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Country and Currency

These days capital markets know few national boundaries and many large firms in the United States borrow abroad. For example, an Americancompany may choose to finance a new plant in Switzerland by borrowing Swiss francs from a Swiss bank, or it may expand its Dutch operation by issuing a bond in Holland.

Also many foreign companies come to the United States to borrow dollars, which are then used to finance their operations throughout the world. In addition to these national capital markets, there is also an international capital market centered mainly in London. There are some 500 banks in London from over 70 different countries; they include such giants as Citicorp, Union Bank of Switzerland, Deutsche Bank, Bank of Tokyo ЈMitsubishi, Banque Nationale de Paris, and Barclays Bank. One reason they are there is to collect deposits in the major currencies. For example, suppose an Arab sheikh has just received payment in dollars for a large sale of oil to the United States. Rather than depositing the check in the United States, he may choose to open a dollar account with a bank in London. Dollars held in a bank outside the United States came to be known as eurodollars. Similarly, yen held outside Japan were termed euroyen, and so on). When the new European currency was named the euro, the term eurodollars became confusing. Doubtless in time bankers will dream up a new name for dollars held outside the United States; until they do, we`ll just call them international dollars.

The London bank branch that is holding the sheikh`s dollar deposit may temporarily lend those dollars to a company, in the same way that a bank in the United States may relend dollars that have been deposited with it. Thus a company can either borrow dollars from a bank in the United States or borrow dollars from a bank in London.4 If a firm wants to make an issue of long-term bonds, it can choose to do so in the United States. Alternatively, it can sell the bonds to investors in several countries. These bonds have traditionally been known as eurobonds, but international bonds may be a less misleading term. The payments on these bonds may be fixed in dollars, euros, or any other major currency. Companies usually sell these bonds to the London branches of the major international banks, which then resell them to investors throughout the world.

Public versus Private Placements. Publicly issued bonds are sold to anyone who wishes to buy and, once they have been issued, they can be freely traded in the securities markets. In a private placement, the issue is sold directly to a small number of banks, insurance companies, or other investment institutions. Privately placed bonds cannot be resold to individuals in the United States but only to other qualified institutional investors. However, there is increasingly active trading among these investors. We will have more to say about the difference between public issues and private placements later.

Protective Covenants. When investors lend to a company, they know that they might not get their money back. But they expect that the company will use their money well and not take unreasonable risks. To help ensure this, lenders usually impose a number of conditions, or protective covenants, on companies that borrow from them. An honest firm is willing to accept these conditions because it knows that they enable the firm to borrow at a reasonable rate of interest.

Companies that borrow in moderation are less likely to get into difficulties than those that are up to the gunwales in debt. So lenders usually restrict the amount of extra debt that the firm can issue. Lenders are also eager to prevent others from pushing ahead of them in the queue if trouble occurs. So they will not allow the company to create new debt that is senior to them or to put aside assets for other lenders. Another possible hazard for lenders is that the company will pay a bumper dividend to the shareholders, leaving no cash for the debt holders. Therefore, lenders sometimes limit the size of the dividends that can be paid.

The story of Marriott in the nearby box shows what can happen when bondholders are not sufficiently careful about the conditions they impose. In the wake of the large losses suffered by Marriott bondholders, several observers predicted that investors would demand more restrictive bond covenants in future transactions.

EURODOLLARS Dollars held on deposit in a bank outside the United States.

EUROBOND Bond that is marketed internationally.

PRIVATE PLACEMENT Sale of securities to a limited number of investors without a public offering.

PROTECTIVE COVENANT Restriction on a firm to protect bondholders.

4 Because the Federal Reserve requires banks in the United States to keep interest-free reserves, there is in effect a tax on dollar deposits in the United States. Overseas dollar deposits are free of this tax and therefore banks can afford to charge the borrower slightly lower interest rates.