Trading and Capital-Markets Activities Manual
Profiles: Brady Bonds and Other Emerging-Markets Bonds
In 1989, the Brady plan, named after then-U.S. Treasury Secretary Nicholas Brady, was announced to restructure much of the debt of developing countries that was not being fully serviced due to economic constraints. The plan provided debt relief to troubled countries and, in theory, opened access to further international financing. It also provided the legal framework to securitize and restructure the existing bank debt of developing countries into bearer bonds. Linking collateral to some bonds gave banks the incentive to cooperate with the debt reduction plan.
Brady bonds are restructured bank loans. They comprise the most liquid market for below-investment-grade debt (though a few Brady countries have received investment-grade debt ratings) and are one of the largest debt markets of any kind. Banks are active participants in the Brady bond market. Once strictly an interbank market, the Brady market has evolved into one with active participation from a broad investor base.
CHARACTERISTICS AND FEATURES
Brady bonds have long-term maturities, and many have special features attached. Callable bonds or step-up coupons are among the most common features. Others pay additional sources of income based on various economic factors or the price of oil. Listed below are the individual characteristics of several types of Brady bonds:
• Par bonds have fixed coupons or
coupon schedules and bullet maturities of 25 to 30 years. Typically, these
bonds have principal-payment and rolling interest-rate guarantees. Because
pars are loans exchanged at face value for bonds, debt relief is provided
by a lower interest payment.
The terms of local debt market instruments also vary widely, and issues are denominated in either local or foreign currency such as U.S. dollars. Brief descriptions of instruments in Argentina, Brazil, and Mexico follow.
Letes are Argentine Treasury bills. They are offered on a discount basis and have maturities of 3, 6, and 12 months. Auctions are held on a monthly basis.
Currently, the primary internal debt instruments issued in Brazil are so-called BBC bonds, which are issued by the central bank. As of mid-1996, BBC bonds were being issued in 56-day denominations, up from 35-, 42-, and 49-day denominations. Total outstandings as of June 30, 1996, were U.S.$49.9 billion, and these instruments are highly liquid. The central bank also issues bills and notes known as LTNs and NTNs that have maturities up to one year (though one NTN has been issued as of this writing with a two-year maturity). LTNs and NTNs are less liquid and have smaller outstandings (U.S.$34.4 and U.S.$18.2 billion, respectively) than BBC bonds.
Though issuance of these bonds has been halted, ajustabonos are peso-denominated Treasury bonds. They are indexed to inflation and pay a real return over the Mexican consumer price index (CPI). These bonds are longer-term instruments with maturities of 1,092 days (three years) and 1,820 days (five years). Ajustabonos pay a quarterly real rate coupon over the CPI and are tax exempt to foreign investors. As of May 1996, U.S.$5.6 billion ajustabonos remained outstanding.
Bondes are floating-rate, peso-denominated government development bonds. They have maturities of 364 and 728 days. Bondes pay interest every 28 days at the higher of the 28-day cetes rate or the retail pagares rate, calculated by the central bank. They are auctioned weekly and are tax exempt to foreign investors. The total amount outstanding as of mid-1996 was approximately U.S.$5 billion.
Cetes are government securities and are the equivalent of Mexican T-bills. They are denominated in pesos and are sold at a discount. Cetes have maturities of 28, 91, 182, 364, and 728 days (though this maturity is presently discontinued). Cetes are highly liquid instruments and have an active repo market.
The capital gain for these instruments is determined by the difference between the amortized value and the purchase price; the daycount convention is actual/360-day. Auctions are held weekly by the central bank for the 28-through 364-day maturities. Foreign investors are exempted from paying taxes on these instruments.
Though these instruments are not currently being issued, they comprised the majority of debt offerings in the time leading up to the 1994 peso crisis. Tesobonos are dollar-indexed government securities with a face value of U.S.$1,000. At the investors' option, they are payable in dollars, and they are issued at a discount. Maturities include 28, 91, 182, and 364 days.
During the week of May 27, 1996, the Mexican central bank sold three-year UDIbonos for the first time. They are inflation-adjusted bonds denominated in accounting units or UDIs (a daily inflation index), which change in value every day. These instruments replaced the ajustabonos. UDIbonos pays interest semi-annually and offer holders a rate of return above the inflation rate. They are auctioned biweekly and may have limited liquidity.
Brady bonds and local debt market instruments can be used for investment, hedging, and speculation. Speculators will often take positions on the level and term structure of sovereign interest rates. Arbitragers will take positions based on their determination of mis-pricing.
DESCRIPTION OF MARKETPLACE
A Brady deal exchanges dollar-denominated loans for an agreed-upon financial instrument. These instruments include various debt instruments, debt equity swaps, and asset swaps. At the close of a collateralized Brady deal (not all Brady bonds are collateralized), collateral is primarily posted in the form of U.S. Treasury zero-coupon bonds and U.S. Treasury bills. The market value of this collateral depends on the yield of 30-year U.S. Treasury strips and tends to increase as the bond ages. Developing countries have also used their own resources for collateral as well as funds from international donors, the World Bank, and the International Monetary Fund (IMF) to support their Brady deals. Local debt instruments are subject to the issuing practices of each individual country.
