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Introduction Crisis and Response Securitization of Debt Valuation New Securities Conclusion Bibliography

Valuation

Valuation of Brady bonds is complex but not impossible. Since the bonds are hybrid instruments, valuation is based on the analysis of three basic components, the U.S. Treasury zero coupon principal guarantee, the rolling interest guarantees (RIGs), and the pure unenhanced sovereign risk. As shown in equation (1), the present value of the principal collateral is derived using the nearest dated U.S. Treasury "principal only" bond corresponding to the maturity date of the Brady instrument.

The calculation of the rolling interest guarantees (RIGs) depends on whether the Brady bond is a floating-or fixed-rate instrument. The RIG collateral for Par bonds is valued as the stream of collateralized fixed-rate coupons discounted by the prevailing appropriate instrument. For example, since there are 3 coupons provided in the case of Mexico, thus investors would use the 5-, 12-, and 18- month U.S. Treasury rates. Discount and other floating-rate Brady bond RIGs are valued on an interest-rate equivalent of the floating coupon series, discounted at 6-, 12-, and 18-month U.S. Treasuries. The calculation of discount and other floating rate Brady bonds are valued by calculating their equivalent yield on an interest-rate swap basis. This is the sum of the equivalent U.S. Treasury bond yield, the swap spread premium and the spread over LIBOR that is dictated by the bond. The value of the stripped sovereign risk collateral is then calculated as the difference between the current market price of the Brady bond minus the present value of the collateral.

In order to make relative value assessments across the spectrum of collateralized and uncollateralized assets, investors isolate and compare the yields of the unenhanced or stripped sovereign component of each Brady bond. The pricing of the sovereign risk depends on a myriad of economic and political factors. While no single factor stands out, Cline (1995) argues that macroeconomic variables such as inflation rate, export ratios, and per capita GDP growth tend to have a large impact on pricing. A study by the IMF (1995), however, suggests that prices reacted very slowly to changes in economic conditions. Instead they postulated that market agents tended to use Mexican bonds as a benchmark for relative pricing. Indeed, Granger causality testing has suggested that price movements of Mexican par bonds preceded the movements of most similar instruments--par and discount bonds, as well as Eurobonds (IMF, 1994). Of course, the correlation often breaks down in countries undergoing significant social, economic, or political unrest, such as the 1994 economic crisis Venezuela. In other words, the graph below suggests that, except in cases of dramatic crisis like Venezuela, international investors have not remained abreast with the performance of individual countries.

The strong correlation between these countries may be due to a number of important factors that may be endogenous to the institutional nature of the securities markets. One major factors was the dominant of role of institutional investors, such as pension funds, hedge funds, and mutual funds, in the emerging markets. During normal levels of market volatility, the funds were able to buy and sell securities according to risk and pricing factors. Yet, during periods of extreme volatility, especially during periods of heavy redemptions, institutional investors were forced to sell the securities in the most liquid markets. Hence, an emerging market fund faced with an unexpected rush of redemptions would be forced to sell securities in countries or regions not affected by a crisis or sell-off in order to generate the cash needed to meet immediate demands. The result was a contagion of the crisis to other countries and regions of the world.

A second factor that explained the high level of correlation between these markets were the techniques used to price Brady bonds. Most market agents use country-specific factors to systematically price the sovereign risk component. Countries are ranked on the basis of a number of political and economic variables, and these rankings are used to assess the spread between the yield on a developing country bond and that on a "risk-free" bond. Factors often considered include (1) political conditions; (2) macroeconomic conditions (especially inflation, growth prospects, and fiscal policy); (3) structural reform, and (4) the country’s balance of payments position and prospects. These rankings tend to be static. For example, in 1995, Mexico was considered to be less risky than Argentina, but Argentina was considered to be more risky than Brazil. All three countries were considered to be less risky than Nigeria. Since the relative risk rankings between countries are usually static then a large movement in one of the bonds will cause corresponding moves in all of the other instruments as the relative ranking is restored.

Agents also use market price as a vehicle to calculate what is the implied default risk. Since one way to determine price is to discount the expected cash flow by the risk-free rate, then the reverse operation will provide implied probability of default.

