Brady Bonds Definition
Brady bonds are a form of government bond. Governments of emerging or developing economies issue brady bonds in an attempt to minimize the nation’s external debt. Brady bonds are liquid in nature, that is, they are financial instruments that can be converted to cash easily, within a short period of time, and at a fair price.
Bardy bnds were named after Nicholas Brady, the secretary of the United States Treasury who proposed a debt-reduction agreement for developing countries in 1989. Brady bonds convert bank loans to new bonds as part of the attempt to revamp the emerging market debt. When it was first created, it was mostly issued by Latin American countries.
A Little More on What is a Brady Bond
After many countries, including Latin American countries, defaulted their debt in the 1980s, Brady bonds were introduced. It is a bailout strategy from the emerging market debt at that time, it was created in 1989.
Primarily, Brady bonds allowed commercial banks to exchange their claims on developing countries, with the introduction of Brady bonds, developing countries are able to remove default debt usually called non-performing debt from their balance sheets. These non-performing debts are however replaced by new bonds (performing bonds) that the same creditor issues.
As part of the efforts to restructure emerging market debt, agencies such as the IMF, the World Bank, and some others are expected to liaise with the commercial bank creditors so as to reduce the debt of developing countries.
When using Brady bonds, defaulted loans are converted into zero-coupon bonds with the United States Treasury. Brady bonds are collateralized and these bonds can be held in Federal Reserve escrow until their maturity date.
The first country to use the Brady (bond) plan was Mexico before other countries like Brazil, Bulgaria, Argentina, Peru, Nigeria, Jordan, among others embraced it.
Despite the appealing nature of Brady bonds, there are certain risk that investors are exposed to. These include credit risk, sovereign risk and interest rate risks. No investor can evade interest rate risk, this is due to the interaction between bond prices and interest rates.
Sovereign risk on the other hand can be higher when a debt is issued by an emerging country with traits such as instability in politics and economy or factors like inflation and exchange rates. Brady bonds are speculative debt instruments because the financial instrument entails notable risk to the investment principal. Also, investors are faced with the risk of default by the issuing country. However, brady bonds offer higher rates of return to investors.
References for Brady Bonds
Academic Research on Brady Bonds
Estimating the likelihood of Mexican default from the market prices of Brady bonds, Claessens, S., & Pennacchi, G. (1996). Journal of Financial and Quantitative Analysis, 31(1), 109-126.
Estimating a risky term structure of Brady bonds, Keswani, A. (2000).
Managing fiscal policy in Latin America and the Caribbean: Volatility, procyclicality, and limited creditworthiness, Gavin, M., Hausmann, R., Perotti, R., & Talvi, E. (1996).
International financial architecture for 2002: a new approach to sovereign debt restructuring, Krueger, A. (2001). Address given at the National Economists’ Club Annual Members’ Dinner. Washington, DC. American Enterprise Institute. November, 26.
The Risks and Returns of Brady Bonds in a Portfolio Framework, Dahiya, S. (1997). Financial Markets, Institutions & Instruments, 6(5), 45-60.
Common factors in emerging market spreads, McGuire, P., & Schrijvers, M. (2003).
Estimating a risky term structure of Brady bonds, Keswani, A. (2005). The Manchester School, 73, 99-127.
Hedging the interest rate risk of Brady bonds, Boudoukh, J., Richardson, M., & Whitelaw, R. (1996).
What credit market indicators tell us, Duca, J. V. (1999). Economic & Financial Review, 2.
A primer on Brady bonds, Lee, S. Y., & Venezia, M. E. (2000).Report of Emerging Markets Fixed Income Research Institute based in Salomon Smith Barney, March, 9.