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Eurobonds: Not Just For Europeans

When even the Iranian government floats Eurobonds, you know there's something funny about the term.

There's a difference between a eurobond and a foreign bond, even from the perspective of a non-European. A Eurobond is a bond issued and traded in a country other than the one in which it's currency is denominated.

Not all originate or circulate in Europe, though most are issued by non-European companies or governments to be traded by European investors. For example, the French government issues euro-denominated bonds (the Franc was discontinued in 2002) that buy and sell on Japanese financial markets. Issuers get creative. A Eurobond can be denominated in U.S. dollars, but issued in Japan by an Australian company. Even Wal-Mart issues bonds in U.S. dollars that trade on the German exchanges.

In fact, most new issues in the international bond market are Eurobonds and it's now larger than the U.S. bond market. (The latter is over $14 trillion total.)

Eurobonds give issuers some additional tools for creative financing, since they can choose a country based on regulatory and tax environment. Investors benefit by having more to choose from.

Eurobonds do carry extra risk, though.

Most investors are moderately familiar with conditions in their own country. But even in this day of Internet-available international news and financial information, events elsewhere are usually much less well tracked.

Added to the natural ignorance of events far away is the significant risk of foreign currency trading. Compared to the size of currency markets, bond trading is small. The equivalent of over $1.5 trillion dollars per day changes hands in the foreign currency markets. By comparison, U.S. Treasury Securities trade around $360 billion per day.

And currency exchange is significantly more volatile - with wider price swings over shorter time frames and greater sensitivity to momentary political changes. Currency risk occurs on longer time frames as well, though.

A bond bought today generally matures a few years later. Suppose, a U.S. investor pays £1,000 (~$1,770 today, hence £1 GBP = $1.77USD today) for a new eurobond which is held to maturity and repaid five years later. When repaid, the issuer repays in GBP (British Pounds) on the face value, £1,000. But in the interim, the exchange rate has changed to £1 = $1.66. The investor will be paid back the equivalent of $1,660. (And this example ignores any complicating factors of local inflation.)

The $110 loss comes entirely from currency risk. Of course, the scales tip both ways. It's possible, and just as likely, for currency rates to change in favor of the investor. The exchange rate may change so that £1 = $1.88.

But then the investment becomes one not merely of bond trading but currency speculation. Not a bad investment medium, millions make enormous sums that way every day, but a much riskier market.

As with any investment, research - both of the historical circumstances of the issuer, as well as current data - is fundamental to making reasonable estimates of future returns. But for those willing to make the effort, the rise of the Internet, the consolidation of European financial markets around the turn of the millennium and other social changes make global investing a new avenue for profit.