Yankee Bonds (Definition) | Advantages & Disadvantages

Yankee Bonds Definition

Yankee bond is a bond issued by foreign entities like foreign banks or foreign financial institutions and is issued and traded in the United States in US dollar currency. These bonds are governed by the Securities Act 1933 and a lot of documents are required to get it registered. and are rated by credit rating agencies like Moody’s, S&P.

Reverse Yankee bonds are also available which are traded and issued outside the US and respective country’s currency.

Yankee Bonds Correlation to Bond Price

Yield and bond prices are inversely related. As the price of the bond increases yield falls, the bond has become expensive for an investor due to a rise in price. Similarly, bond price falls, when yield increases as more and more investors are willing to invest in bonds. Duration, coupon, yield are major factors responsible for the price of the Yankee bond.

Where,

C= periodic payment of the coupon
Y= yield to maturity (YTM)
F= face value of the bond
T= time

In short, the price of the Yankee bond is the present value of all future cash flows of the bond.

If coupon payments are made semi-annually then coupon rate and YTM are divided in half. Depending on the frequency of coupon payments, coupon rate and yield are to be adjusted.

YTM is used as a discounting rate in order to arrive at the present value of the bond.

Example

Yankee bond with a face value of 1000$ with a coupon rate of 4% and YTM of 4% and maturity of 5 years.

The price of the bond using the above formula will be 1000 $, this is because coupon and YTM are the same. When coupons and YTM are different bonds are sold at premium or discount.

If YTM is 3% and 5%, rest other variables remaining the same, bond price will be 1037.17$ and 964.54$ respectively. When YTM falls, the price of the bond will rise and vice-a-versa on increase in YTM. When YTM falls, bonds having fixed coupon rates become popular in the market hence bonds will be available at a premium.

On the flip side, when YTM rises, bonds having a fixed coupon rate become less attractive than other market investments, then bonds will be available at discount.

Advantages

It helps in portfolio diversification for investors to have investments in different emerging economies as bond issuers are different entities outside US investing in US bond markets by issuing Yankee bonds.
Bondholders are protected from currency risk as bonds are issued in home currency USD and repayments are also in USD hence there will be negligible currency risk.
These bonds are actively traded in US debts markets hence Yankee bonds offer the highest liquidity to bond investors.
It has a lesser impact due to political, economic factors prevailing in the US. Bond prices will not change drastically.
The issuer gets access to the US market after fulfilling the complicated requirements of SEC.
The issuer has a fund available for longer duration due to longer tenure of bonds
The market can frequently provide funds at a lower cost than those available in any other market.
It also acts as a natural hedge if the bond issuer has longer tenure receivable in US markets.
It offers a higher yield than the lower yield on other American investment portfolios.

Disadvantages

The basic principle of financial markets – the higher the risk higher the reward. Lower the risk lower the reward hence investor should have the huge risk appetite to bear losses
Some Yankee bonds may turn into junk bonds if the financial performance of the Company is not satisfactory. Also, foreign companies are governed by laws of their nation, any unfavorable changes in the country’s economy would have an impact on the performance of the Company.
Currency mismatch may happen in foreign companies. Companies have borrowed in US Dollars but the majority of earnings may not be in US Dollars, it will be in the company’s home currency and if the home currency depreciates against Dollars then the company has to manage its open risk position effectively in order to pay bondholders and minimize currency losses.
A bond issuer must go through the complicated procedure of registration with SEC and other legal formalities because of which issuing Yankee bonds become a time-consuming procedure.
After the subprime crisis, Yankee bonds have become popular in American markets due to better yield offerings than domestic bonds. So these bonds are sold well when interest rates in the US are lower.

Conclusion

We can conclude that Yankee bonds have become popular in the US post-global crises in 2008. American investors get opportunities to tap emerging economies and diversify their investment portfolios. However, these bonds are not risk-free investments. Investing in Yankee bonds is not everybody’s cup of tea. Through understanding, due diligence of the company, it’s local laws, it’s financial statements is required before taking a big step of investment.

Yankee bond issuer also gets the advantage of the most stable capital market of the US to raise funds for long term requirements. Also, the issue of such bonds may act as a natural hedge for future collections against receivable to the company.