Furthermore, agents use the implied probability of default of well known credits, such as Mexico, to price the instruments of other countries. For example, investors can look at Mexican Brady prices and calculate the implied default probabilities, then they assess whether other countries are more or less risky. An established pricing convention that is used across fixed income instruments marks the price as the yield differential, or spread, of the instrument with a "risk free" benchmark, such as LIBOR for short-term instruments or U.S. Treasuries for longer-dated bonds. For example, if the yield on an instrument is 7.50% and the yield on corresponding U.S Treasuries is 6.00%, then the price that is listed is 150 basis points. Of course, this price reflects the underlying sovereign risk and factors out the collateral instruments. Nonetheless, this characteristic is also responsible for the high level of correlation in these markets, since movements in the underlying risk-free security, U.S. Treasury bonds will lead to a corresponding movement in the Brady markets.

Countries frequently request credit rating agencies to evaluate debt instruments, such as Brady bonds or Eurobonds, to assist investors in their valuation process. Many credit agencies, such as Standard & Poor’s, Moody’s and Duff and Phelps, have established patterns for providing and updating ratings on different emerging markets. Of course, these services are conducted for a fee paid by the country being rated.

Standardized credit ratings are widely recognized in the financial community and allow many lending agencies to put the instruments in their portfolios. For example, most insurance companies are forced to adhere to North American Insurance Commission (NAIC) rules that dictate the quality of portfolios. Furthermore, many pension and fund and endowment by-laws dictate the quality of allowable portfolios. At the same time, the use of standardized ratings provide some feedback to countries on the risk perceptions of the country an added incentive to pursue further economic reforms. Countries with so called investment ratings (better than Baa from Moody’s and BBB- from S&P) find the greatest demand from institutional investors.

New Securities

The securitization of commercial bank debt under the Brady Plan led to a proliferation of related securities and products. One of the first related products to emerge were so-called conversion bonds. In order to purchase some of the collateral for the Par and Discount bonds, the Brady Plan allowed the debtor countries to issue new instruments called Debt Conversion Bonds (DCBs), New Money Bonds (NMBs), Front Loaded Interest Reduction Bonds, (FLIRBs), and Capitalization Bonds (C-Bonds) (CS First Boston, 1993).

Several of the Par and Discount bonds also carried derivative securities called value recovery rights or warrants. These instruments allow bondholders to recapture for of the debt and debt service reduction provided in the program if future economic performance and/or debt servicing capacity of the debtor improves. For example, Mexico, Venezuela, and Nigeria linked warrants to the indices of oil export prices or oil export receipts, or to the level of a terms of trade index, in the case of Uruguay.

The proliferation of related products quickly increased as investors rushed into the Brady bond market. After an initial investment, investors found themselves familiar and comfortable with analyzing the sovereign risk component. One side effect from the widening of the market was that the rich yields were attracting a strong influx of non-dedicated investors and this helped to push down returns. Soon investors began considering local instruments that would provided higher returns while assuming almost the same risk. Of course, the arbitrage between these instruments and Bradies were not perfect. Convertibility risks and slippage risk (movements in the exchange rate during amortization) also meant higher dangers. Nonetheless, the search for yield pulled investors in a wide array of new markets. For example, a set of financial instruments that proved to be very attractive to foreign investors were the Mexican tesobonos. These bonds were of short-duration (30-days to 365-days), but they were also much riskier. Their riskiness became apparent when they almost dragged the Mexican economy under in late 1994 and early 1995. /

Soon many of the products that had been developed for other more developed markets were being applied to emerging markets. New instruments, such as interest rate swaps, Eurobonds, convertibles, and foreign exchange options, appeared for the first time in emerging markets. There was also an unprecedented demand for the securitization of other instruments such as, domestic currency instruments, credit card receipts, and mortgages. Unable to satisfy the demand of investors, many investment banks began putting more emphasis on underwriting equity shares in the many newly privatized companies. There was explosive growth of new investment vehicles, such as American Depository Receipts (ADRs) that represented equity shares in companies. Hence, the securitization of debt through the Brady process was a major causal factor in opening up investor interest in diverse and local emerging market instruments. The new institutional arrangement also helped facilitate a high influx of capital to the region.