The number of market participants in each emerging market differs with the characteristics of each market, such as regulatory barriers, liquidity constraints, and risk exposures. However, there are many participants in the Brady bond market. Securitization of Brady bonds enables banks to diversify and transfer some of their country exposures to other banks. New market participants in the Brady market include investment banks as well as traditional commercial banks, mutual funds, pension funds, hedge funds, insurance companies, and some retail investors.
For many instruments, prices are available on standard quote systems such as Bloomberg, Reuters, and Telerate. In addition, many brokers can quote prices on less developed country (LDC) debt instruments. For all but the most liquid Brady bonds and internal debt instruments, however, transparency can be very limited.
Pricing for the various LDC issues differs across instruments and countries. The price of a Brady bond is quoted on its spread over U.S. Treasuries. Standard bond pricing models are often used to price the uncollateralized bond and un-securitized traded bank loans, with emphasis on the credit risk of the issuers (sovereign risk) in determining whether a sufficient risk premium is being paid. Most of the volatility in Brady bonds comes from movement in the spread over U.S. Treasuries.
Over-the-counter (OTC) options are the primary vehicles to hedge Brady bonds. Because the volume of the OTC options market is approximately one-tenth that of the cash Brady bond market, liquidity is relatively poor. Cash instruments from the identical sovereign issuer can be used to hedge positions. However, as in other hedging situations, mismatch of terms can lead to basis risk. Hedging strategies for Brady bonds are often focused on decomposing the sovereign risk from the U.S. rate risk and on neutralizing the latter. For example, a long fixed-coupon Brady bond position is exposed to the risk that U.S. rates will rise and Brady prices will fall. A hedge aimed at immunizing U.S. rate risk can be established with a short U.S. Treasury, Treasury futures, or forward position.
One of the most significant risks related to trading of LDC debt is sovereign risk. This includes political, regulatory, economic stability, tax, legal, convertibility, and other forms of risks associated with the country of issuance. Real risk is that of potential controls or taxes on foreign investment. While there is no way to predict policy shifts, it can help to be familiar with any current controls and to closely follow the trend of inflation.
Liquidity risk is the risk that a party may not be able to unwind its position. In emerging markets, liquidity risk can be significant. During the Mexican peso crisis, bids on various instruments were nonexistent. Portfolio values of Latin American instruments plunged. In the OTC market, options are far less liquid than cash bonds. As a result, option positions are often held to expiry rather than traded.
Debt issues of various countries are subject to price fluctuations because of changes in sovereign-risk premium in addition to changes in market interest rates and changes in the shape of the yield curve. Spreads between U.S. rates and sovereign rates capture this sovereign-risk premium. In general, the greater the uncertainty of future payoffs, the greater the spread between country rates and U.S. rates. This spread will not necessarily be stable, however, making interest-rate risk at least equivalent to that found in U.S. Treasury instruments.
Less developed country debt that remains in the form of a loan and does not meet the definition of a security in the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities," should be reported and accounted for as a loan. If the loan was restructured in a troubled-debt restrucEagle Tradersg involving a modification of terms, and the restructured loan meets the definition of a security in SFAS 115, then the instrument should be accounted for according to the provisions of SFAS 115. The accounting treatment for investments in foreign debt is determined by SFAS 115, as amended by SFAS 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." SFAS 125 has been replaced by SFAS 140, which has the same title. Accounting treatment for derivatives used as investments or for hedging purposes is determined by SFAS 133, Accounting for Derivatives and Hedging Activities. (See section 2120.1, "Accounting," for further discussion.)
RISK-BASED CAPITAL WEIGHTING
Claims that are directly and unconditionally guaranteed by an OECD-based central government or a U.S. government agency are assigned to the zero percent risk category. Claims that are not unconditionally guaranteed are assigned to the 20 percent risk category. A claim is not considered to be unconditionally guaranteed by a central government if the validity of the guarantee depends on some affirmative action by the holder or a third party. Generally, securities guaranteed by the U.S. government or its agencies and that are actively traded in financial markets are considered to be unconditionally guaranteed.
Claims on, or guaranteed by, non-OECD central governments which do not represent local currency claims that are unconditionally or conditionally guaranteed by non-OECD central governments to the extent that the bank has liabilities booked in that currency are assigned a 100 percent risk weight. Also, all claims on non-OECD state or local governments are assigned to the 100 percent risk category.
LEGAL LIMITATIONS FOR BANK INVESTMENT
Obligations which are guaranteed by a department or an agency of the U.S. government, if the obligation commits the full faith and credit of the United States for the repayment of the obligation, are type I securities and are not subject to investment limitations. Also, obligations guaranteed by the Canadian government are classified as type I securities.
Obligations guaranteed by other OECD countries which are classified as investment grade are type III securities, which limit a bank's investment to 10 percent of its capital and surplus.
Non-investment-grade LDC debt may be purchased under a bank's "reliable estimates" bucket. If a bank concludes, on the basis of reliable estimates, that an obligor will be able to perform, and the security is marketable, it can purchase the security notwithstanding its investment-grade rating. Such securities are subject to a 5 percent limit of a bank's capital and surplus for all securities purchased under this authority.
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