|
|
| Introduction to Brady Bonds |
Unlike traditional bonds which possess risk characteristics of
a single issuer, Brady bonds blend the risk of Principal or Rolling
Interest Guarantees collateralized by high quality securities
with the risk of the debtor nation. Therefore, using one risk
measure is inadequate to price the bonds, so a blended method
must be used. Also, differing bonds from the same issuer possess
differing amounts of collateralized guarantees so comparison between
bonds is difficult without a standardized valuation.
A Brady Bond consists of three risk components;
Valuation of the bond consists of valuing the three components and combining them into a price. Step 1: Find present value of principal collateral by deriving yields from the U.S. Treasury strip yield curve of comparable maturity. Step 2: Value Rolling Interest Guarantee:
For fixed rate bonds, use the U.S. Treasury rates for the first 2 or 3 coupon dates and compute the present value.
For floating rate bonds: Compute the present value by valuing
fixed rate yield on a corresponding Libor based floater via asset
swap or forward rate basis.
Step 3: Value the rest of the non collateralized cash
flows using the risk value determined by the probability of default.
The sum of the present values determined in Steps 1,2 & 3
is the theoretical price of the bond.
Valuation of the Principal Guarantee
The Valuation of the Principal Guarantee of a Brady Bond is straightforward.
For a guarantee that covers a 30 year principal payment, the easiest
way to value it is to price a U.S. Treasury zero coupon bond maturing
in 30 years. Since this is available, the market price is equivalent
to the valuation of the guarantee.
As of the time of this writing:
U.S. Treasury Zero coupon bond
Maturity: 11/15/26
Yield: 6.64%
Price: $14.234 per $1000 face value
Valuation of the Rolling Interest Guarantee (RIG)
As we can see from the above example, the valuation of a fixed guarantee, such as a principal guarantee is fairly simple. The valuation of a rolling interest guarantee is slightly more complex. To simplify our example, we will price the rolling guarantee on a 3 year bond. The guarantee will be collateralized by U.S. Treasuries.
The assumptions are as follows:
Maturity: 3 Years
Coupon: 5%
Coupon is paid annually.
Spot Rates: U.S. Sovereign
1 year 6.0% 16%
2 year 6.5% 16.5%
3 year 7.0% 17.0%
If the bond had no Rolling Interest Guarantee, the cash flows
could be valued like this;
Value of 1st Year 5/(1+.16) = $4.31
Value of 2nd Year 5/(1+.165)2 = $3.68
Value of 3rd Year 5/(1+.17)3 = $3.12
Total Value = $11.11
Now lets value the same 3 year bond with a guarantee on the 1st
coupon only.
Value of 1st Year 5/(1+.06) = $4.72
Value of 2nd Year 5/(1+.165)2 = $3.68
Value of 3rd Year 5/(1+.17)3 = $3.12
Total Value = $11.52
Now lets value the same 3 year bond with a guarantee on the 2nd
coupon only.
Value of 1st Year 5/(1+.16) = $4.31
Value of 2nd Year 5/(1+.065)2 = $4.41
Value of 3rd Year 5/(1+.17)3 = $3.12
Total Value = $11.84
Now lets examine a 1 coupon rolling guarantee:
For the first coupon, interest will be paid no matter what happens.
Either the sovereign will make its coupon payments or the guarantee
will be used. So we will discount this rate at U.S. rates.
Value of 1st Year 5/(1+.06) = $4.72
The second coupon is subject to sovereign default risk, but only
if the sovereign defaults in period 1. So it should be discounted
by 1 period at sovereign rates and 1 period at U.S. rates.
Value of 2nd Year 5/(1+.16)(1+.065) = $4.05
The third coupon is subject to sovereign default risk only if
the sovereign defaults in period 1 or 2 so:
Value of 3rd Year 5/(1+.16)(1+.165)(1.07)= $3.45
Value of 1 Year rolling guarantee: = $12.22
A U.S. Treasury Bond using our spot rates is worth $13.20. So
while it would appear that a fixed guarantee is not as valuable
as a rolling interest guarantee at first look, when the analysis
is performed, it shows that a RIG is more valuable. Also, the
longer the maturity on the bond, the more valuable the RIG .
For floating rate bonds, one must evaluate the floating rate coupons
by valuing them with a constant fixed rate. The easiest way to
accomplish this is by assuming that the floating rate is equivalent
to the floating rate of an interest rate swap and derive the fixed
rate equivalent.
Valuation of the Non Collateralized Cash Flows
The two measures of valuation that are used in valuing non collateralized
cash flows in the Brady bond market are Stripped Yield and Sovereign
Spread. Both represent the return on pure sovereign risk for Brady
bonds.
An Example:
Venezuelan Brady Bonds
Bond Type: Pars DCB
Maturity 3/31/20 12/18/07
Collateralized: Yes No
Yield to Maturity 9.368% 10.430%
Spread to Treasuries 267bp 410bp
By looking at the above analysis, it appears that the expected
return on the DCB is higher than the Par bonds. This is to be
expected in that the DCB's have no collateral guarantee. However,
by using Stripped Yield and Sovereign Spread which measures the
risk premium of the country, stripped of any collateral guarantees,
we get a different picture.
Stripped Yield: 11.926% 10.430%
Sovereign Spread 535bp 407bp
What this tells us is that when we just look at the risk premium
built into each bond for Venezuela's credit, we are getting paid
more for similar risk on the Pars than on the DCB's.
