What Are Brady Bonds?
- Brady bonds are sovereign debt securities, denominated in U.S. dollars (USD), issued by developing countries and backed by U.S. Treasury bonds.
- Brady bonds were first announced in 1989 as part of the Brady plan, named for then U.S. Treasury Secretary Nicholas Brady, which was introduced to help restructure the debt of developing countries.
- Brady bonds encourage investments and assure bondholders of timely payments of interest and principal since they are backed by the purchase of U.S. Treasuries.
Understanding Brady Bonds
Brady bonds are some of the most liquid emerging market securities. The bonds are named after former U.S. Treasury Secretary Nicholas Brady, who sponsored the effort to restructure emerging market debt of, mainly, Latin American countries. The price movements of Brady bonds provide an accurate indication of market sentiment toward developing nations.
Brady bonds were introduced in 1989 after many Latin American countries defaulted on their debt. The idea behind the bonds was to allow commercial banks to exchange their claims on developing countries into tradable instruments, allowing them to get nonperforming debt off their balance sheets and replace it with a bond issued by the same creditor. Since the bank exchanges a nonperforming loan for a performing bond, the debtor government's liability becomes the payment on the bond, rather than the bank loan. This reduced the concentration risk to these banks.
The program, known as the Brady Plan, called for the U.S. and multilateral lending agencies, such as the International Monetary Fund (IMF) and the World Bank, to cooperate with commercial bank creditors in restructuring and reducing the debt of those developing countries that were pursuing structural adjustments and economic programs supported by these agencies. The process of creating Brady bonds involved converting defaulted loans into bonds with U.S. Treasury zero-coupon bonds as collateral.
Brady bonds were named for Nicholas Brady, the former U.S. Treasury Secretary—under Presidents Ronald Reagan and George H. W. Bush—who led the effort to restructure emerging market debt.
Brady Bonds Mechanism
Brady bonds are mostly denominated in U.S. dollars. However, there are minor issues in other currencies, including German marks, French and Swiss francs, Dutch guilders, Japanese yen, Canadian dollars, and British pounds sterling. The long-term maturities of Brady bonds make them attractive vehicles for profiting from spread tightening.
In addition, the payment on the bonds is backed by the purchase of U.S. Treasuries, encouraging investments and assuring bondholders of timely payments of interest and principal. Brady bonds are collateralized by an equal amount of 30-year zero-coupon Treasury bonds.
Issuing countries purchase from the U.S. Treasury zero-coupon bonds with a maturity corresponding to the maturity of the individual Brady bond. The zero-coupon bonds are held in escrow at the Federal Reserve until the bond matures, at which point the zero-coupons are sold to make the principal repayments. In the event of default, the bondholder will receive the principal collateral on the maturity date.
Brady Bonds Investing Risk
- Interest rate risk is faced by all bond investors. Since there is an inverse relationship between interest rates and bond prices, fixed income investors are exposed to the risk that prevailing interest rates in the markets will rise, leading to a fall in the value of their bonds.
- Sovereign risk is higher for debt issued by countries from developing or emerging countries, given that these countries have unstable political, social, and economic factors in terms of inflation, interest rates, exchange rates, and unemployment statistics.
- Credit risk is inherent in emerging market securities given that most will not be rated as investment grade, Brady bonds are classified as speculative debt instruments. Investors are exposed to the risk of the issuing country defaulting on its credit obligations—the interest and principal payments on the bond.
In view of these risks, emerging market debt securities generally offer investors a potentially higher rate of return than is available from investment-grade securities issued by U.S. corporations. In addition to the higher yield on Brady bonds, the expectation that the issuing country's creditworthiness will improve is a rationale that investors use when purchasing these bonds.
While appealing to some market participants interested in emerging market debt, Brady bonds are also risky in that they expose investors to interest rate risk, sovereign risk, and credit risk.
Example of Brady Bonds
Mexico was the first country to restructure its debt under the Brady Plan. Other countries soon followed, including:
- Costa Rica
- Cote d'Ivoire
- The Dominican Republic
- The Philippines
The success of these bonds in restructuring and reducing the debt of participating countries was mixed across the board. For example, in 1999, Ecuador defaulted on its Brady bonds, but Mexico retired its Brady bond debt completely in 2003.