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A dual currency bond is a kind of debt instrument where the coupon payment is denominated in one currency and the principal amount in another. This kind of bond can expose the holder to exchange rate risk. A dual currency bond can be compared with a dual currency swap and dual currency deposit. Key Takeaways A dual currency bond is a kind of debt instrument where the coupon payment is denominated in one currency and the principal amount in another and can expose the holder to exchange rate risk.
The two most common types of dual currency bonds are traditional dual currency bonds and reverse dual currency bonds. Dual currency bond issues are most commonly initiated by multinational corporations and traders on the euro-bond market. Understanding Dual Currency Bonds A dual currency bond is a synthetic security that is redeemed in one currency while interest payments over the life of the bond are made in another currency.
Political Risk The political climate of foreign countries creates portfolio risks because governments and political systems are constantly in flux. This typically has a very direct impact on the economic and business sectors. Political risk is considered a type of unsystematic risk associated with specific countries, which can be diversified away by investing in a broad range of countries, effectively accomplished with broad-based foreign mutual funds or exchange-traded funds ETFs. Taxation Foreign taxation poses another complication.
Just as foreign investors with U. Taxes on foreign investments are typically withheld at the source country before an investor can realize any gains. Profits are then taxed again when the investor repatriates the funds. Currency Risk Finally, there's currency risk. Fluctuations in the value of currencies can directly impact foreign investments, and these fluctuations affect the risks of investing in non-U.
Sometimes these risks work in your favor, other times they do not. In this case, your net return will be enhanced when you convert your profits to U. But the reverse is also true; if a foreign stock declines but the value of the home currency strengthens sufficiently, it further dampens the returns of the foreign position. Minimizing Currency Risk Despite the perceived dangers of foreign investing, an investor may reduce the risk of loss from fluctuations in exchange rates by hedging with currency futures.
Simply stated, hedging involves taking on one risk to offset another. Futures contracts are advance orders to buy or sell an asset, in this case, a currency. An investor expecting to receive cash flows denominated in a foreign currency on some future date can lock in the current exchange rate by entering into an offsetting currency futures position. In the currency markets , speculators buy and sell foreign exchange futures to take advantage of changes in exchange rates. Investors can take long or short positions in their currency of choice, depending on how they believe that currency will perform.
For example, if a speculator believes that the euro will rise against the U. This is called having a long position. Conversely, you could argue that the same speculator has taken a short position in the U. There are two possible outcomes with this hedging strategy. If the speculator is correct and the euro rises against the dollar, then the value of the contract will rise too, and the speculator will earn a profit.
However, if the euro declines against the dollar, the value of the contract decreases. When you buy or sell a futures contract, as in our example above, the price of the good in this case the currency is fixed today, but payment is not made until later. Investors trading currency futures are asked to put up margin in the form of cash and the contracts are marked to market each day, so profits and losses on the contracts are calculated each day.
Currency hedging can also be accomplished in a different way.
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The issue price is the price at which the bond issuer originally sells the bonds. In many cases, bonds are issued at par. Two features of a bond— credit quality and time to maturity—are the principal determinants of a bond's coupon rate. If the issuer has a poor credit rating , the risk of default is greater, and these bonds pay more interest.
Bonds that have a very long maturity date also usually pay a higher interest rate. This higher compensation is because the bondholder is more exposed to interest rate and inflation risks for an extended period. These bonds have a higher risk of default in the future and investors demand a higher coupon payment to compensate them for that risk.
Bonds and bond portfolios will rise or fall in value as interest rates change. Categories of Bonds There are four primary categories of bonds sold in the markets. However, you may also see foreign bonds issued by global corporations and governments on some platforms. Corporate bonds are issued by companies. Companies issue bonds rather than seek bank loans for debt financing in many cases because bond markets offer more favorable terms and lower interest rates. Municipal bonds are issued by states and municipalities.
Some municipal bonds offer tax-free coupon income for investors. Government bonds such as those issued by the U. Agency bonds are those issued by government-affiliated organizations such as Fannie Mae or Freddie Mac. Varieties of Bonds The bonds available for investors come in many different varieties.
