Jelena Matovic Predrag Popovic Spencer Parrish

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Jelena MatovicPredrag PopovicSpencer Parrish
Brady Bonds
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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?

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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.

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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.

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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

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Mexican Par Mexican Discount
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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

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Venezuelan Par Venezuelan Disc.
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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

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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

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Hold or sell Mexican Brady bonds

• November 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

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Hold or sell Mexican Brady bonds

• November 2003.
• Mexican Par
• NPV 71.35
• Current Selling Price 96.20
• Recommendation
• Citibank should sell Mexican Par

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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.

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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

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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.

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Hedge Mexican Exposure

• Brady Bond has two risk components
• Sovereign Risk (Countrys 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 put options in Mexico

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Probability of Mexican default

• Country Risk Score 43 (100 most risky)
• Country Risk Rating C (Aleast, Emost risky)
• Brady Bond buybacks
• Political Risks C
• Economic Policy Risk B
• Economic Structure Risk C
• Liquidity Risk C
• Overall Risk C

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Probability of Mexican default

• Mexico obtained the investment-grade rating
  (Moodys, Standard and Poors 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.

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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