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| Valuation of Brady Bonds |
Introduction to Brady Bonds
Brady bonds were created as a solution to the emerging market debt crisis of the 1980's. These bonds allow an investor to invest in debt of the emerging markets without undertaking any currency risk.
This report gives an overview of Brady bonds by first, examining the emerging market debt crisis that gave rise to Brady bonds, and then, by doing a more detailed analysis. Throughout this paper we use Less Developed Country (LDC) and Emerging Market Country (EMC) frequently. While the definition of an LDC is fairly self explanatory, an Emerging Market Country is an LDC which has either accomplished or is in transition to a market based economy.
Origins of the Less Developed Country Debt Crisis
The genesis of the emerging market debt crisis traces back to the 1970's. As commodity prices rose drastically worldwide due to high inflation, many LDC’s prospered. This is due to the high percentage of commodity based industries in these countries when compared to more developed countries. While inflation assisted these emerging market nations, the concurrent rise in interest rates severely hurt the banking industry worldwide. Loan demand plummeted, and many banks found profit margins squeezed between paying very high rates on deposits and receiving low interest from loans made earlier and retained in their portfolio.
This margin pressure forced banks to look for high margin loans to match the higher deposit rates that were being paid to depositors. The LDC’s found that with their new prosperity, banks were more than willing to lend them substantial amounts of money to finance virtually any project that the country wanted. We will explore this phenomenon in the next section but first a brief review of emerging market country finance is needed.
The United States and other developed nations are able to borrow via established credit markets and worldwide acceptance of their government debt. For the less developed countries (LDC) there is no developed capital market so other means must be found to fund the LDC’s needs. For most LDC’s there were two options of obtaining funds; grants and loans. Initially the only loan and grant sources were either multilateral banks (i.e. World Bank, etc.) or the G7 and other large countries. (G7 stands for Group of Seven, the seven largest economies in the World). While the interest rates tended to be below market or zero, there were other non economic costs that made these sources less desirable. Most of loan monies came with conditions requireing reform of the economy and/or the political system. Much of the grant money came with other, less public conditions from the donor country.
Both of the above options, while economically attractive (in terms of low interest rates) were frequently less attractive to the leaders of LDC’s due to politically unpopular restrictions. When the banks realized that the LDC's were less concerned about interest rates than the lack of conditions on the money, many banks pushed to make loans to LDC’s. The LDC's believing that commodity prices would rise forever (remember the predictions that the world would run out of oil in the 21st century) were eager borrowers.
As commodity prices continued rising through the early eighties, the loan demand and supply continued to rise. A cycle had begun to occur which was not realized until much later. In this cycle, commodity prices rose; this increased the Gross Domestic Product (GDP) of a country’s economy and therefore its capacity to service additional debt. Banks looked at this newfound additional capacity when requested and based on it would make additional loans.
The self reinforcing process continued until commodity prices began to fall. Loans continued as banks continued to believe that the downturn in prices was temporary, but as prices continued to fall, banks stopped lending. As commodity prices fell, LDC’s GDP growth declined and many countries fell into a recession. However debt service requirements continued unabated as the debt service capabilities of these countries decreased. Eventually, many LDC's defaulted on their payments of all debt, whether due from the commercial banks, multilateral banks or sovereign governments.
As the defaults wave spread from country to country, negotiations between the debtor nations and the creditors began. The aim of the negotiations was to reschedule payments so that at least some payments would be received by the creditors. The largest non commercial bank creditors created a forum called the Paris Club (meetings take place at the French Treasury in Paris) to negotiate the debt rescheduling terms.
Initially, most agreements generally consisted of replacing and rescheduling loans coming due shortly with longer term agreements having lower debt service requirements. Each LDC’s debt negotiations were separate as the debt repayment ability of each country varied greatly.
As this process continued, it was realized that even under reduced debt service, many of the less developed countries still were unable or unwilling to service their debts. These countries would return to negotiate more concessionary terms from their creditors. To keep this cycle from repeating, another process needed to be established.
In 1987, Citibank set aside reserves to cover about 25% of the LDC exposure. Other banks followed suit creating a market in LDC debt. Investors having performed economic analyses of a country’s economy and potential to service the debt, would purchase the debt at a deeply discounted rate, often pennies on the dollar. The creation of a defaulted loan market established acceptance that the true value of the loans was substantially discounted from face value. Banks, which had been reluctant to set aside reserves for LDC losses, could now realize at least some money by selling their loans in the defaulted debt market.
Simultaneously, the World Bank was examining ways to create a framework that would allow the LDC’s to reduce economic instability, increase growth and reduce the outstanding debt. Most of the analyses suggested that a combination of debt reduction and economic reform would allow the LDC’s to prosper.
In 1988, J.P. Morgan created Mexican Azted bonds. These bonds were created by collateralizing $3.7 billion in defaulted debt into $2.6 billion worth of 20 year bonds. Principal on the bonds was collateralized by U.S. Treasury securities.
In late 1988, Treasury Secretary Brady, proposed a plan which formalized a proecess of permanent debt reduction. Brady’s plan, which was adopted consisted of debt reduction by permanent restructuring of existing commercial debt at lower interest rates and/or writing off a portion of the existing debt. The resulting restructured debt is exchanged for tradable fixed income securities.
Under Brady’s plan, before a restructuring can be approved, the debtor nation has to undergo a series of suggested economic reforms suggested by the International Monetary Fund (IMF) called a Structural Adjustment Program (SAP). In addition, the restructuring must be approved by the World Bank. A SAP generally consists of targets for inflation, GDP growth, and other economic indicators. Privatization of state monopolies and other decentralization of governmnet services are also included in the plan. Generally a country has to have a track record of 2 to 3 years of success under the SAP before being considered for a Brady type restructuring of its outstanding debt.