They can be separated by the rate or type of interest or coupon payment, by being recalled by the issuer, or because they have other attributes. Below, we list some of the most common variations: Zero-Coupon Bonds Zero-coupon bonds Z-bonds do not pay coupon payments and instead are issued at a discount to their par value that will generate a return once the bondholder is paid the full face value when the bond matures.
Treasury bills are a zero-coupon bond. Convertible Bonds Convertible bonds are debt instruments with an embedded option that allows bondholders to convert their debt into stock equity at some point, depending on certain conditions like the share price.
The convertible bond may be the best solution for the company because they would have lower interest payments while the project was in its early stages. If the investors converted their bonds, the other shareholders would be diluted, but the company would not have to pay any more interest or the principal of the bond. The investors who purchased a convertible bond may think this is a great solution because they can profit from the upside in the stock if the project is successful.
They are taking more risk by accepting a lower coupon payment, but the potential reward if the bonds are converted could make that trade-off acceptable. Callable Bonds Callable bonds also have an embedded option, but it is different than what is found in a convertible bond.
A callable bond is riskier for the bond buyer because the bond is more likely to be called when it is rising in value. Remember, when interest rates are falling, bond prices rise. Puttable Bond A puttable bond allows the bondholders to put or sell the bond back to the company before it has matured.
This is valuable for investors who are worried that a bond may fall in value, or if they think interest rates will rise and they want to get their principal back before the bond falls in value. The bond issuer may include a put option in the bond that benefits the bondholders in return for a lower coupon rate or just to induce the bond sellers to make the initial loan. A puttable bond usually trades at a higher value than a bond without a put option but with the same credit rating, maturity, and coupon rate because it is more valuable to the bondholders.
The possible combinations of embedded puts, calls, and convertibility rights in a bond are endless and each one is unique. Generally, individual investors rely on bond professionals to select individual bonds or bond funds that meet their investing goals. How Bonds Are Priced The market prices bonds based on their particular characteristics. A bond's price changes on a daily basis, just like that of any other publicly traded security, where supply and demand at any given moment determine that observed price.
But there is a logic to how bonds are valued. Up to this point, we've talked about bonds as if every investor holds them to maturity. It's true that if you do this you're guaranteed to get your principal back plus interest; however, a bond does not have to be held to maturity. At any time, a bondholder can sell their bonds in the open market, where the price can fluctuate, sometimes dramatically.
The price of a bond changes in response to changes in interest rates in the economy. This difference makes the corporate bond much more attractive. Each agency has slightly different ratings scales, but the highest rating is AAA and the lowest rating is C or D, depending on the agency. Although larger institutions are often permitted to purchase only investment grade bonds, high yield or junk bonds have a place in an investor's portfolio as well, but may require more sophisticated guidance.
Generally, governments have higher credit ratings than companies, and so government debts are less risky and carry lower interest rates. If a bond is priced at a premium, the investor will receive a lower coupon yield, because they paid more for the bond. If it's priced at a discount, the investor will receive a higher coupon yield, because they paid less than the face value.
Bond prices tend to be less volatile than stocks and they often responds more to interest rate changes than other market conditions. This is why investors looking for safety and income often prefer bonds over stocks as they get closer to retirement. A bond's duration is its price sensitivity to changes in interest rates—as interest rates rise bond prices fall, and vice-versa.
Duration can be calculated on a single bond or for an entire portfolio of bonds. Bonds and Taxes Because bonds pay a steady interest stream, called the coupon, owners of bonds have to pay regular income taxes on the funds received. For this reason, bonds are best kept in a tax sheltered account, like an IRA, to gain tax advantages not present in a standard brokerage account. Issuers of bonds, on the other hand, such as corporations, often receive favorable tax treatment on interest, which they can deduct from their taxes owed.
Local governments and municipalities may issue debt too, known as municipal bonds. Issuers of Bonds There are four primary categories of bond issuers in the markets. However, you may also see foreign bonds issued by corporations and governments on some platforms. Corporate bonds are issued by companies. Companies issue bonds—rather than seek bank loans for debt financing in many cases—because bond markets offer more favorable terms and lower interest rates.
Municipal bonds are issued by states and municipalities. Some municipal bonds offer tax-free coupon income for investors. Government sovereign bonds such as those issued by the U. The entire category of bonds issued by a government treasury is often collectively referred to as " treasuries.
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