Jelena Matovic Predrag Popovic Spencer Parrish Brady Bonds (2004)

Brady Bonds Case Outline March Buy the Mexican par or discount bonds? December Buy Venezuelan par or discount bonds? May Fair opening price of Costa Rican Principal Series A bonds? November 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 Valuation 3 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 Discount T-Bond 30 Yrs YTM 8.56% T-Bill 1 Yr7.51% Country Risk CCC 5.00% Bond YTM12.51% Coupon Interest6.25% Face Value100 P (Default)4.5% T-Bond 30 Yrs YTM 8.56% T-Bill 1 Yr7.51% Country Risk CCC 5.00% Bond YTM12.51% Coupon Interest9.31% (LIBOR + 13/16) Face Value100 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 YTM 8.24% T-Bill 1 Yr7.05% Country Risk C8.00% Bond YTM15.05% Coupon Interest6.75% Face Value100 P (Default)6.00% T-Bond 30 Yrs YTM 8.24% T-Bill 1 Yr7.05% Country Risk C8.00% Bond YTM15.05% Coupon Interest9.31% (LIBOR + 13/16) Face Value100 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 YTM7.73% T-Bill 1 Yr8.32% Country Risk CC6.50% Bond YTM14.82% Coupon Interest6.25% Face Value100 Prob of Default5.00% NPV = $49.15 (May 1990) $49.15 should be a fair price opening price

Hold or sell Mexican Brady bonds November T-Bond 30 Yrs YTM4.02% T-Bill 1 Yr1.01% Country Risk BB4.30% Bond YTM8.32% Coupon Interest6.25% Face Value100 Prob of Default4.3%

Hold or sell Mexican Brady bonds November 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 Score43 (100 most risky) Country Risk Rating C (A=least, E=most risky) Brady Bond buybacks Political RisksC Economic Policy RiskB Economic Structure RiskC Liquidity RiskC 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 YTM11.09% (source bradynet.com) LT T-Bond YTM 5.20% (source bloomberg.com) Country Risk 5.89% P(Default)75.879%