Trading: Better Timing with Brady Bond Model

Among the many facts of life in financial markets is that today's disaster is tomorrow's money-making opportunity-if, that is, your timing is right.

Consider Brady Bonds and a new predictive model from J.P. Morgan that helps owners better time their purchase and sale. Devised by former Treasury Secretary Nicholas Brady, the bonds were basically Chapter 11 for nation states-the 1990 refinancing solution to the enornmous sovereign debt problem created by the U.S. bank's efforts to solve the problem of the Real Estate Investment Trust crash of the '70s. The problem for Bradys, issued to ten countries that pay coupons ranging from eight to 19.43 percent, is that they have call features based on asset values, which reduce their value. Luckily, most Brady countries' credit ratings are still lower than the trigger.

The irony is that the Third-World debt problem was built on the twofold idea that nations don't default, and that the potential of the Third World was so terrific that the loans would seem piffling once the economies of the borrowing nations began to grow, thanks to the loans. The idea was crushed by the size of the debts, most of the countries defaulted, and the banks found you can't foreclose on a country with an army. Thus Brady Bonds, to bail out the banks.

But then these economies-and their credit quality-actually did improve, making the refinancing of the debt both appealing and possible, though also potentially triggering the embedded call options. It was no idle threat; Mexico called their so-called Aztecs, worth $2.55 billion, in late February, and bondholders were paid in mid-March.

The ability to predict the exercise of those calls would allow trading and hedging; but in-house resources to create useful models aren't universally available to bondholders. J.P. Morgan's two-value options model, however, predicted the Aztec call. John Cadley, a J.P. Morgan vp who helped develop the model, says that it's critical for hedge traders to understand their durations, or, for these purposes, by what percentage the market value of the securities will change for each 100 basis point move in the market. The model lets owners of Bradys decide when the bond is in danger of being called, in turn revealing which bonds to buy or sell and when, thus profitting in the sovereign debt market.

-reinbach tfn.com

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