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| Introduction | Historical Background | Issuers | Market Overview |
| Types of Brady Bonds | Market Evolution | Valuation | The Present |
| The Future | Potential evolution of Latin American sovereign debt | Main Features |
Since the first Brady bond was issued for Mexico in 1990, the market has undergone a dramatic transformation and now comprises the largest and most liquid market for Latin America. Overall, there is around US$190 bn of eligible loan debt from 13 countries in Asia, Africa, Eastern Europe as well as Latin America. Secondary market turnover for Brady bonds alone amounted to US$1.58 trillion in 1995, according to statistics from EMTA (the Emerging Markets Traders’ Association), representing 57% of all trading in emerging markets products including options, local markets, Eurobonds and short-term paper. Panama finalised its deal in July 1996, while Peru is hoping to finalize its negotiation towards the end of the year.
An important point to stress is that although the term "Brady bond" can be used to describe an asset class, because of the wide variation in the characteristics of instruments, performance of a particular country’s Bradys can vary widely. During 1996, fixed rate Par bonds, which are typically longer dated instruments carrying collateral on both the principal as well as a rolling guarantee on the interest, significantly underperformed uncollateralised floating rate instruments, particularly those at the shorter end of the yield curve. The main reason for this was a decline in the value of the underlying collateral as US Treasury rates rose, and the relative unattractiveness of a fixed rate coupon in a rising interest rate environment.
The diverse characteristics of instrument types facilitate a myriad of investment strategies - varying from a play on the pure sovereign risk through the purchase of an uncollateralised instrument such as the Argentina FRB, to a play on relative credit outlooks for various countries such as Long Mexico Par, Short Brazil Par, or a view on interest rates by being Long Poland Discount (floating), Short Poland Par (fixed). Certain assets have futures and options available.
The different countries are at various stages of evolution in their Brady plans. Peru has yet to finalize its term sheet, whereas Mexico, the first issuer, in April 1996 completed a US$1.3 bn swap deal to repurchase mainly Par bonds, in exchange for a 30-year uncollateralised global bond which represents pure sovereign risk. Mexico was able to take back the collateral from these instruments, which is it planning to use to reduce the amount owing to the US government as part of the economic stabilization program, thus reducing overall debt servicing costs.
Approximately $190 billion of eligible loan debt from 13 different countries ... ... largest and most liquid of the emerging markets. Fresh loans did not ease the debt crisis ... ... so a new approach was adopted involving debt relief ... ... and swapping remaining debt for tradable fixed income securities. Mexican Aztec bonds were a precursor to conventional Bradys.
The Brady Plan of 1989, accredited to former US Treasury Secretary, Nicholas Brady, consists of a frameworks of bonds created from restructured commercial bank debt. Over the past six years, the Plan has enveloped approximately $190 billion of eligible loan debt from thirteen different countries, and has been instrumental in restoring access to the capital markets for countries previously considered bad debtors. To date, no country has ever defaulted on payment, and the Brady Bond Market has become the largest and most liquid of the emerging markets.
The debt crisis of the early 1980’s, which resulted from a combination of factors including the sluggish growth of industrial countries, rising global interest rates and falling commodity prices, and initiated by Mexico’s suspension of commercial debt payments in 1982, left countries deep in arrears. The first strategy adopted was a program of fresh loans by commercial banks and multilateral organizations, with debtor countries obliged to make structural adjustments. This approach did not having the desired effect of easing the crisis as there was no meaningful reduction in exposure, and early suggestions were not considered effective solutions as they merely perpetuated a deteriorating situation.
In 1987 Citibank set aside reserves to cover about a quarter of its exposure to emerging markets, which promoted other banks to follow suit. This provisioning widened the acceptance of debt forgiveness by openly acknowledging that bank debt, much of which was in arrears, was worth less than its face value, and secondly, giving a boost to the trading of these loans in the secondary market. Simultaneously, the World Bank was investigating ways to engineer a pattern of economic adjustment that would accomplish the three objectives of reducing macroeconomic instability, restoring growth without a significant increase in consumption, and reducing the degree of debt overhang. Analytical work done under the supervision of Jacob Frenkel in the late 1980’s concluded that debt reduction would be of benefit to both debtors and creditors.
