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# **BOX 1 - Brady Bonds: a primer**

Par and Discount bonds have been by far the most popular options in several Brady agreements. Par bonds are 30 years maturity (25 for Philippine Pars) issued at "par", i.e. for the original face value of the loans for which they were exchanged. Par bonds carry a fixed, below market interest rate (relative to the interest rate environment at the time of the issuance). Discount bonds are 30 years maturity floating market interest rate, issued at a discount to original face value of the previously rescheduled loans.

In general, both security types are collateralized as to principal at maturity by US Treasury zero coupon bonds. Par and Discount bonds may possess additional collateral in the form of a cash collateral account usually maintained at the Federal Reserve Bank of NY. The funds in these accounts, which are allowed to be invested in securities rated AA- or better, are maintained in order to pay interest for a specific number of months (usually from 12 to 18 months depending on the country) in the event that the sovereign debtor suspends the interest payments. In effect the collateral provides a "rolling" interest payments guarantee, meaning that if each successive interest payment is made and the collateral is not utilized, it is "rolled" or applied to guarantee the nearest dated unsecured semi-annual interest payment. If the collateral is drawn upon, it is not required to be replaced.

Certain Par and Discount bonds also carry "value recovery" warrants, which give bondholders the opportunity to "recapture" some of the debt and debt service reduction provided in the exchange if the future economic performance and/or the debt servicing capacity of the sovereign debtor improves. For example, in our sample Mexico, Venezuela and Nigeria bonds carry warrants linked to indices of oil export prices or of national oil export receipts.

The value assigned to the principal on Par and Discount bonds is simply the present value of the security used as a collateral. For dollar denominated bonds, the principal is discounted by the risk-free rate of a comparable maturity US Treasury zero-coupon bond.

The interest collateral of a Brady bond is a more complicated component to value since it is uncertain when, if ever, it will be used. This provides an occasion for differences in valuation approaches which arise from assumptions about the probable life of the "roll" of the collateral. One method assumes the limiting case, which ascribes the minimal value to the collateral's current market value, effectively treating it as if there was no life to the "roll" (i.e. default occurs today and collateral is utilized and exhausted to pay the nearest 2 or 3 semiannual interest coupons). Other methods rely on the use of probability models or option pricing formulas to assign probabilities to interest payment default, which are then incorporated in the valuation model.

@To obtain the stripped yield, the value of the principal and interest collateral is calculated as described above, and this notional "market value" of the collateral is subtracted from the current market price. After "stripping" out the values of the principal and interest collateral from the price, an internal rate of return is computed on the non-collateralized contractual cash flows. These non-collateralized interest flows should be discounted by a rate, the _stripped yield,_ that produces a present value which, when added to the collateralized portion of the bond, equals the current market price. The internal rate of return of a Brady bond cash flow with its collateral left intact is simply the bond's implied yield-to-maturity or _blended yield.@_ The value of the "value recovery" warrants, which are linked to the value of the country's oil exports, is usually ignored in the valuation of the bonds.

Swapping floating-rate coupons for fixed rate equivalents (using either the current LIBOR-based Eurodollar swap curve or forward rate curve) places all Bradies on equal footing with other sovereign instruments. In particular it makes possible to compute the _stripped spreads_ for all bonds.

_Source: The 1995 Guide to Brady Bonds. Merrill Lynch, December 6 1994._