Chapter XII International Bond Markets 3

TABLE XII.D Eurobond quotes U.S DOLLAR STRAIGHTS Abbey Natl Treasury 6½ 03 Alberta Province 7¼ 98 Austria 8½ 00 Bank of Tokyo 7 96 Belgium 5½ 03 British Gas 0 21 Canada 6½ 97 China 6½ 04 Issued Bid Offer Chg. Yield 1000 1000 400 100 1000 1500 2000 1000 92¼ 101 104¾ 101⅛ 86½ 12½ 98½ 87¾ 92½ 101½ 105 101½ 86¾ 12¾ 98¾ 88¼ -¼ 7.81 7.28 7.30 7.21 7.69 8.16 7.14 8.69 -¾ -¼ 2.B.4 The Global Bond Global bonds attempt to address one of the frequent shortcomings of Eurobond issues mentioned above: poor liquidity. For many years, Eurobond issuers have attempted to tap into the more liquid domestic markets of the U.S. and Japan. Clearly, access to a wider range of markets makes easier the launching of new issues in larger sizes. Provided there are committed market makers in each market, a larger-size and well-placed issue makes for better liquidity, smaller trading spreads in the secondary market and, hence, a lower cost of funds to the issuer. One of the key problems for accessing the U.S. foreign market with Eurodollar bonds is the usual bearer nature of Eurobonds. In 1988, The World Bank conducted a study, which suggested that anonymity was not that important for many international investors. The World Bank discovered that more than a third of non-resident holdings of USD denominated debt were U.S. T-bills or other U.S. domestic securities issued in registered form. Based on this evidence and the changes in U.S. regulations mentioned above, in 1989, The World Bank launched simultaneously a 10-year 8 3/8% Eurobond issue in the U.S. foreign and Eurodollar bonds markets. The issue size was USD 1.5 billion, which was the largest fixed rate international offering ever. This Eurobond issue was the first global bond. Clearly the ability to trade an issue freely in both European and U.S. domestic markets enhances its liquidity and reduction of issuance costs. The principal distinguishing feature of the bonds was their registered form, which satisfied U.S. regulations. The further requirement of registration under the Glass-Steagall Act was dispensed with under an exemption. The experience of this issue was a big success. The World Bank's global bond issues trade at yields which are lower than both their U.S. domestic bonds (10-20 basis points) and their USD Eurobond (5-10 basis points). As a result, The World Bank now raises bond finance primarily in this form. A key element in global issues is that the issuer should have a homogeneous credit perception around the world. The World Bank, for example, has a favorable perception throughout the world. For example, global World Bank issues are handled in the U.S. by dealers specializing in U.S. government-sponsored agencies. Several governments and big companies have successfully emulated The World Bank. U.S. multinational corporations are not exempted from registration of their issue with the SEC. In order to XII.27 avoid the delay, these borrowers have resorted to a standard Eurobond issue launched simultaneously with a U.S. private placement, which together make an international issue rather than a global bond. III. Foreign Bond Markets Ninety years ago, the international bond markets consisted solely of foreign bonds, that is, bonds issued, placed, and traded in a bond market which was foreign to the issuer's country of incorporation. These markets had most of the features that are standard in today's bond markets: i.Issuers were typically foreign governments or private sector utilities such as railway companies. ii.Issues were subscribed by retail and institutional investors. iii.Issuers and investors were connected by continental private banks and old London merchant houses. iii.Underwriting and the syndication of underwriting risk were established practices, and the structure of a bond was similar to that prevailing today. After WW I, the world saw a strong U.S. economy and a strong U.S. dollar. During this period, world capital markets served primarily to channel European savings into the U.S. economy. Issuance activity elsewhere in the international markets remained small. This dominance of the U.S. foreign bond market, called the Yankee bond market, became even stronger after WW II. For years the Yankee bond market was the largest and most important foreign bond market. In recent years, however, it has been surpassed by the CHF foreign bond market (see Table XII.A). As mentioned above, the growth of the Yankee bond market was impeded by the U.S. Interest Equalization Tax that was in force between 1963-1974. Other foreign bond markets have a sizable share of the international market. Now, we will briefly describe the main features of some of these foreign markets. 