Key Takeaways
- A dual currency bond features interest payments in one currency and the principal repayment in another, exposing investors to exchange rate risk.
- Investors in dual currency bonds may benefit from favorable exchange rate movements, enhancing potential returns.
- Companies may issue dual currency bonds to access a broader range of investors and hedge against potential currency fluctuations.
What Is a Dual Currency Bond?
A dual currency bond is a type of debt instrument in which the periodic interest (coupon) payments are made in one currency and repayment of the principal amount is made in a different currency. These bonds carry exchange rate risk because fluctuations in currency value can affect their returns. Investors often consider dual currency bonds for hedging purposes or to take advantage of favorable exchange rate movements.
We’ll explain the benefits of dual currency bonds and their potential drawbacks.
Dual Currency Bonds Explained
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 (USD) that pays interest in Japanese Yen (JPY) is considered a dual currency bond.
The currency in which the dual currency bond is issued, which is called the base currency, will usually be the currency in which interest payments are made. The principal currency and amount are fixed when the bond is issued and the exchange rate may also be stated. The coupon interest on a dual currency bond is usually set at a higher rate than comparable straight fixed-rate bonds and is paid in the weaker or lower-rate currency.
The two most common types of dual currency bonds are:
- Traditional dual currency bonds: The interest is paid in the domestic currency of the investor and the principal amount is denominated in the issuer’s domestic currency.
- Reverse dual currency bonds: The interest is paid in the domestic currency of the issuer and the principal amount is denominated in the investor’s domestic currency.
Dual currency bond issues are most commonly initiated by multinational corporations and traders on the euro-bond 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 Bond Example
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 EUR/USD 1.24. Hence, principal repayment value per bond is set at (USD1000 x EUR1) / USD1.24 = EUR806.45.
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 the 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
Where:
Key Considerations for 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 any transactions in foreign exchange markets.