1. Case Study: LDC Debt and Brady Bonds
FINA 7360 International Finance
Spring 2017
Kimberly Joseph
Marat Nasyrov
Vandana Seerapu

2. Agenda Introduction to Brady bonds Valuation methodology
Analysis of Mexican Bonds
Analysis of Venezuela’s bonds
Pricing of Costa Rican bonds
Hedging the exposure
Probability of default: Mexico
Summary and conclusions

3. Introduction to Brady bonds
Proposed in 1989 by U.S. Treasury Secretary Brady to resolve the LDC debt insolvency of Latin American countries.
Brady Bonds is a refinanced defaulted sovereign bank loans: reduced claims on principle in return for enhanced credit of remaining exposure
Fixed (par, below-market rate of interest) and floating rate (discount, market-based floating rate of interest) structures
Economic reforms in return for permanent relief in debt and restructuring
• Par bonds have fixed coupons or coupon
schedules and bullet maturities of 25 to
30 years. Typically, these bonds have principalpayment
and rolling interest-rate guarantees.
Because pars are loans exchanged at face
value for bonds, debt relief is provided by a
lower interest payment.
• Discount bonds have floating-rate coupons
typically linked to LIBOR. These bonds have
principal and rolling interest-rate guarantees.
Bond holders receive a reduced face amount
of discount bonds, thereby providing debt
relief.

4. Introduction to Brady bonds
In 1986: 69% of all US LDC in Latin America ($52B)

5. Valuation methodology
Standard bond price valuation technique
! Since cash flows are risky, default risk needs to be incorporated in the price calculation formula -> expected cash flows.
Required inputs to value Brady bond:
Periodic cash flows Ci – based on coupon (fixed / floating)
Probability of default on coupon payments – inverted U shape model
Discount rate – function of the riskiness of cash flow. Rfusa for RG and principal, Rfcountry for the rest.

6. Valuation methodology
Assumptions: Default Probabilities are independent –use binomial tree model. One time default, no refinancing. YTM yield curve is flat - single value rf is used to discount. No default insurance (CDS), non callable.

7. Brady Bonds: Mexico Mexican Par Bonds Inputs Principal 100 T (years)30
Coupon
6.25%
Coupon (S.A.)
3.13%
RG (payments)
9.38%
YTM FC-30yr
12.51%
YTM US Gov.-30yr
8.56%
Mexican Discount Bonds Inputs
Principal
100
T (years) 30
LIBOR
8.50%
Coupon (LIBOR + 13/16 %)
9.31%
Coupon (S.A.)
4.66%
RG (payments)
13.97%
YTM FC-30yr
12.51%
YTM US Gov.-30yr
8.56%

8. Brady Bonds: Mexico
NPV of Mexican Par bond = $ (Market Bond Price $40)
NPV of Mexican Discount bond = $ (Market Bond Price $60)
Recommendation : Buy Mexican Par Bond as it’s calculated price is more than the market bond price and it’s profitability ratio is higher compared to discount bond.

9. Brady Bonds: Venezuela
Mexican Par Bonds Inputs
Principal
100 T 60
Coupon
6.75%
Coupon (S.A.)
3.38% RG
7.88%
YTM Venezuela-30yr
9.91%
YTM US Gov.-30yr
2.56%
Mexican Discount Bonds Inputs
Principal
100 T 60
LIBOR
8.50%
Coupon=LIBOR+13/16
9.31%
Coupon (S.A.)
4.66% RG
10.86%
YTM Venezuela-30yr
9.91%
YTM US Gov.-30yr
2.56%

10. Brady Bonds: Venezuela
NPV of Venezuelan Par bond = $ (Market Bond Price $50)
NPV of Venezuelan Discount bond = $ 93.0 (Market Bond Price $70)
Recommendation : Buy Venezuelan Par Bond as it’s calculated price is more than the market bond price and it’s profitability ratio is higher compared to discount bond.

11. Costa Rica Principle Series A
Face Value $100
Time to Maturity years
Coupon Rate %
Rolling Guarantee
YTM Costa Rica- 20 Yr %
YTM US Gov-20 Yr %
Probability of Default %

12. Costa Rica Principle Series A Pricing
Fair opening price
E[NPV] = $58.15

13. Hold or Sell Mexican Brady Bonds?
NPV= $52.26
November 6, 1996 Par Bond Bid Price = $71.50
Recommendation: Sell Mexican par bonds

14. Mexican Brady Bonds for Diversification
US Rate DVBP- Bond’s price reaction to 1% downward shift in US yield curve
Mexican Par bond DVBP= 8.48%
High correlation with US Treasury yields
Not a good diversification tool

15. Mexico: country risk estimation based in government bonds (UMS, 2003)
Given data: issue 02/2003, 13 years
Price =117.5
Coupon =11.375% (s.a.)
Calculate YTM which is Mexican risk free rate
YTM =YTMmex=9.05%
Calculate CR risk premium (sovereign):
Spread = YTMmex – YTMusa = =412 bp
Use conversion table of country risk and spread over US treasuries to get rating
Actual 2003 rating
The higher the grade, the lower the yield of the bond (spread over base , risk-free rate of government bonds).
Country risk is related to the spread over a base, risk-free rate (U.S or Germany). CR influences the interest on the debt issued by a government of a country. YTMmex= US risk free Treasury + spread (CR risk premium)

16. Hedging the exposure
Bond Price = F(Coupon, YTM). Coupon is fixed, YTM varies and depends on many factors
YTM = Base rate (rf) + Spread (country premium)
Bond Risk
YTM: Base rate
Interest risk fluctuations
(inflation, US rate change)
Bond futures
CBOT US
YTM: Country spread (sovereign default, socioeconomic and political volatility)
CDS, Put options
Other: Call option, liquidity, currency
Bond Price = F(Coupon, YTM). Coupon is fixed, YTM varies and depends on many factors
YTM = Base rate (rf) + Spread (country premium)
Base rate - Interest rate fluctuations (central bank, inflation) – Bond futures CBOT US
Country spread – sovereign default, socioeconomic and political volatility, etc – CDS, put option
Other – call option, liquidity, currency

17. Probability of default: Mexico Mid-Term Macroeconomic Indicators
Mexico GDP is expected to grow at 3.7% next five years ( )
Debt as ratio of GDP is anticipated to decrease

18. Probability of default: Mexico
As of 2003 inflation rate and interest rate has dropped
Yields on government bonds have been decreasing (lower country risk spread)

19. Probability of default: Mexico
Macroeconomic indicators are stable
Debt management is stable – retired Brady Bonds
Political and structural factors are moderate
Moderate probability of default (2003)
Investment grade, Baa2

20. Summary and conclusions
Refinancing idea worked well – many countries ultimately retired their debt
Diversified sovereign risk from lending banks in US
Create an attractive market for EM debt since backed by the U.S. Treasury
Accelerate Economic reforms and reopened access to global capital markets
However...
Did not solve major structural problems which continue to undermine EM economies
Lost investment opportunity for commercial banks from discount/below market interest rates brady bonds
Has been mostly retired/refinanced with more market-friendly tools

21. Questions
Thank you!

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