Brady 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 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.

Features

Brady bonds have long-term maturities, and many have many features such as callable bonds or step-up. Some Brady bonds also have additional income sources based on economic factors or the price of oil. Below are some characteristics of different types of Brady bonds.

• Par bonds have fixed coupons or coupon schedules and bullet maturities of 25 to 30 years.
• Discount bonds have floating-rate coupons typically linked to LIBOR. These bonds have principal and rolling interest-rate guarantees.
• Front-loaded interest-reduction bonds provide a temporary interest-rate reduction. These bonds have a low fixed-interest rate for a few years and then step up to market rates until maturity.
• Debt conversion bonds (DCBs) and new money bonds are exchanged for bonds at par and yield a market rate. Typically, DCBs and new money bonds pay LIBOR + 7⁄8. These bonds are amortized and have an average life of between 10 and 15 years.

Emerging Markets Bonds

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.

• Letes are Argentine Treasury bills. They are offered on a discount basis and have maturities of 3, 6, and 12 months. Letes are sold through auctions every month.
• The primary internal debt instruments issued in Brazil are called BBC bonds. These bonds are issued by the central bank.
• In Mexico there are different debt instruments such as Ajustabonos, Bondes, Cetes, Tesobonos, and UDIbonos.
  • Ajustabonos are peso-denominated Treasury bonds. They are indexed to inflation and pay a real return over the Mexican consumer price index (CPI).
  • Bondes are floating-rate, peso-denominated government development bonds. They have maturities of 364 and 728 days.
  • 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.
  • 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.
  • UDIbonos 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.

Issuing Practices

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.

Pricing

The price of a Brady bond is quoted on its spread over U.S. Treasuries. The bonds are usually priced using the standard bond pricing models, 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 of Brady bonds comes from movement in the spread over U.S. Treasuries.

Risks

Sovereign Risk

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.

Liquidity Risk

In emerging markets, liquidity risk can be significant. During the Mexican peso crisis, bids on various instruments were nonexistent.

Interest-Rate Risk

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.

Reference: Federal Reserve Board