The recognition of a discount from face value created an avenue for an approach collateralising the discounted value of these loans, and in February 1988, J.P. Morgan launched Mexico’s Aztec bonds, consisting of $3.7 billion of Mexican sovereign loan debt restructured into $2.6 billion worth of 20-year securities, at a floating coupon of Libor plus 1.625%, with the principal fully collateralized by S Treasury zero-coupon bonds. The outcome was disappointing, which, combined with a lack of progress in Argentina and Brazil, catalyzed a change in the official strategy.
Just over a year later, the Brady Plan was proposed, with its focus on debt reduction and market orientation in the form of correlating discount levels to secondary market trading prices, with explicit recognition of debt forgiveness by creditor banks by either restructuring commercial bank debt at lower interest rates or writing it down. Debt is then exchanged for tradable fixed income securities, and as before, debtor countries are obliged to make macroeconomic adjustments in accordance with International Monetary Fund guidelines.
The debtor country’s foreign reserves were to be used for the purchase of the collateral enhancement.
Since Mexico issued the first Bradys in 1990 ... ... twelve additional countries have followed. Mexico, Brazil & Argentina account for more than 2/3 of Brady Bonds issued. Structures have become more complex ... ... but are based on first Bradys.
In February 1990, Mexico became the first country to issue Bradys, converting $48.1 billion of its eligible foreign debt to commercial banks, and offered banks two options for the exchange of their loans into tradable securities.
The Discount Bonds gave a 35% discount in the face value of the debt, but offered a market-based coupon of Libor plus 0.8125%, while the Par bonds were issued at face value, but included a below-market coupon of 6.25%. Banks also had a third option, which allowed them to carry the full principal amount of the loans on their books while providing new lending of at least 25% of their existing exposure over three years.
The principal on both types of bonds was fully collateralized in the form of US zero-coupon bonds, and there was a rolling interest guarantee covering 18 months’ worth of interest payments.
Since then, twelve other countries have followed suit, Panama’s bonds are trading on a "When Issued" basis while Peru has issued a term sheet to creditors. Chile and Colombia are the only two Latin American countries not in the market for this type of deal as they have not needed to restructure external debt.
Although structures have become more complex over time, the basic principles were based on the Mexican deal. One major option added in later issues was the buy-back option, which allows a country to repurchase part of its debt at an agreed discount, enabling it to participate in a debt reduction program.
Investment & Commercial Banks make markets ... ... to a wide-ranging investor base. Market is dominated by Latin American issues ... ... but Poland & Bulgaria provided geographic diversification. Mainly US dollar-denominated ... ... and longer dated ... ... evenly divided between fixed and floating rates.
Both investment and commercial banks make active markets in Brady bonds, and the investor base has widened to include mutual funds, money managers, insurance companies and pension funds. Portfolio managers are increasingly looking to these instruments as the core of the emerging markets or yield enhancement and portfolio diversification.
The vast majority of outstanding Brady bonds are US dollar denominated, and although some bonds have been issued in other major currencies, including Deutschemarks, the non dollar issues tend to be relatively illiquid.
The market is largely a longer dated market - over half of current outstanding Bradys have maturities of longer than 20 years, and over 72% have maturities longer than 10 years.
Outstandings are evenly divided between fixed and floating rate instruments.
Long maturities ... and generally the most liquid. Short-term floaters ... issued at Par. Step up for initial 5-7 years ... ... then float for the remainder of the term.
Issued prior to principal rescheduling.
While these variations are less liquid than the par/discounts, they contain a much shorter average life as amortization payments begin ordinarily after 5-7 years. Also, with the exception of the FLIRB’s interest collateral, these variations do not have credit enhancements.
Market Evolution
Implementation of a Brady bond deal has tended to boost the perception of creditworthiness for the issuing country. Favorable perceptions are also associated with a reduced near term debt-service burden and the presence of collateral enhancements, which have commonly been followed by:
An IMF "structural adjustment agreement" details strict fiscal and monetary procedures which must be implemented prior to a Brady issuance. These procedures insure that government macroeconomic policies will lead to economic stability and sustainable growth.
The Brady process exchanges loans for bonds with strong, recognized collateral and extends maturities, reducing near-term debt-service requirements.
The Brady process securitizes outstanding loans into bonds, creating a more uniform liquid market for such securities. Brady bonds are traded through a recognized settlement process in Euroclear/Cedel.
