International Fixed Income

Topic VA: Emerging Markets-Brady

Bonds

Outline

• Brady Bonds• Valuation and Interest Rate

Sensitivity• Numerical Example

I. History of Brady Bonds

• In late 70's and early 80's, major banks provided loans to developing countries

• In August 82, Mexico announced that it would default on its external debt; succeeded by similar declarations from Brazil, Argentina, Phillipines,...

• How important was this?– The nine largest U.S. banks had loans to the 17 most highly

indebted countries with a book value that was twice the banks' total capital.

• The next seven years involved negotiations between the parties, which stressed austerity programs in exchange for financial assistance, the idea being that these countries could grow out of their debts.

• On the whole, things did not get much better...

History Continued...

• In March, 1989 Treasury Secretary Nicholas Brady announced a change in policy, namely the goal was now to reduce the burden of the debt through market-based debt and debt-service reduction.

• The outcome ended up being the following:– instead of providing new money, banks would voluntarily

reduce their claims on the debtor countries in return for credit enhancements on their remaining exposure, such as collateral accounts to guarantee the principal and some interest funded by IMF, World Bank, etc...

– a large share of these claims have been securitized into bonds- so called Brady Bonds-, and are traded in the OTC market

– e.g., trading volume on emerging market debt has gone up from 1.5 billion in 1985 to 200 billion in 1992.... spreads have halved in the past few years... actively traded market

Brady Bond Example(Argentina Par Bonds

2023)• Size of Issue: $13 billion• Fixed interest rate (builds up to 6%

over the first six years)• $ Denominated• Principal in full and 12 months'

interest payments collateralized by US Treasury zero-coupon obligations (i.e., guaranteed)

Bond Valuation

• This bond pays off in $ at a fixed rate; therefore, its price should equal the fixed cash flows, discounted at the spot rates of interest. (Recall early lectures).

• This doesn't quite work. Why?• These bonds have default risk --- just like

early 80's, the countries might suspend their debt payments. However, part of the bond is guaranteed, since it is backed by US Treasury obligations.

• The Argentina Par Bond's price looks like...

Argentina Par Bond (Prices)

0

10

20

30

40

50

60

70

80

90

7/ 20/ 1992 7/ 20/ 1994 7/ 20/ 1996 7/ 20/ 1998

Mex. Assasination

Peso Crisis

LTCM Bz. real crisis

II. Valuing a Brady Bond

• There are two components:– A guaranteed portion, which includes the underlying

principal and some interest payments (usually 12-18 months)...How are these valued?• By fixed cash flow methods using U.S spot rates

– A nonguaranteed portion, which includes $ denominated promised interest payments over the thirty years. These are subject to default risk....How are these valued?• If U.S. spot rates are independent of emerging market default

rates, then we can discount the expected cash flows (i.e., adjusted for the probability of deafult) at the spot rates; if they are not independent, then we need a multifactor model of interest rates and default rates.

• The SUM of these components equals the Brady Bond Value.

The Strip Spread

• The markets often quote a strip spread... What is this?

• The strip spread measures the default premium.– Remove the guaranteed portion of the Brady Bond

-- gives an adjusted price of nonguaranteed component

– Find the constant spread over the zero rates which makes this adjusted price equal to the discounted cash flow of the promised interest rates.

– Thus, if the default risk was close to zero, then the spread would be close to zero as well.

Strip Spread Mathematics

T

t

CNG

G

GBradyNG

NGGBrady

tstr

t

T

P

P

PPP

PPP

5.1

)(1

par

2

2

22Tr

where

Find the spread, s, that sets the nonguaranteed price equal to the discounted “promised” cash flow.

Example Strip Spread(Argentina Par Bond

7/92-12/95)

0

500

1000

1500

2000

2500

Strip Spread

7/92 12/95

Brady Bonds

050

100150200250300350400450500

5/6/

1993

11/6

/199

3

5/6/

1994

11/6

/199

4

5/6/

1995

11/6

/199

5

5/6/

1996

11/6

/199

6

5/6/

1997

11/6

/199

7

5/6/

1998

11/6

/199

8

(Argentina)(Brazil)(Mexico)

Brady Bonds

050

100150200250300350400

5/6/

1993

11/6

/199

3

5/6/

1994

11/6

/199

4

5/6/

1995

11/6

/199

5

5/6/

1996

11/6

/199

6

5/6/

1997

11/6

/199

7

5/6/

1998

11/6

/199

8

(Latin)(Total)

Brady Bonds

050

100150200250300350400450500

5/6/

1993

11/6

/199

3

5/6/

1994

11/6

/199

4

5/6/

1995

11/6

/199

5

5/6/

1996

11/6

/199

6

5/6/

1997

11/6

/199

7

5/6/

1998

11/6

/199

8

(Fix)(Float)

Brady Bonds

050

100150200250300350400450500

5/ 6/ 1993 5/ 6/ 1995 5/ 6/ 1997

(Argentina)(Brazil)(Mexico)(Latin)(Total)(Fix)(Float)

Interest Rate Sensitivity• What’s the effect on the interest rate

sensitivity of the bond as default rates increase?– Dollar duration drops as the life of the bond (and

its value) shortens.

– Its affect on duration is ambiguous: as default probability increases, more weight is given to early coupons and guaranteed principal than later coupons, leading to a tradeoff.

• What about floating rate debt?– If default probability is zero, its duration is 6

months; what happens if the probability is one?

III. Numerical Example

• Consider a 5.5% 2-yr semi-annual coupon bond.

• Now suppose that this bond has the following characteristics:– guaranteed principal– nonguaranteed interest, with default

probability each 6-mth period of P=.15– First, price the guaranteed part, and

then the nonguaranteed component.

Recall the Data from Class

8972.,9222.,9476.,9730. 25.115. rrrr

72.89100 2 dPG

First, the guaranteed part:

Second, the Brady Bond:

The way to value this bond is to realize today’svalue is the discounted value of all future expectedcash flows. These cash flows only occur if there isno default, i.e., if (1-p) occurs.

Brady Bond Mathematics

99.6

)28.156.188.127.2(

)15.1(75.2

)1(

][

5.

2

5.

2

5.

t

T

t

t

t

T

t

tt

t

T

ttNG

d

dpC

dCEP

Thus, the price of the Brady Bond is89.72+6.99=96.71

What About the Strip Spread?

T

t

T

t

CNG

tstr

tstr

tP

5.1

75.2

5.1

2

2

2

2

99.6

Given the interest rates of 5.54%, 5.45%, 5.47% and 5.5%;solve for the strip spread s. Note that this is one equationand one unknown, but needs to be done on a computer.

What is S? S=36.42%!