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Jelena Matovic Predrag Popovic Spencer Parrish

Brady Bonds (2004). Jelena Matovic Predrag Popovic Spencer Parrish. 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?

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Jelena Matovic Predrag Popovic Spencer Parrish

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  1. Brady Bonds (2004) Jelena MatovicPredrag PopovicSpencer Parrish

  2. 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?

  3. 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.

  4. 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.

  5. 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

  6. Mexican Par Mexican Discount

  7. 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

  8. Venezuelan Par Venezuelan Disc.

  9. 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

  10. 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

  11. 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%

  12. Hold or sell Mexican Brady bonds November 2003. Mexican Par • NPV = $71.35 • Current Selling Price = $96.20 • Recommendation: Citibank should sell Mexican Par

  13. 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.

  14. 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

  15. 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.

  16. 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)

  17. Probability of Mexican default • Country Risk Score 43 (100 most risky) • Country Risk Rating C (A=least, E=most risky) • Brady Bond buybacks • Political Risks C • Economic Policy Risk B • Economic Structure Risk C • Liquidity Risk C • Overall Risk C

  18. 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.

  19. 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%

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