Corporate issuers that otherwise may have been considered quite creditworthy were often unable to access international capital markets prior to a Brady restructuring due to sovereign risk problems. The renewed perception of creditworthiness that the Brady process initiates has benefited the private sector by opening up foreign debt markets providing the means to obtain additional, and often much cheaper, capital.
Bonds have 3 distinct features ... ... principal collateral ... ... interest collateral ... ... and sovereign portion.
Despite their esoteric features, Brady bonds lend themselves to the same valuation techniques applied to more conventional fixed-income securities. The basic notion is that the price of a given bond represents the present value of its stream of payments.
The bond has three distinct features-principal collateral, interest collateral and the sovereign portion. When evaluating a Brady bond, it is necessary to strip out the enhancements attached in order to understand and analyze the risk and relative valuation ascribed by the market to each respective sovereign issuer. Removing the present value of the US Treasury strip and present value of the guaranteed interest stream will produce the stripped yield, which is the yield-to-maturity of the unenhanced interest stream. This stripped yield is based upon the credit quality or sovereign risk of the issuing nation.
Further analysis of collateralized Brady bonds includes assessing the present value of the collateral as a percentage of the Brady’s market price. The value of the US Treasury component acts as a floor, in that the bond would not trade below the value of the collateral.
Par/discount bonds and FLIRB’s also include a partial guaranty of interest on a "rolling" basis. Money is deposited by the Brady-issuing government with the New York Federal Reserve in amounts covering 12-18 months of interest payments. If collateral must be utilized for interest payments, the Brady government is not required to replace the cash collateral.
Bonds include, in several cases, detachable warrants or recovery rights predicated upon economic/industry performance. Probably the most high profile of which are Mexico’s Value Recover Rights (VRR’s) based on numerous variables including oil price, GDP and oil production levels.
There are many influences on the Brady bond market. These range from developments in the country itself, dictating sovereign risk, the US Treasury market - both directly, due to the price of the underlying collateral, and indirectly, in respect of relative returns - and regional developments such as the 1994 Mexico devaluation. During the course of 1996 the predominant driving force behind instruments has been the US Treasury market, and shorter dated uncollateralised floating rate instruments have significantly outperformed fixed rate collateralized instruments, offering very different risk-reward profiles. Brady bonds usually trade at a higher yield than comparable sovereign or quasi-sovereign Eurobonds carrying the same risk, to compensate for the greater volatility.
Perhaps one of the most important developments for the market was rating agency, Moody’s removal of a one-notch credit differential between a country’s sovereign credit ceiling and its Brady bonds, which had previously existed because instruments were predominantly held by creditor banks. This action was significant in that it acknowledged the growing trend of a shift in ownership to end investors.
The issuance of a Brady deal is generally regarded as marking a country’s return to the international financial marketplace. Peru is in the process of finalizing its deal, but few new issuers are expected to follow. Instead the future development of the market will be dictated by its evolution. Mexico has already restructured some of its Brady bonds in its Brady swap deal on April 1996. In 1995, Argentina repurchased some of its Par and Discount bonds in open market tender, but has ruled out a swap deal, saying that there would be little investor appetite for such a deal as the FRB represents pure sovereign risk. This was not the case for Mexico, which has only collateralized Bradys. The Central Bank of Brazil had legislation approved in Congress in September to buy back or restructure all $57bn of its Brady bonds. In addition, from time to time, certain assets may be used as payment for government privatizations, which at times has driven up the price.
Potential evolution of Latin American sovereign
debt
Stage 1 Issuance, marking the country’s return to the international financial markets and improvement in the perception of the sovereign credit.
Stage 2 Potential to issue further sovereign debt, such as a global, at a cheaper cost to the country. Increased corporate issuance.
Stage 3 Potential of buy-back either outright by open market tender (Argentina Q3 1995), or swap deal (Mexico, Q2 1996) exchanging Brady bonds for longer-term, cheaper debt.
As countries go through the process of structural reform and the perception of their sovereign credit gradually improves, we expect Brady bonds to eventually be replaced by debt that is cheaper to fund, or repurchased. Poland is the only country with Brady bonds to carry an investment grade sovereign rating, and for the Latin American countries, although some restructuring has started, no significant liquidity has yet been taken out of the market through repurchases or swaps.
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