It is interesting to note that the introduction of some instruments allowed the linkages between some of the markets to break down. For example, unlike the Brady Bonds, ADRs do not use a common benchmark for establishing pricing information--although there is some correlation in the ADR market and the NYSE. The impact of the ADRs into the rest of the domestic equity market depends on importance of these instruments on the local capital markets. For example, during the 1994 peso crisis, many of the equity markets in Latin American countries plummeted; yet, the Colombian market showed great stability due to its relative isolation from the other regional markets.

The securitization of Latin American debt instruments allowed greater sophistication of the market. The introduction of local instruments and the expansion of the investor base sparked the demand for financial market innovation. One of the first innovations was the introduction of simple options. Market agents began to offer instruments allowing investors to buy (call) or sell (put) Brady bonds. These instruments not only allowed investors to hedge their investments, but many used it as a way to increase their returns. The use of options, however, has proven to be an expensive proposition. Due to the fundamental role of price variance in pricing options, large shifts in the underlying prices often exploded the price of option instruments. Although most traders prefer to use the Black Scholes pricing model to calculate the price of options, there are some drawbacks. First of all, the Black Scholes assumes a European option, while Brady options are of the American variety. Second, the high level of volatility suggests that other volatility models, such as GARCH, may be better suited.

Many market agents also began introducing derivative products that allowed investors to gain from the possible rewards found in Latin American securities without making a direct investment. These products became known as structured products and proliferated in the early 1990s. One example is the fixed income appreciation note. This note allows an investor to purchase a AAA note where the principal is fully protected and the interest is linked to the performance of Argentine par bonds. If the note is purchased when the bonds are at 60, then the investor gets paid only if the bonds appreciate beyond 63. At that time the investor receives 115% of the appreciation. The result is exposure to the benefits of the Brady market, without risking the principal. The result was a proliferation of actors and instruments that helped deepen the market and thus reduce the level of volatility.

The integration of Latin American securities into global markets also made the region more vulnerable to international credit cycles. This was underscored by the tightening of U.S. monetary policy during 1994. The policy eventually helped lead to the Mexican devaluation and the regional crisis. Nonetheless, U.S. institutional investors continued to channel capital abroad, albeit at a slower pace. According to a study by Intersec, U.S. pension funds channeled $42 billion into foreign investments during 1994, up 5% from 1993 (Institutional Investor, 1995). Furthermore, the trend is expected to accelerate during the second half of the decade. The reason for this increase will be a drive for more portfolio diversification. U.S. institutional investors currently hold less than 5% ($303 billion) of their assets abroad. By the year 2000, they are expected to hold 12% ($725 billion) of their portfolios abroad. While these investments are being distributed along a wide host of international investments, a significant portion are being channeled into emerging markets fixed income activities.

The 1994 Trading Volume Survey by the Emerging Markets Trading Association (EMTA) indicated that despite the downturn in fixed income markets, trading volume in emerging market instruments rose 40% year-on-year in 1994. Although Brady trading make up the lion share of trading and posted large gains, significant increases were posted in local instrument/local currency trading as well as options.

Conclusion

The Brady debt restructuring program served as an important catalyst to channel investment back into Latin America. The program allowed the restoration of creditworthiness to many developing countries and allowed a rapid return of capital to the region. This time the new investment came in the form of securities. This facilitated the transfer of assets, better analysis of the risk factors, and an improved method of pricing the sovereign risk. These characteristics allowed the market to be more responsive to changes in local and international conditions. The introduction of Brady bonds, however, not only sparked demand for local market instruments, it also allowed a transformation of these markets.

On one hand, the securitization of foreign debt increased the vulnerability of many developing countries to changes in the international financial environment and shocks in any of the major emerging market countries. The tightening of the international credit cycle during 1994 underscored the instability, and subsequent crisis, in Mexico’s domestic capital markets. The characteristics of some of the large institutional investors increased the correlation between the markets as funds were forced to liquidate any salable asset to generate cash for redemptions. Securitization, however, also made it easier for these countries to bounce back from economic crises. Indeed, the Mexican example demonstrates that capital inflows were restored a mere five months after the sharp devaluation. Furthermore, there are signs that delinking can occur when investors consider some countries or markets to be relatively independent.