Once acceptable progress has been made by the country under the SAP, a country could request a meeting with its commercial bank creiditors to request a Brady type restructuring of its outstanding debt. This is generally done in conjunction with restructuring of the country’s outstanding non commecial debt. During these negotiations, the country must get all its commercial creditors to agree to a general framework of a minimum of debt foregiveness as well as restructuring. All the creditors must abide by this plan and provide at least the minimum level of relief agreed to.
Under Brady’s plan, the structural adjustments suggested by the IMF in conjunction with debt relief, have allowed many countries to experience explosive growth and attract foreign investment to modernize their economies. Countries that have undergone a Brady plan restructuring are:
General Characteristics of Brady Bonds
1. Coupon: Bonds with coupons may have fixed, step or floating rates or combinations of each. 2. Maturity: Brady bonds have semiannual interest payments and generally amortize at a rate specified in the prospectus. 3. Collateral: Principal and certain interest is collateralized by U.S. Treasury zero coupon bonds and other high grade instruments. 4. Certain Par or Discount bonds have "Value Recovery Rights" or other options. 5. Bonds are issued as registered and/or Bearer Bonds.
Types of Brady Bonds
Each Brady transaction is unique. Just as the amount of forgiveness varies from transaction to transaction, the types of bonds issued differs as well. Below we have listed the most common types of bonds issued.
Par Bonds
Maturity: Registered 30 year bullet issued at par (or at the original face value of the sovereign loan).
Coupon: Fixed rate semi-annual below market coupon (relative to interest rate environment at time of issuance) but coupon will increase in specified increments at specified dates.
Guarantee: Rolling interest guarantees from 12 to 18 months (2 to 3 coupon payments) until maturity. Generally principal is collateralized by U.S. Treasury zero-coupon bonds
Discount Bonds (DB)
Maturity: Registered 30 year bullet amortization issued at discount (or at discount to original face value of sovereign loan).
Coupon: Floating rate semi-annual LIBOR (London Intermarket Bank Offered Rate) market coupon.
Guarantee: Rolling interest guarantees from 12 to 18 months ( 2 to 3 coupon payments) until maturity. Generally principal is collateralized by U.S. Treasury zero-coupon bonds.
Front Loaded Interest Reduction Bonds (FLIRB)
Maturity: Bearer 15 to 20 year semi-annual bond. Bond has amortization feature in which a set proportion of bonds are redeemed semi-annually.
Coupon: Initially offered with a fixed below market coupon rate which is later replaced by a LIBOR market rate until maturity.
Guarantee: Rolling interest guarantees generally of 12 months available only during the first 5 or 6 years.
Debt Conversion Bonds (DCB)
Maturity: Bearer bonds maturing between 15-20 years. Bond has amortization feature in which a set proportion of bonds are redeemed semi-annually. Bonds issued at par.
Coupon: Amortizing semi-annual LIBOR market rate.
Guarantee: No collateral is provided
New Money Bonds (NMB)
Maturity: Bearer bonds maturing between 15-20 years. Bond has amortization feature in which a set proportion of bonds are redeemed semi-annually. Bonds issued at par.
Coupon: Amortizing semi-annual LIBOR market rate.
Guarantee: No collateral is provided
Past Due Interest (PDI)
Maturity: Bearer bonds maturing between 10-20 years. Bond has amortization feature in which a set proportion of bonds are redeemed semi-annually. Bonds issued at discount.
Coupon: Amortizing semi-annual LIBOR market rate.
Guarantee: No collateral is provided
Capitalization Bonds (C-Bonds)
Issued in 1994 by Brazil in their Brady plan.
Maturity: Registered 20 year amortizing bonds initially offered at par. Bond has amortization feature in which a set proportion of bonds are redeemed semi-annually.
Coupon: Fixed below market coupon rate stepping up to 8% during the first 6 years and holding until maturity.
These bonds capitalize (or add to principal) the interest difference between the current step coupon rate and the notional 8%, thus interest accrues on both the principal and any capitalized interest.
Both capitalized interest and principal payments are made after a 10 year grace period.
Value Recovery Rights or Warrants
Mexico, Venezuela, and Nigeria have attached to their Par and Discount bonds rights or warrants which grant bondholders the right to recover a portion of debt or debt service reduction as stated in the exchange agreements, should their debt servicing capacity improve. For these countries whose economies are closely linked to the price of oil, an increase in oil export prices will increase the price of the warrant. In effect, some are known as Oil Warrants because they are linked to oil export prices and thus to the oil export receipts.
For example, Mexico in their Brady agreement provided Value Recovery Rights to the holders of the Discount Bond and Par Bonds. These rights gave the holder a cash payment based on the difference between the export price of Mexican crude oil and a reference price. The reference price was calculated by the price of oil at the time of issuance $14 multiplied by an inflation factor calculated by the IMF.
Collateral and Rolling Interest Guarantees
The Collateral and Rolling Interest Guarantees are a reserve in case a country not honoring an interest payment. Collateral consists of funds maintained in a cash account usually at the Federal Reserve Bank in New York and typically invested in AA- or better securities, for the purpose of paying the interest. A rolling interest guarantee (usually 12 to 18 months or 2 to 3 coupon payments) remains in effect as each successive coupon payment is made and the collateral continues to guarantee the next successive unsecured coupon payment. In the event the collateral is used, there is no obligation to replace it.
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