3.A Yankee Bonds Yankee bonds must be registered under the Securities Act of 1933, which involves meeting the disclosure requirements of the U.S. S.E.C. If the bonds are listed (usually NYSE), they must also be registered under the Securities Exchange Act of 1934. The ordinarily long four-week registration period can be speeded up by shelf registration. In shelf registration, the borrower files a prospectus that covers all anticipated borrowing within the coming year. Then at the time of a new issue, the borrower only has to add a prospectus supplement, which takes only a week to clear. Yankee issues are usually rated by a bond rating agency such as Standard and Poor's Corporation or Moody's Investors Services, Inc. A rating is necessary if the bonds are to be sold to certain U.S. institutional investors. Use of the Yankee bond market has tended to be restricted to borrowers with AAA credit ratings. XII.28 There is no withholding tax on coupon payments to foreigners who purchase Yankee bonds. Coupons are usually paid semiannually. The secondary market for Yankee bonds tends to be more liquid than that for USD Eurobonds and bid/ask spreads are smaller. New issue costs are smaller than for Eurobonds (about 7/8% versus 2% for Eurobonds). Therefore, we should be cautious in comparing interest rates in the Yankee market with rates in the dollar Eurobond market: smaller issue cost and more frequent coupon payments should be taken into account. Example XII.17: On October 17, 1994, the weekly Barron's, published the following quotes for Yankee Bonds, in the Bonds Section: 126 57 55½ 92½ 53 108¾ 110 3.B 112½ 45 45¾ 84 40 84 99 FOREIGN BONDS AmocoCda 7¼ 13 6.3 178 CdnPc 4s perp 8.5 175 CdnPc 4s reg 8.4 50 CGDina 8s 04 9.1 39 Cuba 4½77mf ... 42 EmplCA 5s04 ... 4 Inco 7¾ 16 7.5 38 119 47½ 47 88 45 104 104 116½ 47 47½ 84½ 42 104 103 117¼ 47¼ 47½ 88 42 104 104 -1¼ -¾ -½ +3 -10¾ -1 +½ Samurai Bonds and JPY Eurobonds In May 1984, the U.S. and Japan announced, as part of the general agreement on Japanese financial deregulation, a reduction in restrictions on JPY Euro financing. The Euro-JPY would be expanded to allow, for the first time, both Japanese and non-Japanese corporations to make public JPY Eurobond issues, and foreign banks would be allowed to serve as lead managers. The market was opened to issues by foreign banks in 1985, and dual-currency, zero-coupon, and FRNs were also approved. Although some restrictions remained, the consequences of deregulation were immediately apparent, with the amount of JPY Eurobonds achieving second place after the USD Eurobonds in 1991. Issuance terms (i.e., maturity, calls, denominations, etc.) on JPY Eurobond are unregulated and standard practice on Eurobond issues is applied. There is no requirement of a Japanese lead manager, but non-Japanese lead managers must have offices in Tokyo. Euro-JPY bonds are usually listed in Luxembourg or London, while samurai bonds are listed on the Tokyo Stock Exchange. The main issuers of JPY Eurobonds are supranational agencies (The World Bank, EU), governments (New Zealand, Argentina), government agencies, international commercial banks and multinational corporations. Aside from supranational agencies and governments, most non-Japanese borrowers have sought to swap the proceeds of their issues out of JPY into their domestic currency or a secondary currency of exposure. 