On the other hand, the securitization process provides an avenue for international investors to become more sensitive to the differences and similarities in economic performance and political stability among developing countries. Although the tight correlation between Brady bonds suggests that many investors have not fully differentiated between markets, a delinking process should begin to develop as investors begin to use many of the financial tools that have been recently introduced into the market. These changes should, indeed, help mitigate the developing world’s vulnerability to sharp cyclical swings, often regardless of domestic policy management. They should also help reduce moral hazard and encourage sound policy implementation.

Bibliography

Antowska, Iwona "The Brady Plan and the Poland Debt Reduction" Soviet and Eastern European Foreign Trade. Fall 1991 v 27 n 3.

Black, Fischer and M. Scholes "The Pricing of Options and Corporate Liabilities" Journal of Political Economy, . 81: 637-654 (May-June, 1973).

Business Week, . "A Talk With Mexico’s Finance Chief: ‘We Have a Short-term Problem" January 23, 1995, No. 3408, p. 59.

Cardoso, Eliana Ann Helwege Latin America’s Economy: Diversity, Trends, and Conflict . Cambridge: MIT Press, 1992.

Cohen, Benjamin J. In Whose interest?: Iinternational Banking and American Foreign Policy. New Haven: Yale University Press, 1986.

Clark, John "Debt Reduction and Market Reentry under the Brady Plan." Quarterly Review. Federal Reserve Bank of New York, 18, 4 Winter 1993, pp. 38-62.

Cline, William R. International Debt Reexamined. Washington, DC : Institute for International Economics, 1995.

Council of the Americas Washington Report "Debt Strategy Updated" May/June 1989, p. 7.

CS First Boston An Introduction to Emerging Market Fixed Income Instruments, . May 1993.

Devlin, Robert Debt and Crisis in Latin America. Princeton: Princeton University Press, 1989.

Dil, Shaheen F. "The Debt Debacle: Can the Brady Plan Help?" The Journal of Commercial Bank Lending. . Nov 1989.

Emerging Markets Traders Association (EMTA) 1994 Debt Trading Volume Survey. May 1, 1995.

Euromoney. "Suddenly, Its Latin Time Again" August 1995, p. 15-16.

Euromoney. "The Growing War Between Cedel and Euroclear" May 1981, p. 35-42.

Heath, Jonathan "The Devaluation of the Mexican Peso in 1994" Policy Papers on the Americas, Center for Strategic and International Studies, Washington, D.C. 1995.

IMF World Economic Outlook . Washington D.C., 1994.

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Institutional Investor. "Euroclear the Way" March 1994, pp. 185-188.

Institutional Investor. "America’s Largest Overseas Investors" July 1995.

Islam, Shafiqul "Beyond Brady: Toward a Strategy for Debt Reduction." Business in the Contemporary World. 1989 v 2 n 1.

Lustig, Nora "The Mexican Peso Crisis: The Foreseeable and the Surprise" Brookings Discussion Papers in International Economics, Brookings Institute, June 1995.

Perry, Clayton "Will They Pay?" CS First Boston Fixed Income Research Bulletin, March 24, 1995.

Sachs, Jeffrey. "Developing Country Debt and Economic Performance" Chicago: NBER, 1989.

Stallings, Barbara Banker to the World . Berkeley: University of California Press, 1987.

Taylor, Paul "Securitization Can Overcome ‘Sovereign Ceiling" Emerging Market Report . Duff & Phelps Credit Rating Co., 1994.

The Banker. "Euroclear Bonding the Market" July 1984, pp. 70-73.

The Economist. Feb. 13, 1993.

Unal, Haluk, Asli Demirguc-Kunt, and Kwok-Wai Leung, "The Brady Plan, 1989 Mexican Debt-Reduction Agreement, and Bank Stock Returns in United States and Japan" Journal of Money, Credit, and Banking . Vol. 25, No. 3, (August 1989, Part I).

World Bank World Debt Tables . Washington D.C.: World Bank Books, 1994.

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