which the bond is issued, which is called the base currency, will be the currency in which interest payments are made. The principal currency and amount are fixed when the bond is issued & in case of miltiple currency bonds there is the involvement of more than two correncies.

Unbundleing can be understood by the following example :-

A bond issued in U.S. dollars which pays interest in euros will be considered a dual currency bond. With some dual currency bonds, the interest is paid in the currency of the investor and the principal is redeemed in the issuer’s domestic currency. Still other bonds make interest payments in the currency of the issuing entity and repay principal in the investor’s currency. The coupon interest on a dual currency bond is usually set at a higher rate than comparable straight fixed-rate bonds and is paid in the weaker or lower rate currency.

Let’s look at an example of setting a fair interest rate on a dual currency bond. Assume a bond is issued with a par value of $1,000 and has a maturity date of one year. Interest is to be paid in U.S. dollars and the principal repayment at maturity will be in euros. The current spot exchange rate is EURUSD 1.24. Hence, principal repayment value per bond is set at (USD1000 x EUR1) / USD1.24 = €806.45. At the end of the first year, then, the cash flow on this bond is $1,000r + €806.45. If the one-year market rates are 4% in the dollar market and 7% in euro market, the interest rate at which the bond should be issued is:

1000 = (1000r/1.04) + 1.24(806.45/1.07)

1000 = (1000r/1.04) + 934.58

1040 = 1000r + 971.96

r = 0.068, or 6.8%

A eurobond is a bond denominated in a currency not native to the issuer's home country. Eurobonds are commonly issued by governments, corporations, and international organizations.

Eurobonds give issuers the opportunity to take advantage of favorable regulatory and lending conditions in other countries. Eurobonds are not usually subject to taxes or regulations of any one government, which can make it cheaper to borrow in the eurobond market as compared to other debtmarkets.

(b). Both parties in a dual currency swap will come to the deal with the intention of reducing a risk. That risk is that the fact that the relevant bond uses two different currencies may mean that the real-terms cost of issuing or buying a bond is different from what is expected. In other words, the party knows the amount it will pay or be paid in the foreign currency, but won't know what this will translate to in its own domestic currency.

(c). There is a relationship between the yield of the bonds, and the general trend of the currency: when people are willing to take risks, low-yielding currencies depreciate, as investors buy high yielding bonds and don't hedge the currency risk. When markets turn (and stocks fall), low-yielding currencies outperform, because of the unwind of aforementioned trades.

(d). Non-financial or Business risk Financial Risk

1.    Meaning	Business risk is the risk of not being able to make the operations profitable so that the company can meet its expenses easily.	Financial risk is the risk of not being able to pay off the debt that the company has taken to get the financial leverage.
2.    What it’s all about?	Business risk is purely operational.	Financial risk is related to the payment of debt.
3.    Avoidable?	No.	Yes. If the firm doesn’t take debt, there would be no financial risk.
4.    Duration	Business risk will be there as long as the company operates.	Financial risk would be there until the equity financing is increased drastically.
5.    Why?	Every business wants to perpetuate and expand; and with continuation comes the risk of not being able to do it.	To generate better returns and to tap into the lure of financial leverage, company gets into debt and takes the financial risk.
6.    How to handle it?	By systemizing the process of production and operation and by minimizing cost of production/operation.	By reducing debt financing and by increasing equity financing.
7.    Measurement	When there’s variability in EBIT.	We can look at the debt-asset ratio, and financial leverage multiplier