What is a Dragon Bond
A dragon bond is a fixed-income security issued by an Asian bank, except Japan, which is denominated in a foreign currency, often in U.S. dollar or the Japanese yen. Denominated in currencies deemed more stable currencies than the home currency, they are attractive to foreign investors.
BREAKING DOWN Dragon Bond
Dragon bonds can be more complex than other bonds because of international differences in taxation, regulatory compliance issues facing firms that issue them, plus limited liquidity in trading them in secondary markets.
They are, however, structured to be as appealing as possible to investors outside of Asia mainly because they mitigate the foreign exchange risk that can impact returns as currency values change. In most respects, dragon bonds represent the Asian equivalent of eurobonds in that they are denominated in what are widely viewed as stable currencies, but traded in Asia, not Europe.
How Dragon Bonds Mitigate Currency Risk
Dragon bonds, first introduced by the Asian Development Bank (ADB) in 1991, to broaden the market for fixed-income securities in Asia and develop more active Asian financial markets. Although Asian companies had issued bonds in local currencies, they appealed mostly to domestic investors limiting access to capital.
Foreign investors were often reluctant to buy bonds dominated in currencies that could fluctuate rapidly. Currencies such as the U.S. dollar and Japanese yen were considered stable enough for accumulating assets.
For example, an Indonesian company might issue a 20-year bond denominated in Indonesian rupiah (IDR), with a coupon rate of 4-percent paid annually. If the U.S. dollar/Indonesia rupiah (USD/IDR) were 10,000 rupiahs per one U.S. dollar, then a 100-million rupiah bond would be the equivalent of $10,000. Each interest payment of 4 million rupiah would represent $400 at the time the bond is issued.
To an Indonesian investor, an investment of 100 million rupiah would pay 4 million rupiah per year with return of principal after 20 years. But for an investor buying such a bond with U.S. dollars, an unfavorable movement between the relative value of the two currencies could create extra risk.
If in the next year the exchange rate shifted from 10,000 IDR/1 USD to 11,000 IDR/1 USD, then the first coupon payment of 4 million rupiah would only be worth only about $364 instead of $400 as anticipated when the bond was first issued. The bond's 100-million rupiah face value would be worth about $9,091. And if the prevailing interest rate moves up, the value of the bond would be even lower.
However, a dragon bond denominated in U.S. dollars, while still subject to interest rate risk, would not be subject to currency risk. The regional economy has changed significantly in the years since the introduction of dragon bonds in 1991, including the 1997 Asian financial crisis, and the growth of the Chinese economy. However, the dragon bond help Asian markets attract more foreign investment.