What Is a Dual Currency Bond?
A dual currency bond is a debt instrument in which the coupon and principal payments are made in two different currencies. The currency in which the bond is issued, which is called the base currency, will be the currency in which interest payments are made. The principal currency and amount are fixed when the bond is issued.
Dual currency bond issues are most commonly initiated by multinational corporations and traders on the eurobond market. Variations of dual currency bonds are Shogun bonds, Yen-linked bonds, multiple currency clause bonds, foreign interest payment bonds, and heaven-and-hell bonds.
- Dual currency bonds are bonds for which the coupon and principal payments are made in different currencies.
- These bonds are most often initiated by multinational corporations.
- Dual currency bonds include some additional risk if the exchange rate between the two currencies is unfavorable.
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. For example, a bond issued in U.S. dollars that pays interest in euros is considered a dual currency bond.
With some dual currency bonds, the interest is paid in the currency of the investor and the principal is redeemed in the issuer’s domestic currency. Other bonds make interest payments in the currency of the issuing entity and repay the principal in the investor’s currency.
Example of a Dual Currency Bond
Assume a bond is issued with a par value of $1,000 and has a maturity date of one year. Interest is to be paid in U.S. dollars and the principal repayment at maturity will be in euros. The hypothetical spot exchange rate is EURUSD 1.24. Hence, principal repayment value per bond is set at (USD1000 x EUR1) / USD1.24 = €806.45.
At the end of the first year, then, the cash flow on this bond is $1,000r + €806.45. If the one-year market rates are 4% in the dollar market and 7% in euro market, the interest rate at which the bond should be issued is:
- 1000 = (1000r / 1.04) + 1.24 (806.45 / 1.07)
- 1000 = (1000r / 1.04) + 934.58
- 1040 = 1000r + 971.96
- r = 0.068, or 6.8%
Special Considerations of Dual Currency Bonds
The exchange rate associated with the coupon and principal may be specified at the time of bond issuance in the trust indenture. An issuer may also decide to make payments based on the spot rates at the time coupons and principals are paid.
A dual currency bond issuer will typically set an exchange rate that allows payments in the stronger currency to appreciate more. In addition, the designated principal repayment amount at maturity allows for some appreciation in the exchange rate of the stronger currency.
Dual currency bonds are subject to exchange rate risk. If the currency in which the principal will be repaid appreciates, the bondholder will make money; if it depreciates, they will lose money. Investors can use dual currency swaps, which have a fixed exchange rate at issuance, to offset the exchange risk of dual currency bonds. Dual currency bonds are also used to hedge exchange rate risks directly without necessarily transacting in foreign exchange markets.