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Retiring the Bradys

Nov 1, 1999

Brazil joins the growing trend-offering paper that's more liquid but equally high-yielding.

Arminio Fraga
Brazil has rarely cut the same dash on the world's secondary bond markets as other Latin sovereigns, such as Argentina and Mexico, which often swoop into the markets with audacious, well-timed swaps. But that may be changing. Brazil is becoming less of a wallflower these days, as the team of Central Bank President Arminio Fraga has shown with a $2 billion Brady swap in October.

As such, it has joined a growing number of countries using the bear market in Bradys to retire debt, smooth out yield curves and save money to boot. Fraga and his team brought the sovereign to market a week after Uruguay retired Bradys and, by many accounts, will be followed by other sovereigns like Venezuela gearing up for similar deals.

Daniel Gleizer, the central bank's director of international affairs, was jubilant. He said the operation was a "spectacular" success. "We are killing several birds with one stone with this operation. [We are] increasing reserves, reducing and improving the profile of our foreign debt. We came back with a foreign debt that was $900 million smaller and even [increased] our reserves." Specifically, the central bank retired $2.9 billion in various types of Brady bonds, including highly liquid C bonds, in exchange for $2 billion in 2009 global bonds.

This was Brazil's first full-blooded Brady swap since Thailand's financial crash in 1997 detonated the emerging-market crisis.

According to lead managers Chase Securities and JP Morgan, the deal releases $520 million locked up in US Treasury zero coupon bonds used to back collateralized bonds and allows Brazil to realize $205 million in savings since it no longer needs to service bonds withdrawn from the market.

The exchange gave investors the opportunity to switch out of illiquid discount and par bonds and move into more liquid but equally high-yielding globals. The swap also had the advantage of calming market fears that Ecuador's default on its Brady bonds in September would contaminate the other Latin borrowers.

Changing Its Ways
Gleizer says markets should expect more deals like these from Brazil whenever conditions are appropriate. The central bank, now under the control of market-hardened professionals, is shedding its reluctance to rapidly enter markets and exploit opportunities as they arise. Mexico, for instance, often mounts such opportunistic deals. Brazil's deal followed a lightning Mexican operation led by Goldman Sachs to retire $525 million of Bradys for $425 million in 2009 global bonds. In August it retired $510 million worth of Bradys.

This deal followed a previous exchange offer that was not as well received. The earlier deal was a $3 billion, five-year global bond in April led by Salomon Smith Barney and Morgan Stanley Dean Witter. The issue raised $2 billion in cash and included a swap mechanism that also retired $1 billion in Bradys, but observers criticized the central bank for overpaying and flooding the market with relatively short dated paper. Coming quickly to its own defense, the bank responded that the operation was intended both to raise new money and mark the end of Brazil's currency crisis, which had seen the real collapse by over 30% since January.

This time around, though, the intention was very different. The October swap was more about liability management than raising fresh money or making a statement. Indeed, Gleizer decided to scrap a planned cash portion altogether because market conditions were so rough on October 15, when the bonds were priced. By not hitting investors for cash then, Brazilian officials further ensured that the second swap would do well.

Cindy Powell, managing director at Chase Securities in New York, says the swap was planned to start tidying up the cluttered market in Brazilian risk. The savings and gains from collateral were an added bonus. She says probably more so than in any other Latin American country with Brady bonds, the existence of those bonds in Brazil's yield curve is a distorting factor. Furthermore, Brazil's C bond is one of the most liquid emerging-market securities in the world, which investors tend to treat as a proxy for less accessible Latin and Asian equity and fixed-income assets. Whenever fund managers are hurt elsewhere in the region or in Asia, they habitually sell C bonds to cut their exposure or realize profits.

Although Brazil still has a considerable mass of Bradys outstanding, the swaps enable it to gradually chip away at bonds that are widely considered to be particularly undesirable assets since they represent defaulted debt from the crises of the early 1980s. As Brazil and other Latin countries struggle with market-oriented reforms, the debt crises of nearly 20 years ago are something that they would rather leave behind.