3.C Swiss Franc International Bonds XII.29 There is no CHF Eurobond market and international borrowers have access to what is for all intents and purposes a domestic market only. The Swiss government does not allow issues in CHF outside Switzerland and international banks may not lead-manage, co-manage or underwrite issues by foreign borrowers except through subsidiaries incorporated in Switzerland. This regulation has created in Switzerland the largest foreign bond market in the world. The CHF is chosen as a unit of account with relatively stable purchasing power, while Swiss banks act as politically neutral institutions. CHF foreign bonds are bearer bonds, have annual coupons, and have a minimum denomination of CHF 5000. They are usually listed and traded on one of the Swiss stock exchanges. CHF bonds are usually lead managed by one of the "big three": Swiss Bank Corporation, Union Bank of Switzerland, or Credit Suisse. A certain percentage of the Swiss francs received by the borrower have to be converted to other currencies. While nonresidents are subject to a 35% withholding tax on Swiss franc domestic bonds, they are exempt from withholding on CHF foreign bonds. Therefore, it is not rare to find that foreign (to Switzerland) savers are lending to foreign borrowers, with the amount of the debt obligation fixed in terms of CHF. IV. Differences Among Bond Markets 4.A Issuing Techniques Domestic bonds are usually underwritten by a syndicate of national banks. Dutch, British, Canadian and Swiss government bonds are sold under a tender system, where banks place bids. In the U.K. once an issue has been listed, the Bank of England often sells part of a gilts issue directly on the market through its broker. Eurobonds are issued through an international syndicate of financial institutions. Institutional investors may buy new bonds directly a few days before they are officially issued. This is the socalled gray market. In the Eurobond market bonds are sold under a variety of procedures: the traditional issuing system, the bought deal, the FPRO, and the tender system. 4.B Dealing Trading of U.S. domestic bonds is transacted between market makers, which are specialized in financial institutions. On European bond markets, orders are generally sent to the exchange floors through brokers. In the U.S. trading usually takes place over the counter, although some bonds, especially foreign dollar bonds, are listed on the NYSE. Over the counter trading also takes place in Switzerland, U.K., Germany, the Netherlands for non-government issues. In Japan, bonds are both traded over the counter and on the securities exchanges. XII.30 In brokers' markets bond buyers and sellers pay the same price, but must pay a commission to the broker. In the U.S. prices are net of commissions, but there is a bid-ask spread on all quotations. Although the Eurobond market has no physical location, most of the bonds are listed on the Luxembourg or London stock exchanges to satisfy the requirement of obtaining a public quotation at least once a year or quarter. However, very few transactions go through the exchange. 4.C Quotations Bonds are usually quoted on a price-plus-accrued-interest basis. This means the price is quoted separately (as a percentage of the bond's nominal value) from the percentage coupon accrued from the last coupon date to the trade date. That is, Cash price = Quoted price + Accrued Interest = P + A. This means that the market price, P, is clean of coupon effect -i.e., accrued interest, A- and allows meaningful comparison between various bonds. Other bonds, like convertible bonds, index linked bonds or FRNs where the coupon is determined ex-post (at the end of the coupon period) are quoted with coupons attached. Some straight bonds follow this method, as in the U.K. gilt market, the market for UK government bonds. In the U.K., bonds with more than five years to maturity are traded without any separate allowance for accrued interest (i.e., with the coupon attached). That is, in the U.K. gilt market the price quoted falls on the ex-dividend, or ex date, the date when the bond trades without the next coupon payment. Example XII.18: The U.K. gilt quotation. The ex date is normally 37 calendar days before each coupon date, plus or minus a couple of days to allow for weekends and vacations. An investor who buys the bond during this thirty-seven-day-period does not receive the coupon. Instead, it goes to the previous bondholder. Furthermore, investors are allowed to trade cum, or ex-dividend, for a period of 21 days preceding the ex date. This is known as special ex-dividend. In Graph XII.1, we reproduce the unusual hypothetical market price behavior over time for a long term U.K. gilt, assuming that the market interest rate stays constant. (Tax effects not included.) ¶ GRAPH XII.1 MARKET PRICE BEHAVIOR OF A LONG-TERM UK GILT 21 days 37 days | Coupon payment | Special ex-date Ex-date Time Coupon payment Bonds also differ in the way accrued interest is calculated and in frequency payment. In the U.S., straight bonds usually pay a semiannual coupon. The day-count method is used in accrued interest XII.31 calculations is based on 30-day months in a 360-day year. The same day-count method is used in West Germany, Switzerland, and the Netherlands. Example XII.19: An investor holding a U.S. straight bond for one month receives 30/360 or 1/12 of the annual coupons (1/6 of the semiannual coupon). ¶ By contrast, the U.K., Canada, and Japan use a day-count based on the actual number of days in a 365-day year. Example XII.20: An investor holding a Japanese straight bond for February 1995 will receive 28/365 of the annual coupon. ¶ Straight Eurobonds use the U.S. convention regardless of their currency of denomination, so that a yen or sterling Eurobond uses a 30-day month in a 360-day year. Straight Eurobonds pay annual coupons. On the other hand, Euro-FRNs use actual days in a 360-day year, which is also the convention used for money markets and short-term deposits. This follows naturally since FRN coupons are indexed to short-term interest rates. Euro-FRNs pay quarterly or semiannual coupons. Table XII.E summarizes the characteristics of the major bond markets. TABLE XII.E COUPON CHARACTERISTICS OF MAJOR BOND MARKETS (Straight bonds) Market Usual Frequency of coupon Day count (month/year) Yankee bonds and U.S. corporate semiannual 30/360 U.K. corporate and GBP money markets semiannual actual/365 U.S., U.K., and other Treasury bonds semiannual actual/actual Canada semiannual actual/365 Japan semiannual actual/365 Australia semiannual actual/365 Switzerland semiannual 30/360 Germany annual 30/360 Netherlands annual 30/360 France annual actual/365 Eurobonds annual 30/360 XII.32 FRNs Most money market instruments 4.D quarter or semiannual actual/360 at maturity actual/360 Yields Most financial institutions around the world calculate and publish yields-to-maturity on bonds. Unfortunately, the methods differ across countries. Therefore, yields are not comparable. Most European institutions calculate an annual, and accurate, actuarial yield-to-maturity using the AIBD-recommended formula. U.S. (and often U.K.) institutions publish a semiannual actuarial yield. Example XII.21: A U.S. bond issued at par with 12% coupons will pay USD 6 semiannually per USD 100 of face value, and is reported as having a semiannual yield-to-maturity of 12%. Europeans would quote this bond as having a 12.36% (annual) yield-to-maturity. ¶ The situation is even worse in Japan, where financial institutions tend to report yield-to-maturity based on simple-interest calculation. The sample formula given below shows how this is done: Yield = [ C + 100 - P ] x 100, T P where C is the coupon rate, P is the current price of the bond, and T represents the years to maturity. This simple yield understates the true yield-to-maturity for bonds priced over par and overstates the yield for bonds priced below par. Example XII.22: A Japanese bond has 5 years left to maturity, the coupon rate is 12%. The bond is selling at 95. The yield (for a Japanese financial institution) would be 17.89. ¶ Example XII.23: On September 21, 1994, the Financial Times published the following yields on International Government Bonds: BENCHMARK GOVERNMENT BONDS Australia Belgium Canada* Denmark France BTAN QAT Germany Bund Italy Japan No 119 Netherlands Spain UK Gilts Coupon 9.000 7.250 6.500 7.000 8.000 5.500 6.750 8.500 4.800 4.100 5.750 8.000 6.000 Red Date 09/04 04/04 06/04 12/04 05/98 04/04 07/04 04/04 06/99 12/03 01/04 05/04 08/99 Price 93.1800 91.1500 84.4000 85.6500 101.2500 82.4700 93.5000 81.3900 103.5870 97.0710 87.7000 80.7000 88-30 Day's Change +0.050 -0.450 -0.200 -0.230 -0.450 -0.410 +0.590 +0.220 -0.190 -0.100 -9/32 XII.33 Yield 10.10 8.63 8.94 9.22 7.56 8.21 7.71 11.81 3.91 4.55 7.64 11.37 8.83 Week ago 10.00 8.63 8.80 9.18 7.45 8.03 7.52 12.00 3.92 4.56 7.45 11.37 8.50 Month ago 9.40 8.42 8.79 8.87 7.26 7.84 7.27 11.72 3.92 4.61 7.31 11.01 8.44 US Treasury* ECU (French Gov) 6.750 9.000 7.250 7.500 6.000 11/04 10/08 08/04 11/24 04/04 85-02 100-07 98-03 96-18 82.2800 -11/32 -12/32 -7/32 -13/32 -0.600 9.02 8.97 7.52 7.80 8.81 London closing. *New York mid-day Gross (including withholding tax at 12.5 per cent payable by nonresidents) Prices: US, UK in 32nds, others in decimal 4.E 8.70 8.69 7.42 7.68 8.62 8.64 8.65 7.29 7.52 8.43 Yields: Local market standard. Legal Aspects Bonds are issued in either bearer or registered forms. In most of the issues on Eurobond markets, the bearer of a bond is assumed to its legal owner. Bearer bonds provide confidentiality, which is very important to some investors. On the other hand, in the U.S. owners must be registered in the books of the issuer. Share registration allows for easier transfer of interest payments and amortization. Coupons are usually paid annually on markets where bonds are issued in bearer form (this reduces the cost associated with coupon payments). Straight Eurobond coupons in all currencies are paid this way. In many countries, retail purchases of foreign bonds are restricted. The motivation for these restrictions stems from exchange controls or attempts by government to ensure domestic investor protection. Example XII.24: In 1981 France imposed a special exchange rate for security transactions. This forced French investors to pay a currency premium to purchase and sell bonds. This regulation was promulgated to curb capital outflows and defend the French franc. On the other hand, in the U.S., the Glass-Steagall Act is designed to protect domestic investors. ¶ V. Bonds Indexes Bond indexes are benchmarks for measuring performance and quantifying risk across fixed income bond markets. Government bond indexes are considered the benchmark for international comparisons. The government indexes measure the total principal, and interest returns in each market and can be reported in different currencies. Government bond indexes tend to include only traded issues available to international investors, thus the indexes provide a realistic measure of market performance. There are two approaches to the calculation of bond indexes: (1) Use a small but representative sample of actively traded bonds. This index provides a good indication of short-term movements in interest rates. (2) Use all the bonds in the market. Since many issues are not liquid and their prices old, exhaustive market indexes tend to lag the interest rate movements, but they reflect the current valuation of a market portfolio. XII.34 The first approach tends to be used to calculate daily indexes, and the latter, monthly indexes. Given the high correlation among all bond prices on a given bond market, bond indexes tend to be highly correlated.  J.P. Morgan Daily Government Bond Indexes J.P. Morgan publishes widely used daily bond indexes. The J.P. Morgan Government Bond Indices are comprised of only traded markets, instruments, and issues, providing liquidity without sacrificing stability. Investors therefore benefit from lower transaction costs both in their initial investment and in their ongoing management. The index tracks only issues that are readily available for purchase at actively quoted prices. All instruments included in the index must be tradeable and redeemable for cash, and they must not appeal to domestic investors for local tax or regulatory reasons. Of all the non-U.S. fixed income domestic government bonds maintained by the GBI, approximately 85% are considered to be "investable." The J.P. Morgan family of indices tracks only issues within this traded universe. Each month, constituent index bonds are reviewed to identify any new issues or changes in liquidity classification. Purchase and sinking fund redemptions, reopenings, funging, exchanges, buy-ins, and reverse auctions are reflected in changes to the amounts outstanding.  Graph XII.2 compares the annualized yield on the J.P. Morgan Government Indexes for the main three Euro-area markets. GRAPH XII.2 J.P. Morgan Government Bond Indexes Despite marked differences in index composition, the yield of the government indexes tend to move together has converged over the years. The European monetary union had a clear effect on the yield convergence across European bond markets. XII.35 Many institutions calculate bond indexes, which are widely cited in the financial press. As was the case for international equity markets, there are domestic bond indexes and international bond indexes. Investment banks calculate daily and monthly indexes. For example, in