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Brady BondsBrady Bonds(2004)(2004)

Brady Bonds Case Outline• March 1990. - Buy the Mexican par or discount bonds?• December 1990. - Buy Venezuelan par or discount bonds?• May 1990. - Fair opening price of Costa Rican Principal

Series A bonds?• November 2003 - Hold or sell Mexican Brady bonds?• Useful Diversification Tool?• Method and estimation of country risk for Mexico with Brady

bonds?• How can Citibank hedge its Mexican exposure?• Probability of Mexican default in the future?

Brady Bonds• Goal: Permanently restructure outstanding sovereign loans into

liquid debt instruments. • Used by an emerging markets• Coupon bearing bonds with

– Fixed– Step– Floating – Hybrids

• Principal and certain interest is collateralized by U.S. Treasury zero coupon bonds and other high grade instruments.

Brady Bonds• Creditor banks exchanged sovereign loans for Brady

bonds• Certain bonds incorporate warrants. • Debtor governments had their principal, interest

reduced by using Brady Bonds.• Countries involved in the Brady Plan restructuring:

– Argentina, Brazil, Bulgaria, Costa Rica, Dominican Republic, Ecuador, Mexico, Morocco, Nigeria, Philippines, Poland, Uruguay and some Eastern European countries.

Brady Bond Valuation3 Risk Components– Principal collateral in the form of US Treasury

zero coupon principal guarantee. – Rolling interest guarantees comprised of securities

on deposit with the Federal Reserve Bank. – Sovereign risk

Mexican Par Mexican DiscountT-Bond 30 Yrs

YTM8.56%

T-Bill 1 Yr 7.51%

Country Risk CCC

5.00%

Bond YTM 12.51%

Coupon Interest 6.25%

Face Value 100

P (Default) 4.5%

T-Bond 30 Yrs YTM

8.56%

T-Bill 1 Yr 7.51%

Country Risk CCC

5.00%

Bond YTM 12.51%

Coupon Interest 9.31% (LIBOR + 13/16)

Face Value 100

P (Default) 4.50%

Mexican Par/Discount• Mexican Par

NPV = $40.8 (real price $100)• Mexican Discount

NPV = $56.6 (real price $65)

Recommendation (March 1990.): Citibank should buy Mexican discount bonds

Venezuelan Par Venezuelan Disc.T-Bond 30 Yrs

YTM8.24%

T-Bill 1 Yr 7.05%

Country Risk C 8.00%

Bond YTM 15.05%

Coupon Interest 6.75%

Face Value 100

P (Default) 6.00%

T-Bond 30 Yrs YTM

8.24%

T-Bill 1 Yr 7.05%

Country Risk C 8.00%

Bond YTM 15.05%

Coupon Interest 9.31% (LIBOR + 13/16)

Face Value 100

P (Default) 6.00%

Venezuelan Par/Discount• Venezuelan Par

NPV = $36.66 (Payed $100)• Venezuelan Discount

NPV = $47.04 (Payed $70)

Recommendation (December 1990.): Citibank should buy Venezuelan discount bonds

Costa Rican Principal Series A• T-Bond 30 Yrs YTM 7.73%• T-Bill 1 Yr 8.32%• Country Risk CC 6.50%• Bond YTM 14.82%• Coupon Interest 6.25%• Face Value 100• Prob of Default 5.00%NPV = $49.15

(May 1990) $49.15 should be a fair price opening price

Hold or sell Mexican Brady bondsNovember 2003.• T-Bond 30 Yrs YTM 4.02%• T-Bill 1 Yr 1.01%• Country Risk BB 4.30%• Bond YTM 8.32%• Coupon Interest 6.25%• Face Value 100• Prob of Default 4.3%

Hold or sell Mexican Brady bondsNovember 2003.Mexican Par• NPV = $71.35• Current Selling Price = $96.20

• Recommendation: Citibank should sell Mexican Par

Useful Diversification Tool?• Approx. 60% variance in Mexican par prices

is attributable to changes in US Treasury.

• Conclusion: High correlation between Mexican Brady Bonds and US Treasury. Therefore, not a good diversification tool.

Estimation of Country Risk with Brady Bonds

• Brady Bond YTM = US T-bill + Spread• Therefore,

Country Risk = Brady Bond YTM – Risk Free YTM

• Stripped yield spread may provide a better indicator of the creditworthiness of the Brady issuer than the yield-to-maturity spread

Why Brady Bond• Brady par bond, joins U.S. interest rate risk to an

exposure to sovereign credit risk. • Investor Expects (Hopes) for:

– The issuing country's creditworthiness will improve.– The spread of the Brady yield over the U.S. Treasury yield

will fall– Brady bond will gain value, assuming relatively stable

U.S. bond yields and values.

Hedge Mexican Exposure• Brady Bond has two risk components

Sovereign Risk (Country’s political & econ. Risk)Interest Rate Risk (US Interest rate fluctuations)

• The market prices the (risky) coupon payments in terms of a spread over a U.S. Treasury.

• Hedging Vehicles Suggestion: – Hedge Interest Rate Risk with CBOT T-bond futures– Hedge Sovereign Risk with currency options in Mexico

and assets also subject to Mexican Sovereign Risk (Mexican stocks, Mexican real assets)

Probability of Mexican default• Country Risk Score 43 (100 most risky)• Country Risk Rating C (A=least, E=most risky)• Brady Bond buybacks• Political Risks C• Economic Policy Risk B• Economic Structure Risk C• Liquidity Risk C• Overall RiskC

Probability of Mexican default• Mexico obtained the investment-grade rating

(Moody’s, Standard and Poor’s and Fitch IBCA)

• Positive change in the export structure, the healthy financing of the external sector deficit, the low level of foreign debt, and the change in the production structure.

• Overall, low default probability.

Probability of Mexican default• Current Mex. Par YTM 11.09% (source

bradynet.com)

• LT T-Bond YTM 5.20% (source bloomberg.com)

• Country Risk 5.89%

• P(Default) 75.879%