Pricing the Stripped Yield and Sovereign Spread
Lets price a 3 year U.S. Treasury bond. (For simplicity, we will
assume annual coupons)
Assumptions: Annual Coupons
Interest Rate 5%
Spot Rates: 1 yr - 6%
2 yr - 6.5%
3 yr - 7.0%
Coupon Payments:
Value of 1st Year: $5/(1+.06) = 4.71
Value of 2nd Year: $5/(1+.065)2 = 4.41
Value of 3rd Year: $5/(1+.07)3 = 4.08
Principal Payment:
Value of 3rd Year: 100/(1+.07)3 = 81.63
Total Value = 94.83
Yield To Maturity (YTM) = 6.969%
A pure sovereign risk bond is valued the same way as the above
bond, but spot rates are higher due to the higher risk of the
issuer. We will assume that sovereign spot rates are 1000bp higher
than U.S. rates.
Assumptions: Annual Coupons
Interest Rate: 5%
Spot Rates 1yr - 16%
2yr - 16.50%
3yr - 17%
Interest Payments:
Value of 1st Year: $5/(1+.16) = $4.31
Value of 2nd Year: $5/(1+.165)2 = $3.68
Value of 3rd Year: $5/(1+.170)3 = $3.12
Principal Payment:
Value of 3rd Year: $100/(1+.170)3 = $62.44
Total Value $73.55
Yield to Maturity 16.963%
Lets value a Principal Guranteed Sovereign Bond:
Interest Payments:
Value of 1st Year: $5/(1+.16) = $4.31
Value of 2nd Year: $5/(1+.165)2 = $3.68
Value of 3rd Year: $5/(1+.170)3 = $3.12
Principal Payments:
Value of 3rd Year: 100/(1+.07)3 = $81.63
Total Value $92.74
Yield to Maturity 7.66%
As you can see the Principal Guranteed Bond is worth more than
the non guaranteed bond.
To derive the Sovereign risk and Stripped Yield we must make a
critical assumption. The assumption is that the current price
is equal to the theoretical price. This would be the case in an
efficient market.
The stripped yield would be the discount rate that of all the
non collateralized cashflows are discounted by.
So:
Value of 1st Year: $5/(1+X%)
Value of 2nd Year: $5/(1+X%)^2
Value of 3rd Year: $5/(1+X%)^3
Principal Payment:
Value of 3rd Year: 100/(1+.07)3 = $81.63
Total Value of Bond = $92.74
Solving for X% = 16.014%
So, given the same bond with a price of 92.74 and a YTM of 7.66
the sovereign spread would be the spread above the yield curve
that equates to the price of the bond.
The sovereign spread is the spread above U.S. Treasury spot rates.
We specified that the spread was 1000bp over treasuries, but the
equation to calculate this is as follows:
Interest
Value of 1st Year: $5/(1+.06+X%)
Value of 2nd Year: $5/(1+.065+X%)2
Value of 3rd Year: $5/(1+.07+X%)3
Principal
Value of 3rd Year: 100/(1+.07)3
Total Value of Bond = $92.74
Solving for X = 10.00%
While an understanding of the theoretical approach to valuation
of a Brady Bond is important, the sovereign risk is what determines
relative value for most investors.
By comparing sovereign risk (sometimes called stripped yield)
of two different issuers bonds, one can determine the market valuation
of the risk of each sovereign credit. If an investor's analysis
differs from the market perception he or she can take a position
in the undervalued bond with the assumption that the market will
eventually decrease the sovereign risk therefore increasing the
price of the bond.
Brady Bonds allow the investor to invest in a sovereign debt of
an emerging market country without taking on the currency fluctuations
of local market debt (if available). One must not overlook the
difficult hurdles that must occur if a Brady transaction is to
occur. The Structural Adjustment Programs developed by the IMF
are stringent, and generally politically unpopular in the debtor
nation. Streamlining government generally means reducing services
and jobs in the nation and for countries where government has
provided a large portion of services, this is generally unpopular.
Those countries that have undergone this process and have qualified
for a Brady transaction are generally well on their way to true
unsecured capital market access. For the astute investor, Brady
bonds allow investors to get incremental yield (frequently 300
bp or more versus comparable maturity treasuries) without taking
currency risk, by doing economic analysis on emerging market economies,
viewing the political situation in a specific country, and examining
the competitiveness of its industries.
We at Graicap believe that by focusing our efforts on a certain
region of the world, adept analysis can provide large rewards
for investors. We believe that certain African countries present
great opportunities for the patient long term investor. Our goal
at Graicap is to present our analysis of where the opportunity
lies and to assist investors in positioning themselves for the
appreciation we believe is forthcoming.
James C. Rice Jr.
Director of Fixed Income Sales and Trading
Graicap Investment Bankers
300 River Place
Detroit, MI 48207
(313) 259-3082
Please read our disclaimer.
Home Page |
BradyNet Pro |
Search |
CyberExchange
General Correspondence: bradynet@bradynet.com
Questions/Problems? support@bradynet.com
This site copyright © 1995-2000 BradyNet.com
Forfaiting |
Closing Prices |
Live Prices |
New Issues |
Ratings
BradyNet Tour |
BradyNet FORUMs |
BradyNet Email Directory |
Index (Site Map)
Analysis & Research |
BradyNet Center |
News |
Jobs
