Brady Bonds2

Brady bonds are dollar-denominated bonds, issued mostly by Latin American countries in the 1980s, named after U.S. Treasury Secretary Nicholas Brady.

History

Brady bonds were created in March 1989 in order to convert bonds issued by mostly Latin American countries into a variety or "menu" of new bonds after many of those countries defaulted on their debt in the 1980's. At that time, the market for sovereign debt was small and illiquid, and the standardization of emerging-market debt facilitated risk-spreading and trading. In exchange for commercial bank loans, the countries issued new bonds for the principal and, in some cases, unpaid interest. Because they were tradeable and came with some guarantees, in some cases they were more valuable to the creditors than the original bonds.

The key innovation behind the introduction of Brady Bonds was to allow the commercial banks to exchange their claims on developing countries into tradeable instruments, allowing them to get the debt off their balance sheets. This reduced the concentration risk to these banks.

The plan included two rounds. In the first round, creditors bargained with debtors over the terms of these new claims. Loosely interpreted, the options contained different mixes of "exit" and "new money" options. The exit options were designed for creditors who wanted to reduce their exposure to a debtor country. These options allowed creditors to reduce their exposure to debtor nations, albeit at a discount. The new money options reflected the belief that those creditors who chose not to exit would experience a capital gain from the transaction, since the nominal outstanding debt obligation of the debtor would be reduced, and with it the probability of future default. These options allowed creditors to retain their exposure, but required additional credit extension designed to "tax" the expected capital gains. The principal of many instruments was collateralized, as were "rolling interest guarantees," which guaranteed payment for fixed short periods. The first round negotiations thus involved the determination of the effective magnitude of discount on the exit options together with the amount of new lending called for under the new money options.

In the second round, creditors converted their existing claims into their choice among the "menu" of options agreed upon in the first round. The penalties for creditors failing to comply with the terms of the deal were never made explicit. Nevertheless, compliance was not an important problem under the Brady Plan. Banks wishing to cease their foreign lending activities tended to choose the exit option under the auspices of the deal.

By offering a "menu" of options, the Brady Plan permitted credit restructurings to be tailored to the heterogeneous preferences of creditors. The terms achieved under these deals indicate that debtors used the menu approach to reduce the cost of debt reduction. Furthermore, it reduced the holdout problem where certain shareholders have an incentive to not participate in the restructuring in hopes of getting a better deal.

The principal amount is usually but not always collateralized by specially issued U.S. Treasury 30-year zero-coupon bonds purchased by the debtor country using a combination of International Monetary Fund, World Bank, and the country's own foreign currency reserves. Interest payments on Brady bonds, in some cases, are guaranteed by securities of at least double-A-rated credit quality held with the Federal Reserve Bank of New York.

Countries that participated in the initial round of Brady bond issuance were Argentina, Brazil, Bulgaria, Costa Rica, Dominican Republic, Ecuador, Mexico, Morocco, Nigeria, Philippines, Poland, Uruguay.

Types

There are two main types of Brady bonds:

• Par bonds were issued to the same value as the original loan, but the coupon on the bonds is below market rate, principal and interest payments are usually guaranteed.
• Discount bonds were issued at a discount to the original value of the loan, but the coupon is at market rate, principal and interst payments are usually guaranteed.

Other, less common, types include front-loaded interest-reduction bonds (FLIRB), new-money bonds, debt-conversion bonds (DCB), and past-due interest bonds (PDI). Brady Bond negotiations generally involved some form of "haircut" - meaning that the value of the Bonds resulting from the restructurings was less than the face value of the claims before the restructurings. For Par Bonds, creditors kept the same face value, but received a below-market interest rate, while for Discount bonds, investors received a market interest rate on a lower bond face value.

Guarantees attached to Brady bonds include collateral to guarantee the principal, rolling interest guarantees, and value recovery rights. Not all Brady bonds will necessary have all of these forms of guarantee and the specifics will vary from issuance to issuance.

Current status

Although the Brady Bond process ended during the 1990s, many of the innovations introduced in these restructurings (call options embedded in the bonds, "stepped" coupons, Pars and Discounts) were retained in the later sovereign restructurings in, for example, Russia and Ecuador. Ecuador, in 1999, became the first country to default on its Brady bonds. In 2003, Mexico became the first country to retire its Brady debt.