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Birth of the A-Bond

Sep 1, 2005

Brazil exchanged its benchmark Brady C-bond with a new, improved bond called the A-bond, thanks to some clever liability management.

The Brazilian Treasury marked the end of an era in emerging markets in August, when it replaced 80% of its C-bonds with a new bond named the A-bond. For many years, the C-bond (or Front Loaded Interest Reduction with Capitalization Series L Bond) was the most liquid emerging-market bond and the benchmark for the asset class.

But Brazil wanted to rid itself of the stigma attached to the so-called Brady bonds, issued as part of the debt restructurings orchestrated in the early 1990s by former US Treasury Secretary Nicholas Brady. In a deal last month led by JP Morgan and CSFB, Brazil eliminated the biggest Brady bond of all and saved itself some money as well.

"The C-bond was trading outside the curve," says José Antonio Gragnani, assistant secretary at the National Treasury, "so it was pushing up Brazil's country risk. [The new bond] is highly beneficial." Investors agree. "This was a win-win both for Brazil and for investors," says a major US emerging-market portfolio manager.

Broader Appeal
Many institutional investors could never buy the C-bond, even though it has more than doubled in price since September 2002, because it was issued as part of a debt restructuring. The market for the plain vanilla A-bond is therefore much wider. Furthermore, unlike its predecessor, the A-bond has no cap on price appreciation. The C-bond was callable at par once every six months (in April and October). As long as the C-bond traded below par, this was no problem for investors. The C-bond began trading above par from time to time starting in 2004, but the threat of a call at par limited its upward movement. "If you believe this is an improving credit, as we do, you want that upside," says the portfolio manager. The market quickly drove the yield down, with the A-bond trading at 103.25 ten days after launch. The C-bond was retired at 101.25.

Brazil won an extended tenor in the exchange without conceding any extra yield. JP Morgan and CSFB set the coupon at 8%, the same as the C-bond, and took bids on the new bond's tenor. After sounding out the market they set the maximum extension on the C-bond, due to expire in April 2014, at four years. In the end, investors were happy to go to the long end – the extension set in the auction was three years and nine months.

"Investors simply exchanged a bond worth one price for another bond worth the same price," says Moctar Fall of JP Morgan, joint manager. "Brazil gave up the call feature, and for that investors were willing to extend the tenor. We could have fixed the maturity and had investors bid on price, but investors have more ownership of the outcome when you do it this way. It was very simple and very successful."

Amortization
Extending the tenor was important for Brazil because both the C-bond and the A-bond are amortizing bonds. Delaying maturity by almost four years gave Brazil a payment holiday. That is significant because Brazil has a heavy amortization schedule of $6 billion-$7 billion a year between 2005-2007. It will now be spared two annual payments of $300 million each for the next four years.

Investors tendered $4.4 billion in C-bonds, out of $5.6 billion outstanding. It seems likely that Brazil will now exercise its call on the remaining $1.2 billion in October. Investors expect the Treasury to examine its options for retiring other Brazilian Brady Bonds, with a market value of about $7.8 billion. The Treasury is unlikely to take the same route as it did with the C-bond because these Brady Bonds are not callable and most trade below par.

The success of the C-bond swap is a demonstration of investor confidence in Brazil, even though the deal took place in the middle of a nasty political corruption crisis (see "Stormy Seas," p.41). Even worse, the day the offer expired on July 21 was also the day China revalued the renminbi and London was gripped by a terrorist scare. Far from being derailed by these events, Brazil's A-bond surged ahead. LF



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