Powell says that chiseling away at the overhang of Bradys should also make it easier for public and private sectors to access markets in the future. "Investors always point to [Brazil's sovereign yield curve] and say that they can buy the discount [yielding] 1,200 basis points over Treasurys and are more liquid than the globals. The number of Bradys is very substantial [but] over time it will be whittled away," she notes. Icaza adds that the swap has smoothed out the yield curve. "The 2008 is not traded much and we have placed a [2009] point on the 10-year curve, which is more liquid because of its size. You rationalize the curve."

Still Criticized
However, as they were in April, Fraga and Gleizer are being criticized for paying too much, misjudging the time of the operation and not winning better terms. The swap was launched after US share prices resumed their decline, the benchmark C bond kept heading down and the real was testing the R$2.00 per dollar level, its lowest point since March. On the eve of the deal's closing, ING Barings emerging market team in New York noted that the debt "profile adjustment is imperceptible in the broad context of all [Brazil's] bonded debt. Brazil is financing its short-term financial needs by cashing in the collateral while at the same time substituting higher-coupon, shorter-maturity bonds."

Barings added that historically, the outcome of Brazil's exchanges of Bradys for eurobonds has been mixed. For example, investors who exchanged par bonds for 2027s in June 1997 had to wait almost two years to match the return achieved by discounts. It estimated that between then and June 1998, the global eurobond 2027 returned as much as 25% less than the pars.

Although it is true that Brazil is paying the highest coupon ever on an international bond at an 14.5%, Gleizer judged it a price worth paying. This was probably his last chance to access the market this year as anxiety starts rising over the possible impact of the year 2000 bug on the world financial system. At the end of October, CSFB and Deutsche Bank placed E500 million in seven-year eurobonds for Brazil with a coupon of 12.11%, or 685 basis points above the corresponding Bund. The sale further stretched out Brazil's euro bond curve, following its issue earlier in the year of three- and five-year euro paper. But analysts said Y2K concerns forced Brazil to pay a premium to the secondary market prices of these securities. Brazilian officials say they hope to continue selling more bonds in the weeks ahead, if market conditions remain favorable.

Gleizer has said Brazil will probably carry out more swaps in 2000. Brazil's central bank is undergoing a culture change as younger men with market and investment banking backgrounds take over from academics and bureaucrats.

Fraga, 42, spent six years on Wall Street as a managing director at Soros Fund Management before President Fernando Henrique Cardoso appointed him to the central bank in March.

Fraga is widely regarded as one of the brightest and most innovative financiers of his generation. Gleizer was previously research director at CSFB Garantia, the bucaneering Sao Paulo investment bank where Fraga also once worked.

Avoiding Flamboyance
Still, bankers doubt Brazil's future market incursions will be as flamboyant as Mexico's or Argentina's. Congress, deeply suspicious of financial markets, is keeping a wary eye on their activities and an aggressive media is constantly on the lookout for any hint of impropriety. Fraga and his team may have a considerable reputation for personal integrity, but they cannot afford to offend powerful politicians who have a limited grasp of high finance. In April, senators detained Francisco 'Chico' Lopes, Fraga's predecessor at the central bank, for refusing to answer a Senate committee's questions about his personal finances and the circumstances surrounding the real crisis in January. A banker commented "there is no doubt that Arminio is interested in being flexible, but private deals have a strange connotation for the Brazilians."

In any case, most bankers advise against excessively complex deals that then need to be sold to a broad range of investors. In May, the government's Banco Nacional de Desenvolvimento Economico e Social (BNDES) and Goldman Sachs had to pull a debt swap because it was so complicated. Under the plan, investors would have been able to exchange about $22.5 billion in Brazilian corporate debt for new 10-year BNDES debt. The deal failed partly because the corporates, who were not consulted, felt their image in the markets would suffer. Above all, though, the transaction flopped because it was so complex that even professional bond analysts struggled to understand its intricacies.

Says Chase's Powell: "One of the reasons [our] deal was successful was because it was real simple. [When] you deal with a large number of investors, institutional investors, commercial banks and guys doing it for the first time, it is the 'Keep it simple' principle that works."

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