Topic 4 - Bonds ((vi) Brady Bonds))

Question 1

Brady Bonds

Answer 1

• Formulated in 1990, as a solution to the emerging market debt crisis of the 1980s.
• A Brady plan is a debt-reduction program whereby sovereign debt (mostly loans from foreign banks) is repackaged into tradable Brady bonds, generally with collateral.
• Collateral is provided by international organizations like IMF, World Bank in exchange for the implementation of an economic reform program by the countries
• Close to 20 countries have issued Brady bonds and the total market capitalization is close to $100 billion.

Question 2

Different types of bonds from Emerging Markets

Answer 2

Investors wishing to buy bonds issued by emerging countries have several alternatives:

• Domestic bonds:
• Domestic bonds are issued locally by a domestic
borrower and are usually denominated in the local
currency.
• Various restrictions and liquidity problems reduce
the amount available to foreign investors

• Foreign bonds
- Foreign bonds are issued on a local market by a
foreign borrower and are usually denominated in
the local currency.
- Foreign bond issues and trading
are under the supervision of local market
authorities.

Foreign bonds include:
Yankee bonds (in the U.S)
Rembrandt bonds (in the Netherlands)
Samurai bonds (in Japan)
Matador bonds (in Spain)
Bulldog bonds (in the UK)

• International bonds
- International bonds are underwritten by a
multinational syndicate of banks and are placed
mainly in countries other than the one in whose
currency the bond is denominated.
- These bonds are not traded on a specific national
bond market.
- Issuance of international bonds is less restricted
(compared to that of foreign bonds) by national
regulations.

• Brady bonds
• In 1990, the Brady plan allowed emerging
countries to transform nonperforming debt into
Brady bonds.

Question 3

Investors trying to buy bonds by emerging countries (domestic bonds)

Answer 3

• They can directly access the domestic bond markets of some emerging countries.
• These emerging markets have been growing, albeit in an erratic fashion.
• Various restrictions and liquidity problems reduce the amount available to foreign investors.
• Latin America dominates the fixed-income market of emerging countries, but some European and Asian markets, such as Turkey, Hungary, the Czech Republic, India, Indonesia, and the Philippines, are also worth mentioning.
• These instruments are generally denominated in the local currency and carry the exchange risk of that currency. On the other hand, local governments are less likely to default on these bonds, because they can always print more national currency.

Question 4

Investors trying to buy bonds by emerging countries (Foreign Bonds)

Answer 4

• They can buy foreign bonds directly issued by some emerging country or corporation on a major national bond market.
• The bond is issued in the national currency of that market.

Question 5

Investors trying to buy bonds by emerging countries (International bonds)

Answer 5

• They can buy international bonds issued by emerging countries.
• Latin American governments and firms represent the largest share of these new issues denominated in U.S. dollars and other major currencies.
• Major issuers come from Mexico, Argentina, Venezuela, and Brazil.

Question 6

Investors trying to buy bonds by emerging countries (Brady Bonds)

Answer 6

• They can buy Brady bonds on the international capital market.
• In 1990, the Brady plan allowed emerging countries to transform nonperforming debt into Brady bonds, which are traded on the international bond market.

Question 7

Characteristics of Brady Bonds

Answer 7

• Brady bonds come with a large menu of options, which makes their analysis somewhat complicated.
• The basic idea is to replace existing government debt with Brady bonds, whose market value is less than the par value of the original debt, but that are more attractive than the original debt because of the guarantees provided and their tradability on the international bond market.

Question 8

Brady Bonds: Types of Guarantees

Answer 8

Three types of guarantees can be put in place. These guarantees are not available on all types of Brady bonds.

1. Principal collateral: The U.S. Treasury issues long-term (e.g., 30-year) zero- coupon bonds to collaterallize the principal of the Brady bond. The collateral is paid for by a combination of the IMF, the World Bank, and the emerging country. The value of the collateral increases with time and reaches par value at maturity of the Brady bond.
2. Rolling-interest guarantee: The first semiannual coupons (generally three) are guaranteed by securities deposited in escrow with the New York Federal Reserve Bank, to protect the bondholder from interest suspension or default. If an interest payment is missed, the bondholder will receive that interest payment from the escrow account. If the interest payment is made by the emerging country, the interest collateral will be rolled forward to the next interest payments.
3. Value recovery rights: Some bonds issued by Mexico and Venezuela have attached warrants linked to the price of oil. Investors can get extra interest payments if the oil export receipts of these countries increase over time.

Question 9

Types of Brady Bonds

Answer 9

Two major types of Brady bonds have been issued:

1. Par bonds (PARs): These can be exchanged dollar for dollar for existing debt. Typically, these bonds have fixed coupons and a long-term maturity (30 years) and are repaid in full on the final maturity. In some cases, the coupon is stepped up progressively over the life of the bond. The debt reduction is obtained by setting a coupon rate on the par value of the bond well below the current market interest rate. In other words, the market value of the bond is well below its face value, because of the low coupon. These bonds are sometimes known as interest-reduction bonds. The difference between the par value of the bond and its market value at issue time can be regarded as the amount of debt forgiveness.
2. Discount bonds (DISCs): These are exchanged at a discount to the par value of the existing debt but with a “market-rate” coupon. These bonds are sometimes known as principal-reduction bonds. Typically, these bonds have floating-rate coupons (the London interbank offer rate, or LIBOR, plus a market-determined spread) and a long maturity (20 years or more).

Other types of Brady Bonds:

3. Front-loaded interest-reduction bonds (FLIRBs): These have low initial coupons that step up to higher levels for a number of years, after which they pay a floating rate.
4. New-money bonds (NMBs) and debt-conversion bonds (DCBs): These are generally issued together through the new-money option of the Brady plan. This option is designed to give debtholders incentives to invest additional capital in the emerging country. For every dollar of NMB subscribed, the investor can exchange existing debt for DCBs in a ratio stated in the Brady plan (typi- cally $5 of DCBs for each $1 of NMBs). The incentive is provided by making DCBs more attractive than the bonds available in other Brady options.
5. Past-due interest bonds (PDIs): These are issued in exchange for unpaid past interest. In a way, they pay interest on interest.