FRBSF WEEKLY LETTER June 10, 1988 The Eurobond Market-Its Use and Misuse This Letter discusses the growth, structure, and subject to the same registration requirements and attributes of the Eurobond market. An aspect of other regulations as domestic bonds, Eurobonds this market that has attracted relatively little can be issued on very short notice. An entire is­ attention is the attractiveness of Eurobonds aris­ sue may be underwritten by a single commercial ing from motives related to tax evasion. or investment bank, and the secondary market is well developed. What's a Eurobond? A Eurobond is a bond issued by a corporation or Issuers of Eurobonds almost exclusively have public agency outside the national jurisdiction of been large highly-rated corporations and govern­ any country, and generally not registered in or mental agencies. In most cases these issuers also subject to regulation by any government. It may are active borrowers in their own domestic mar­ or may not be denominated in the same currency kets. Even though "Euro" and domestic bond as that of the issuer's home country. The Euro­ markets often handle issues by the same firms in bond market sprang up in the mid-1970s, and the same currencies, there is evidence that the grew rapidly in scope until recently, particu- Euro and domestic markets nevertheless are seg­ larly between 1981 and 1986. In 1987, issuance mented. Researchers have demonstrated that tapered off somewhat, leading to speculation instruments in the two markets are imperfect about the demise of the market. However, like substitutes. Considerable spreads between rates Mark Twain, reports of its demise are premature. on otherwise comparable instruments issued in the domestic and the Euro markets often prevail. Because Eurobonds are issued outside of the Sometimes these spreads are positive, and some­ country of the issuer, they generally are exempt times negative. "Clientele effects;' where issuers from most regulations, restrictions, and taxes that and investors are imperfectly mobile across mar­ would apply to comparable domestic bonds. It is kets, seem to playa role in determining the estimated that about $750 billion of Eurobonds magnitude and sign of these spreads. currently are outstanding (including non-dollar bonds), with daily turnover in the secondary mar­ Several factors may help to explain why these cli­ ket of about $13 billion. entele effects exist. First, there is the question of legal jurisdiction, recourse, and enforcement. It Initially, Eurobonds were issued primarily in may be more difficult for the holder of a Euro­ fixed-rate form and denominated primarily in bond than a domestic bond to sue the issuer or U.S. dollars. Since the early 1980s, increasing to force the issuer into bankruptcy. Indeed, it is numbers of new issues are denominated in other not even clear how and where such legal pro­ currencies. Eurobonds also increasingly include ceedings would take place. This question of legal floating interest rate pricing (with and without enforceability of claims may be the reason that "caps" and "collars"), conversion features, and Eurobonds generally contain few, if any, restric­ warrants, among other things. Eurobonds fre­ tive covenants. The legal questions also may quently are combined with swap agreements by explain why the Eurobond market is dominated the issuers. on the issuers' side by highly-rated borrowers. The market for Eurobonds Differences in registration and disclosure require­ The primary market for Eurobonds is a direct ments are another factor explaining both the placement market. Issuers generally sell directly existence of Eurobonds and the differences be­ to investors without a public auction for the se­ tween the pricing of these bonds and domestic curities. Unlike domestic bonds, Eurobonds are bonds. The U.S. Securities and Exchange Com­ bearer bonds; the identity of the investor is not mission provided impetus to the development of recorded. Moreover, because Eurobonds are not the Eurobond market when it announced in 1964 FRBSF that any public offering would be exempt from Prior to July 1984, non-U.s. investors holding u.s. u.s. registration if it "is made under circum­ domestically-issued securities were subject to stances reasonably designed to preclude distribu­ withholding tax. This provided an impetus for the tion or redistribution of the securities within, or issuance of Eurobonds through financial inter­ to nationals of, the United States;' and is carried mediaries outside the United States. Eurobonds out "in a manner which will result in the se­ issued by U.S. firms in the Netherland Antilles curities coming to rest abroad:' Eurobond issues enabled foreign investors to purchase U.S. se­ thus avoid the costs and delays associated with curities comparable to domestic securities, but registration of domestic securities. Moreover, in exempt from withholding. In many