Transcript International Fixed Income

International Fixed Income
Topic VA:
Emerging Markets-Brady Bonds
Outline
• Brady Bonds
• Valuation and Interest Rate Sensitivity
• Numerical Example
I. History of Brady Bonds
• In late 70's and early 80's, major banks provided loans to developing
countries
• In August 82, Mexico announced that it would default on its external
debt; succeeded by similar declarations from Brazil, Argentina,
Phillipines,...
• How important was this?
– The nine largest U.S. banks had loans to the 17 most highly indebted
countries with a book value that was twice the banks' total capital.
• The next seven years involved negotiations between the parties,
which stressed austerity programs in exchange for financial
assistance, the idea being that these countries could grow out of
their debts.
• On the whole, things did not get much better...
History Continued...
• In March, 1989 Treasury Secretary Nicholas Brady announced a
change in policy, namely the goal was now to reduce the burden of
the debt through market-based debt and debt-service reduction.
• The outcome ended up being the following:
– instead of providing new money, banks would voluntarily reduce their
claims on the debtor countries in return for credit enhancements on
their remaining exposure, such as collateral accounts to guarantee the
principal and some interest funded by IMF, World Bank, etc...
– a large share of these claims have been securitized into bonds- so called
Brady Bonds-, and are traded in the OTC market
– e.g., trading volume on emerging market debt has gone up from 1.5
billion in 1985 to 200 billion in 1992.... spreads have halved in the past
few years... actively traded market
Brady Bond Example
(Argentina Par Bonds 2023)
• Size of Issue: $13 billion
• Fixed interest rate (builds up to 6% over the first
six years)
• $ Denominated
• Principal in full and 12 months' interest
payments collateralized by US Treasury zerocoupon obligations (i.e., guaranteed)
Bond Valuation
• This bond pays off in $ at a fixed rate; therefore, its price
should equal the fixed cash flows, discounted at the spot
rates of interest. (Recall early lectures).
• This doesn't quite work. Why?
• These bonds have default risk --- just like early 80's, the
countries might suspend their debt payments. However,
part of the bond is guaranteed, since it is backed by US
Treasury obligations.
• The Argentina Par Bond's price looks like...
Argentina Par Bond (Prices)
90
80
70
60
50
40
30
LTCM
Bz. real crisis
Mex. Assasination
Peso Crisis
20
10
0
7/20/1992
7/20/1994
7/20/1996
7/20/1998
II. Valuing a Brady Bond
• There are two components:
– A guaranteed portion, which includes the underlying principal
and some interest payments (usually 12-18 months)...How are
these valued?
• By fixed cash flow methods using U.S spot rates
– A nonguaranteed portion, which includes $ denominated
promised interest payments over the thirty years. These are
subject to default risk....How are these valued?
• If U.S. spot rates are independent of emerging market default rates,
then we can discount the expected cash flows (i.e., adjusted for the
probability of deafult) at the spot rates; if they are not independent,
then we need a multifactor model of interest rates and default rates.
• The SUM of these components equals the Brady Bond
Value.
The Strip Spread
• The markets often quote a strip spread... What is this?
• The strip spread measures the default premium.
– Remove the guaranteed portion of the Brady Bond -- gives an
adjusted price of nonguaranteed component
– Find the constant spread over the zero rates which makes this
adjusted price equal to the discounted cash flow of the promised
interest rates.
– Thus, if the default risk was close to zero, then the spread would
be close to zero as well.
Strip Spread Mathematics
PBrady  PG  PNG
 PNG  PBrady  PG
where PG 
 PNG 
par
(1
rT
2
T

t .5
1
) 2T
Ct

rt  s 2 t
2
Find the spread, s, that sets the nonguaranteed price
equal to the discounted “promised” cash flow.
Example Strip Spread
(Argentina Par Bond 7/92-12/95)
2500
2000
1500
Strip Spread
1000
500
0
7/92
12/95
11/6/1998
5/6/1998
11/6/1997
5/6/1997
11/6/1996
5/6/1996
11/6/1995
5/6/1995
11/6/1994
5/6/1994
11/6/1993
5/6/1993
Brady Bonds
500
450
400
350
300
250
200
150
100
50
0
(Argentina)
(Brazil)
(Mexico)
11/6/1998
5/6/1998
11/6/1997
5/6/1997
11/6/1996
5/6/1996
11/6/1995
5/6/1995
11/6/1994
5/6/1994
11/6/1993
5/6/1993
Brady Bonds
400
350
300
250
200
150
100
50
0
(Latin)
(Total)
11/6/1998
5/6/1998
11/6/1997
5/6/1997
11/6/1996
5/6/1996
11/6/1995
5/6/1995
11/6/1994
5/6/1994
11/6/1993
5/6/1993
Brady Bonds
500
450
400
350
300
250
200
150
100
50
0
(Fix)
(Float)
Brady Bonds
500
450
400
350
300
250
200
150
100
50
0
5/6/1993
(Argentina)
(Brazil)
(Mexico)
(Latin)
(Total)
(Fix)
(Float)
5/6/1995
5/6/1997
Interest Rate Sensitivity
• What’s the effect on the interest rate sensitivity
of the bond as default rates increase?
– Dollar duration drops as the life of the bond (and its
value) shortens.
– Its affect on duration is ambiguous: as default
probability increases, more weight is given to early
coupons and guaranteed principal than later coupons,
leading to a tradeoff.
• What about floating rate debt?
– If default probability is zero, its duration is 6 months;
what happens if the probability is one?
III. Numerical Example
• Consider a 5.5% 2-yr semi-annual coupon bond.
• Now suppose that this bond has the following
characteristics:
– guaranteed principal
– nonguaranteed interest, with default probability each
6-mth period of P=.15
– First, price the guaranteed part, and then the
nonguaranteed component.
Recall the Data from Class
r.5  .9730, r1  .9476, r1.5  .9222, r2  .8972
First, the guaranteed part:
PG  100  d 2  89.72
Second, the Brady Bond:
The way to value this bond is to realize today’s
value is the discounted value of all future expected
cash flows. These cash flows only occur if there is
no default, i.e., if (1-p) occurs.
Brady Bond Mathematics
PNG 

T
 E[C ]  d
t .5
t
t
T
2t
C
(
1

p
)
 dt
 t
t .5

T
 2.75(1  .15)
t .5
2t
 dt
 ( 2.27  1.88  1.56  1.28)
 6.99
Thus, the price of the Brady Bond is
89.72+6.99=96.71
What About the Strip Spread?
PNG 
T

6.99 
t . 5
Ct
1

rt  s 2 t
2
T

t  .5
2.75
1

rt  s 2 t
2
Given the interest rates of 5.54%, 5.45%, 5.47% and 5.5%;
solve for the strip spread s. Note that this is one equation
and one unknown, but needs to be done on a computer.
What is S?
S=36.42%!