Yale School of Management 1 Emerging Market Finance: Lecture 13: Emerging Market Debt

Yale School of Management 2 The History of Emerging Market Debt Emerging market Debt at the turn of the Century The EM debt crisis in the 1980’s The EM Financial Crises 2

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5 The Brady Bond Market The Brady Plan for Mexico (1990) Characteristics of Brady Bonds:  U.S. dollar-denominated bond issued by an emerging market, particularly those in Latin America, and collateralized by U.S. Treasury zero-coupon bonds. (repayment of principal insured.)bondU.S. Treasuryzero-coupon bondsprincipal  Named for Treasury Secretary Nicholas Brady, who helped institute the program of debt-reduction.  The Brady bonds themselves are coupon-bearing bonds with a variety of rate options (fixed, variable, etc.), with maturities of between 10 and 30 years.maturities  Often include warrants for raw materials available in the country of origin or other options. 3

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Yale School of Management 11 Managing EM Bond Portfolio Risk: Adjusted Duration Model Adjusted Duration for international bond portfolios. (Thomas and Willner (1997)) Conventional model assumes world yield curve moves in lock step (i.e. parallel shift) Modified duration model allows for different sensitivity  AU =1.25,  FR =0.65,  JP =0.30, etc. Can you improve upon the Model? 4

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Yale School of Management 16 Step 1: U.S. Bond Rating Equivalent Evaluate each bond by its EM Score and classify it as to its stand along U.S. bond rating equivalent. We use a model based on the well documented and established U.S. Z-Score Approach. The EM-Score Model*: EM Score = (X 1 ) (X 2 ) (X 3 ) (X 4 ) whereX 1 = Working Capital/Total Assets X 2 = Retained Earnings/Total Assets X 3 = EBIT/Total Assets X 4 = Book Value Equity/Total Liabilities Rating EM Corporate Bonds

Yale School of Management 17 Step 2: Adjusted Bond Rating for Foreign Currency Fluctuation Vulnerability  Each bond is analyzed as to the issuing firm’s vulnerability to problems in servicing its foreign currency denominated debt if the local currency is devalued.  Vulnerability is assessed based on (1) the relationship between non-local currency revenues minus costs compared to non-local currency interest expense and (2) non-local currency revenues vs. non-local currency debt. Finally, (3) the level of cash is compared with the debt coming due in the next year.

Yale School of Management 18 If the firm has high vulnerability, e.g., low or zero non- local currency revenues and/or low or zero revenues/debt, and/or a substantial amount of foreign currency debt coming due with little cash liquidity, then the bond rating equivalent in step 1 is lowered by a full rating class, e.g., BB+ to B+. Average vulnerability results in a one-notch, e.g., BB+ to BB, reduction. There is no upgrade for a good vulnerability assessment.

Yale School of Management 19 Step 3: Adjustment for Industry Risk The original (step 1) bond rating equivalent is compared to the generic industry bond rating equivalent. For up to one full letter grade difference between the two ratings, step 2’s bond rating equivalent is adjusted up or down by one notch. For example, if the rating from step 1 is BBB and the industry’s rating is BBB-, BB+, or BB, then the adjustment is one notch down. If the difference is more than one full rating class but less than two full ratings, there is a 2-notch adjustment, etc.

Yale School of Management 20 Step 4: Adjustment for Competitive Position Step 3’s rating is adjusted up (or down) one notch if the firm is a dominant (or not) company in its industry or if it is a domestic power in terms of size, political influence and quality of management. It is possible that the consensus competitive position result is neutral (no change in rating).

Yale School of Management 21 Step 5: Adjustment for Market Value vs. Book Value of Equity Most Emerging Market Eurobond Issuers have public equity shares outstanding. Since market equity value should reflect expectations and book equity reflects historical values, we adjust the bond rating equivalent (BRE) for the market/book equity ratio. EM Scores and their bond rating equivalents are compared using the two measures of equity value. Where significant differences manifest, a further adjustment is made:

Yale School of Management 22 Adjustment Process: BRE (Book) vs. BRE (Market) BRE DifferenceAdjustment ± 0,1 Notch=None ± 2 Notches=± 1 Notch ≥ ± 3 Notches=± 2 Notches

Yale School of Management 23 Step 6: Bond Specific Adjustment Any unique aspects of the bond, e.g., collateral, guarantees, etc., could impact the final rating and spread. Step 7: Sovereign Risk Spread Adjustment  The next step in the process is to add the sovereign yield differential vs. comparable duration U.S. Treasury bonds to the yield spread of the bond based on its rating equivalent (BRE) from Step 5.

Yale School of Management 24 BRE = BBB U.S. BBB bond rating Spread (OAS) vs. U.S. Treasuries = 100 b.p. (1%) U.S. Treasury Yield = 6.5% U.S. T-Bond vs. Emerging Market Sovereign Yield = 300 b.p. (3%) Required Yield = 10.50% Example