the U.S., the Wall Street Journal publishes the Lehman Brothers and Merrill Lynch daily domestic indexes. Among the most popular international bond indexes we find: (a) Salomon Brothers publishes daily indexes. They are published monthly in Euromoney. (b) Lombard Odier and Cie. publishes daily indexes since 1982. They are published in the Wall Street Journal (Europe). (c) The Financial Times publishes daily quotes on "benchmark" bonds representative of each market. (d) The ISMA publishes total-return and price-only indexes for the Eurobond market. (e) Intersec publishes monthly indexes in Institutional Investor. Example XII.25: On November 15, the Wall Street Journal published the following U.S Bond Indexes: MAJOR INDEXES HIGH LOW (12 MOS) CLOSE NET %CHG 12-MO CHG %CHG FROM 12/31 %CHG U.S. TREASURY SECURITIES (Lehman Brothers indexes) 4158.35 3966.84 Intermidiate 4042.70 + 8.47 + 5656.03 4897.46 Long-term 4954.83 + 39.81 + 1604.42 1307.21 Long-term 1320.03 + 8.92 + 4500.55 4199.01 Composite 4954.83 + 15.28 + 0.21 0.81 0.68 0.36 - 65.50 588.28 274.06 179.42 - 1.59 10.61 17.19 4.04 - 74.01 557.80 251.09 179.46 - 1.80 10.12 15.98 4.04 U.S. CORPORATE DEBT ISSUES (Merrill Lynch) 709.45 656.43 Corporate Mas 665.13 + 518.52 487.79 1-10 Yr Mat 498.14 + 544.83 490.84 10+ Yr Mat 494.67 + 332.37 317.57 High Yield 325.97 + 520.54 477.83 Yankee Bonds 482.89 + 0.27 0.17 0.43 0.14 0.27 - 30.19 10.70 38.23 5.45 27.29 - 4.34 2.10 7.17 1.70 5.35 - 32.60 13.22 39.14 1.03 28.58 - 4.67 2.59 7.33 7.33 5.99 1.79 + 0.86 + 2.10 + 0.46 + 1.31 + VI. Why Do Investors Care About International Bonds? We already know the answer to the above question: portfolio diversification. From the point of view of returns, the U.S. bond market has been generally attractive, but from 1986 to 2011 the U.S. bond market has never ranked first. Since 1986, the Australian, British and Japanese bond markets have outperformed the rest of the developed bond markets three times each, while the Canadian, French, and Swedish bond markets have outperformed the rest only one time each. While investing in foreign bonds can increase your returns, adding foreign bonds can significantly reduce the overall risk of your bond portfolio. Diversification also works in the world bond market. The lower the correlation, the greater the diversification benefits. Within the domestic U.S. bond market, correlations are relatively high. These high correlations reflect common sources of XII.36 uncertainty in U.S. monetary and fiscal policies as well as in U.S. economic activity. Therefore, as the number of U.S. fixed-income instruments in the portfolio increases, the reduction in risk soon becomes marginal. Foreign policies, however, are not synchronized with those of the U.S. Because of the lack of co-movements across national markets, the risk reduction attained from investing in a given number of global securities is likely to be much greater. Example XII.26: The correlation between Treasury and U.S. corporate bonds is of the order of .92. Unless we consider non-investment-grade bonds, the correlations in the U.S. fixed-income markets are generally above .90. On the other hand, correlations between U.S. bonds and foreign bonds are significantly lower. Table XII.F shows the correlation coefficient of government bonds returns in USD of some markets (19932009). TABLE XII.F Correlations of Monthly Government bond returns in USD (1993-2009) Market with US Bonds Australia .30 Canada .40 Denmark .43 France .45 Germany .43 Italy .41 Japan .22 U.K. .42 U.S. 1.00 Global .65 Emerging Markets .18 with German Bonds .48 .36 .96 .98 1.00 .78 .40 .66 .43 .87 .03 with Japanese Bonds .15 .05 .36 .37 .40 .20 1.00 .19 .22 .65 -.05 Source: J.P. Morgan. Emerging markets, Japanese and Australian governments bonds would have provided the best diversification instrument for U.S. bondholders. ¶ 6.A Benefits from International Diversification Given the above correlations, we can form an internationally well-diversified bond portfolio that will outperform a U.S. bond portfolio, in the mean-variance space. The optimal allocation, however, can place a very low weight on the U.S. bond market. This allocation might no be reasonable for many U.S. investors (remember the “home bias”). Therefore, we consider a minimally diversified portfolio: 10% invested in developed