instances, for­ practice, the SEC waives Eurobond registration as eign investors could have recovered the U.S. long as the security is not sold directly to u.s. withholding tax on comparable domestic se­ investors during an initial 90-day "seasoning curities by meeting certain conditions, including period:' (Eurobonds brought back into the U.S. demonstrating that taxes were being paid on the are supposed to be registered. It is possible that interest to the investor's home government. How­ many are not.) Thereafter, the security may be ever, many foreign investors in domestic bonds traded in the u.s. Indeed, because Eurobonds are preferred not to recover taxes withheld, presum­ bearer bonds, it probably is quite easy for a u.s. ably because they were not reporting the income investor to purchase the security at issue (during at home. This suggests both that the "expense" the seasoning period) through an intermediary. of reporting outweighed the loss due to withhold­ ing, and that many overseas investments in dol­ The taxation of Eurobond interest lar bonds. may have been held for purposes of tax The third and perhaps most important feature evasion. that separates the Eurobond from the domestic bond market is the differing tax treatment of the The U.S. withholding tax for foreign investors in two types of instruments. Unlike domestic bonds, U.s. securities was repealed in July 1984. Yet Eurobonds issued by U.S. firms traditionally were Eurobond issuance continued to grow, perhaps (until 1984) exempt from u.s. withholding tax. in part because it still is easier to hide the iden­ Other Eurobonds often are exempt from with­ tity of investors in unregistered Eurobonds than holding tax in other countries. A non-U.s. in­ in domestic securities. Many investors in Euro­ vestor who buys a Eurobond issued before 1984 bonds make purchases through custodian ac­ by a u.s. firm outside the United States essen­ counts at Swiss banks. It has been estimated that tially would be exempt from u.s. taxation. Bond in the past 40 to 60 percent of all Eurobonds earnings might be subject to taxation in the in­ were held in such portfolios. Some of these funds vestor's own country, in the same way that U.S. undoubtedly were savings that went undetected investors' earnings on Eurobonds are subject to and untaxed in their countries of origin. The U.S. taxation of interest income. Eurobonds may provide both tax-free interest to such portfolios as well as an absence of a paper In addition to legitimate business and investment trail leading to the savers who deposited the orig­ reasons for holding Eurobonds, there may be in­ inal principal. vestors who choose to hold Eurobonds to evade taxation. Because Eurobonds are in bearer form Eurobond investment may represent a large flow and the identity of the owner never is recorded, it of undetected and untaxed income for Ameri­ is difficult to trace interest income on Eurobonds. cans. But the misuse of Eurobonds probably is an Thus, investors may be able to avoid reporting in­ even more serious problem in other countries, come from this source and thereby evade taxa­ particularly newly developing countries. Euro­ tion in their home country. bonds may be the destination for some of the "flight capital" leaving such countries. In other This does not mean that all or even most Euro­ cases, funds invested in Eurobonds may originate bond investors are tax evaders. But it does mean in criminal activity. Eurobonds are attractive to that the market may be misused for tax evasion these investors because they offer the security of by some. It also means ~hat tax evasion has sig­ low default risk and protection from high inflation nificance for the structure of and pricing in the and currency depreciation, together with discre­ Eurobond market. tion and secrecy. A Fourth of July firecracker Alive and well The bulk of Eurobonds issued by u.s. firms tradi­ Over the past year, the Eurobond market de­ tionally were issued through financial subsidiar­ clined sharply and returned to its 1985 levels. ies in the Netherlands Antilles. Generally, such The 1987 decline was related to a number of fac­ Eurobonds were issued with a provision stating tors, including the October stock market crash, that the bond becomes callable in the event of the fall of the u.S. dollar, high real interest rates any change in tax laws or treaties that would af­ on bonds, diminishing Eurobond profit margins, fect the bond, including withholding taxes. On and some complaints about trading and mar­ July 4, 1987, the u.s. Treasury Department an­ keting procedures. The July 4 action of the U.S. nounced a 30 percent withholding tax on Euro­ Treasury compounded the jitters in this market. bonds that had been issued by u.s. firms in the Even so, the non-U.S. dollar segment of the Euro­ Netherlands Antilles before 1984, ending a 40­ bond market actually grew in 1987, and U.s.