Dollar Denominated Debt

Debt is traditionally thought of as a conservative financial instrument. You buy a bond, it pays you interest (tax exempt or taxable), and then you receive your principal back when the bond matures. The interest you receive depends on the duration (time until you get your money back), riskiness of the borrower (traditionally the US government has been the safest lender with the lowest rates, but it may not be that way forever), and the overall level of interest rates in the economy (either the prime rate or LIBOR).

There are many, many variations on bonds, however, and this view of debt is out-dated. Convertible bonds allow the debt to be converted into shares of the company’s stock at certain price points, which allows the company to offer a lower interest rate on debt (because of this “upside”). Distressed debt is often bought by hedge funds and others as a way to take over companies in distress because post-reorganization the equity holders are generally wiped out and the debt-holders receive the new company’s shares.

A risk with debt and all financial instruments is an implied currency risk. In the US we don’t directly “see” the impact of the falling dollar in our day to day activities, but it is immediately evident if you leave the country and go somewhere with a strong currency, as I found out when I traveled to Norway and spent $20 US to buy a drink and lunch for 2 in a decent cafe was over $100. More subtle signs of the dollar’s decline are the hordes of foreign tourists from countries that have a trade surplus with the US buying everything in sight – Dan and I saw an entire upscale mall full of them in San Francisco.

Along with changes in currencies, there is a general hunger for “yield” meaning income that can be earned with relatively low risk (or at least according to models and rating agencies), meaning that borrowers are rushing to market to take advantage by issuing debt at historically low long term rates. Countries that may have had difficulty borrowing in the past or paid high rates like Mexico are now able to issue at interest rate levels that are very low by historical standards – Mexico is now able to borrow with a 10 year maturity at 5.85% (in local currency). These types of rates are at historical lows.

In addition to governments (with decent credit ratings) going out to market for more debt, companies are also issuing debt to take advantage of these historically low rates. Even if the companies have no immediate use for the cash, they are taking advantage of the rates to build funding if the economy turns, for acquisitions, or even to buy back stock and take advantage of leverage to increase EPS. Per this article in the WSJ:

Their timing could hardly be better. Average corporate bond yields finished Monday at 3.28%, just 0.01 percentage point from the all-time low going back to 1973, according to the Barclays U.S. investment-grade index. Industrial bond yields are even lower, at 3.07%.

For private companies in foreign countries, often local banks provided financing. In the US corporations traditionally don’t rely on banks to the same degree and issue bonds to the general public (many of which are bought by pension funds and insurance companies, as well). As banks pull back around the world, foreign companies are now trying to take advantage of 1) historically low interest rates 2) hunger for yield by tapping into this demand for debt by buyers.

Many of the issuers in other countries are now issuing “dollar denominated” bonds. Dollar denominated debt means that they agree to pay at the rate of the US dollar against their local currency, regardless of what happens to the local currency. This insulates the buyer (probably a foreigner from the US) from currency fluctuations in countries like India, Mexico and Chile – but on the other hand it makes the entire transaction much riskier from the seller’s perspective (assuming they don’t hedge this risk). There aren’t just US dollar denominated bonds – there are Euro denominated bonds, Yen denominated bonds, and likely more Chinese currency denominated bonds in the future.

The interesting part for me is the long term “evolution” of debt from a relatively straight-forward low risk instrument (except for default risk, which supposedly could be “rated”) to a very complex instruments with myriad risks. One OBVIOUS risk on these dollar denominated bonds is – what happens when the country’s currency falls vs. the US dollar and these bonds have to be paid back in US dollars? What do you think happens?

According to this article “Weak Rupee Hits India Bondholders“:

The Indian rupee’s sharp depreciation has added to the woes of Indian companies scrambling to repay foreign currency bonds – and it is increasing the likelihood that foreign investors will be hurt… in 2005-2007… the rupee was strengthening, trading at a record of around 40 rupees to a dollar. The bonds were sold only to foreign investors, and companies used the money to fund their growth plans… Indian companies have to repay nearly $3.4 billion in foreign-currency bonds before the end of 2012.
But now, many of these bonds are coming due when the rupee has lost nearly 40% from its high and is trading around all-time low levels.

The article goes on to mention several companies who are having trouble making payments and asking for reprieves from lenders, which typically involves extending terms and / or changing the interest rates. And since these were sold to foreigners, good luck trying to take action within the Indian legal system unlike the US where debt can lead to an implied stake in the post-bankruptcy entity (this wasn’t mentioned in the article and I am not an expert on this so it is only my opinion).

I don’t know how any investor looking for yield and wanting to avoid currency risk just assumed that these risks didn’t exist because they were being borne by the issuer and not them when they received their payment in US dollars. Now these chickens are coming home to roost, and it is pretty obvious in retrospect that these issues were very risky on the currency side and were much closer to a high risk investment than a vanilla boring interest bearing security. The hunger for yield and the fact that these were issued in US dollars made them appear to be much less risky than they apparently turned out to be.

Cross posted at Trust Funds for Kids and LITGM

5 thoughts on “Dollar Denominated Debt”

  1. One difference between physical risk and financial risk is that physical risk doesn’t change when you notice it. It’s still dangerous to be near a volcano even though you know about the risk, and a crack in a bridge girder doesn’t go away just because someone discovers it. But financial risks can change as markets reprice securities to discount newly discovered hazards. The first batch of dollar-denominated Indian bonds might be overpriced, though it doesn’t appear so at the time. As lenders learn from experience about risks that weren’t initially evident, the market price of the bonds will decline to a point where they again become competitive, and the yield required to attract buyers to new issues will rise. The free flow of information and an unregulated price system, not top-down supervision by legislators, bureaucrats and “consumer watchdogs”, is the best way to minimize financial risks.

  2. A company with an inflation sensitive product (toilet paper) can borrow dollars (sell corporate bonds) at say 3.5%, secure in the knowledge that our government is going to inflate the dollar at 3-5% and maybe more.

    So, the money is free at least, and probably will be paid back in inflated dollars. Probably, borrowing that cash is a profitable transaction in itself, plus any investment opportunities.

    The trick is that you need a source of inflated cash produced by a stable consumer products business.

  3. I would suggest, if Obama is re-elected, stay away from unionized companies like Chrysler and GM. A lot of the bond holders were retired employees, not bond funds as was alleged at the time.

  4. I have recently bought quite a bit of Israel Bonds. These are debt instruments issued by the State of Israel in the US and payable in US Dollars. Clearly, there is geopolitical risk. Nonetheless, I think that Israel is more likely to be standing at the maturity of any bonds issued today than is the Islamic Republic, which will most likely disintegrate into chaos, poverty, and ethnic warfare. Although, if worst came to worst, I would regard the loss of my principle as a charitable contribution to a cause near and dear to my heart.

    Here is a comparison of rates as of today:

    Length US Israel
    2-Year 0.27 0.70
    3-Year 0.36 1.25
    5-Year 0.71 2.25
    10-Year 1.63 3.53

    This is for the $25,000 minimum, fixed rate bonds. There are smaller bonds and floating rate bonds too.

    If you are an active member of a Jewish community in the US, Israel Bond salesmen will reach out to you unbidden. If you have a lower profile, or are not Jewish, they will be happy to sell you some bonds. Here is their Website:

    It contains full information on the bonds and how to buy them. You can even set up an account online.

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