bond markets and 90% invested in the U.S. bond market. Graph XII.3 presents the five year performance (risk and return) of this 10/90 bond portfolio and a 100% U.S. bond portfolio. XII.37 GRAPH XII.3 Domestic vs. Diversified Bond Portfolio: Rolling 5-year Performance (1990-1999) Source: T. Rowe Price In eight of the 10 rolling five-year periods, the 10/90 portfolio outperformed the U.S. bond portfolio. In six out of ten periods, however, the 10/90 portfolio had modestly higher volatility. Keep in mind, that the 10/90 portfolio does not represent an optimal portfolio. An optimal portfolio, would have clearly moved the risk-return performance to the Northwest in the mean-variance space. Example XII.27: From 1978 to 1989, an investor could have maintained the 10.1 percent return on the U.S. index while reducing risk from 11.0 percent –the U.S. risk- to 9.8 percent. Alternatively, keeping the portfolio risk (SD) constant, the return could have been increased form 10.1 to 11.7 percent. This improvement of 160 basis points could have been achieved by passively investing 51% in the dollar, 43% in the yen, 4% in Canadian dollar, and 2% in pounds. ¶  Another theoretical word on hedging We can measure the benefits of hedging in light of financial theory. Long-term relationships exist between expected return and risk. Assuming risk is priced uniformly in the bond market and in the foreign exchange market, any reduction in risk must be accompanied by a reduction in expected return. Under this situation, hedging reduces risk but adds no value to the portfolio on a risk-adjusted basis. On the other hand, what if segmentation occurs in international capital markets? It could very well be that risk is not priced uniformly across markets. In such a case, hedging could add value. This dilemma, still unresolved, remains a major challenge to researchers in international investment.  XII.38 6.B The Impact of Currency Hedging Investing in international bonds entails currency risk. If currency exposure is to be avoided, hedging can dramatically reduce the risk of non-USD bonds. The usual hedging tools, forward contracts, futures and option, can be used to reduce currency risk. Example XII.28: Currency hedging. One possible strategy is entering into a forward contract every month to sell the value of the investment in the foreign currency. At the end of the month, if the foreign currency has depreciated, the translation loss on the bond will be offset by the gain on the forward contract. Of course, any gain due to a currency appreciation will also be offset by a loss on the forward contract. Overall, this strategy should yield much more stable returns. ¶ Stripping away the currency risk by forward hedging also allows the investor to measure how returns are affected by exchange rates. Recall that local returns are completely irrelevant for U.S. investors, whereas hedged foreign returns could have been realized in practice. Thus, currency-hedged returns provide the only correct benchmark to measure the impact of exchange rate movements. Example XII.29: From 1978 to 1989, hedging JPY exposure dropped the volatility of the JPY bond market from 17.3% to 6.4% a year. This hedged Japanese bond market volatility was much lower than the volatility of the U.S. bond market, which was 11%. ¶ While hedging currency risk decreases volatility, hedging currency movements can increase or decrease returns. The intuition is very simple. During periods of USD appreciation, hedging would have enhanced performance of the foreign bond market, while during periods of USD depreciation, hedging would have hurt the performance of the foreign bond market. Example XII.30: Figure XII.4 shows the relation between monthly unhedged international bond (USD) returns and monthly changes in the TWC USD Index from 1988 to 2013. There is a clear inverse relation between both series. That is, as the USD appreciates, unhedged international bond (USD) returns decrease. Figure XII.5 shows the relation between monthly hedged international bond (USD) returns and monthly U.S. bond returns from 1988 to 2013. Both series seem highly correlated. Now, once hedging is done, international bonds behave similarly to domestic bonds. That is, currency exposure breaks the high correlation between international bonds and U.S. bonds. XII.39