Calling for the End of Latin Brady Bonds
By Margaret Elliott
It's the end of an era. Brady bonds—a nasty reminder of the fragility of the Latin American economies—are disappearing. Some $19.5 billion in Bradys have been retired in the past 12 months, mostly from Latin America. From Mexico and Brazil to the latest entrants in the Brady swap business, Argentina and Venezuela, the fixed-income landscape of Latin America is changing. And the change opens up new opportunities for derivatives players in the region.
Basically it's a good-news story. The economies of these four major Latin countries have stabilized. Even more attractive for investors and traders, neither the stock nor bond markets have been unduly affected by the currency turmoil in evidence in southeast Asia since late spring. Certainly, the Latin markets felt tremors, but by September it was clear that this currency crisis was not catching.
Between sovereign and corporate debt issuance, the Latin American bond markets now sport a wide variety of instruments and maturities, and the over-the-counter derivatives markets in these countries are flourishing, particularly as the retirement of Brady bonds means that the underlying instruments represent pure plays on these economies. "Bradys were always a confusing instrument to price off,” says Hari Hariharan, managing director of Santander Investment in New York. "The fact that U.S. Treasuries were involved meant that there was at least a 40 percent correlation with the U.S. bond market.”
Sovereign fixed-income instruments in Latin American countries come in three types: local currency bonds, global hard-currency-denominated Eurobonds and Brady bonds. The latter are a holdover from the dog days of economic crisis; Brady bonds are securitized versions of distressed commercial debt issued as international, mostly dollar-denominated bonds collateralized by U.S. Treasury bonds. Local currency bonds—the fastest-growing area of the Latin fixed-income markets—are quite short-term in nature, often under one-year. In addition to the Brady's, derivatives players are most interested in the global bonds. Those that are issued to replace Bradys are often 20 to 30 years in duration, and most countries have also issued a chunk of brand new debt, Eurobonds, alongside. Between the amortizing Bradys and the new globals, a hard currency yield curve is emerging in Latin America, particularly in Brazil, Mexico and Argentina.
|"Theoretically, a Brady can be valued via stripped yield over Treasuries. In practice, it is impossible to match the yield on a dynamic basis.”
senior vice president and head of global emerging market options, ING Barings
One trading strategy in the new globals (and the extant Bradys) is to play one instrument off against another. "As the amount of new global bonds increases, so to do liquidity and interest,” says Benoit Ruaudel, head of emerging markets fixed income, North America, at Societe Generale in New York. "Technically, not having the Treasury collateral makes these bonds easier to trade, but the pure country risk makes them less volatile, as are the underlying economies.”
In addition, the new globals are bringing in a whole new set of investors. "Many traditional Eurobond investors cannot or are not willing to invest in Bradys,” says Ruaudel. "But the new swapped or exchanged globals are seen as Eurobonds, even when they are not issued through the normal syndication process.” (A Brady swap usually involves just one bank, not a syndicate.) These investors provide liquidity to both the underlying and the options.
The new globals have other attractions to derivatives players. These bonds are easy to value, unlike Bradys which are callable, have principal and interest guarantees, and oil warrants in some cases. "Theoretically,” says Mohamed Grimeh, senior vice president and head of global emerging market options at ING Barings, "a Brady can be valued via stripped yield over Treasuries. In practice, it is impossible to match the yield on a dynamic basis because you cannot sell the rolling interest guarantee or the oil warrants for their theoretical values.”
Now that the globals have arrived in enough size—$3 billion from Brazil, $2.75 billion from Mexico, $4.25 billion from Argentina and $4 billion from Venezuela—interest is growing on options on the globals. The presence of globals gives options dealers more flexibility in hedging credit volatility. "In the past, if a customer bought a large Mexico par option from me, I had to go out and buy back either the Mexican par volatility or Mexico discount and U.S. Treasury volatility. Now I can look at the UMS 16 and 26 and buy the cheapest hedge.”
Another trade hedge funds are fond of is using Latin American options, both on Bradys and globals, as proxies for a view on U.S. Treasuries. "It is cheaper to take a view on U.S. Treasuries in Latin American instruments because the volatility is often mispriced.” An option on a global bond is an option on credit spreads combined with U.S. interest rates. "Depending on your view on future correlation between spreads and interest rates, global bond options might look underpriced and overpriced against Treasury volatility,” says Grimeh.
Fixed-income investors of all stripes have been flocking to Latin America this year. "One impetus,” says Santander's Hariharan, "is the need to get money out of Asia.” But it isn't the only reason. "Local currency bonds in Latin America—in all the emerging markets, save Asia—have had a big year,” says Robert Hedges, managing director of ING Barings. "The returns from local currency bonds have outpaced those of Bradys or hard-currency bonds.” He says returns for a portfolio of Latin local bonds would have yielded 15 percent to the end of August, while a similar mix of Bradys and hard currency globals would have only brought home 12 percent. "Yet many fixed-income investors see the need to hedge some of these exposures and there aren't enough exchange-traded products to do the job.”
|"Technically, not having the Treasury collateral makes these bonds easier to trade, but the pure country risk makes them less volatile, as are the underlying economies.”
head of emerging markets fixed income, North America, Societe Generale
While most investors in local currency bonds are looking for the full upside (or downside) of both capital appreciation and currency kick, some investors seek to limit the downside or ensure the ability to get any profit at the end of the term. The way to do this, says SocGen's Ruaudel, is through a simple stop-profit hedge. "If you buy local six-month T-bills when the local currency is weak, and the currency recovers or remains stable after the first three months, then you buy a nondeliverable forward to lock in the profit,” he explains.
Hard-currency-denominated bonds will continue to be attractive as the pricing on the most recent Brady swaps shows. Ven-ezuela's recent successful swap was priced at just 325 basis points above the equivalent U.S. Treasury. Nevertheless, money managers ate up the issue. Since anyone holding a relevant bond can put it up for trade, issuing countries never quite know what the take-up will be. In Venezuela's case, they figured on roughly $2 billion. In the event, $3.5 billion in Bradys were swapped and an additional $500 million in new bonds were issued.
Only days later, Argentina stepped up with another $2.25 billion global, swapped for $2.39 billion in outstanding Bradys. The price: 300 basis points over Treasuries. And Panama, a new entrant as well, issued $700 million in new globals at a slim 250 over 30-year Treasuries.
With all these new bonds, the yield curve environment of Latin American bonds is changing dramatically, says ING Barings' Grimeh. Now for each country you have two relatively liquid yield curves, the global and the Brady. As Brady buybacks and the issuance of new globals continues, the two curves will converge. As liquidity increases, eventually you will see the derivatives market expand, as it has in the developed markets, to include credit derivatives, swaptions, caps and floors.
But don't write off Bradys just yet. Some $125 billion are still outstanding and it will be five to six years before they all disappear, according to Santander Investment. Nevertheless, the chopping and changing in the Latin American fixed-income markets could yield some profitable pickings for derivatives players as the new instruments and old combine to provide interesting arbitrage possibilities.