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The ABC of emerging market bonds

Flush with Opec petrodollars after the oil prices hikes of the seventies, a handful of New York money centre banks - Citi, J. P. Morgan, Chase Manhattan, Bank of America, Chemical, Manny Hanny - lent almost a billion dollars to governments in Latin America, Central Europe and Southeast Asia in a series of jumbo syndicated Euromarket loans. This debt carnival was known as "petrodollar recycling" Recession, soaring interest rates and the collapse of commodities as diverse as copper, crude oil, tin and even gold in the early 1980's forced borrowers such as Brazil, Mexico, Poland and Indonesia to the brink of default. Wriston was wrong. Countries did go bankrupt and not even a legendary Wall Street banker could send in the US Marines on gunboats to get his money back.

By the late 1980's, the fate of the American money centre banks was tied to the resolution of the Third World sovereign debt crisis. The MBA countries (Mexico, Brazil, Argentina) alone owed Wall Street bankers $600 billion. Uncle Sam was forced to get into the act to protect the bankers from the consequences of their own busted Third World sovereign loans. The magic formula for the resolution of the Third World debt crisis was a concept known as "securitisation." The basic idea was to convert the bankers loans into long term bonds, where the principal but not the interest payments, would be sold to pension funds, insurance companies and foreign central banks as a traded instrument on the global capital market. This was the genesis of the modern $500 billion emerging market bond markets that exist now.

Securitisation has been one of the most revolutionary financial innovations on Wall Street. Home mortgages, credit card debt, consumer loans, computer leases were pooled, packaged and sold as marketable securities by New York's investment bankers. For instance, the mortgage backed securities market now dwarfs even US Treasury bonds as the largest debt capital market in the United States. There was no reason why Third World debt could not be securitised via government guarantees from the IMF. Nicholas Brady, the American finance minister under the first Bush Administration, saw his name achieve financial immortality under the Brady Bond Programme.

The IMF played a critical role in the success of the Brady Programme. It provided a liquidity lifeboat to Third World government borrowers as long as they agreed to undertake economic, monetary, fiscal and even political reform. Mexico was the test case for the first Brady Program in 1989 where the Wall Street bankers forgave 35 per cent of Mexican debts in exchange to convert the balance into new dollar denominated 30 year Brady Bonds where the principal was backed by Uncle Sam, with zero coupon US Treasury bonds as collateral.

The Mexican Brady program was replicated in Brazil, Argentina, Poland, Nigeria, Philippines, Bulgaria and even Jordan. The bankers got some of their loans back, the IMF and the US Treasury got de facto economic control over sovereign borrowers in the Third World in exchange for fresh money and institutional investors who bought the new Brady Bonds in the international capital market got a liquid, high yield, dollar denominated bond with a principal guaranteed by the full faith and credit of the American government. The Brady Bond market is now almost $200 billion EM debt instruments such as "Par Bradys" C-bonds and "discount Bradys" are all variants of the original sovereign restructuring deals between Uncle Sam, the Wall Street bankers, the IMF and the sovereign borrowers in the early 1990's.The Brady Bond programme was Wall Street, Uncle Sam and the IMF's imprimatur of good financial housekeeping on a Third World borrower nation. It meant a sovereign debtor had agreed to undertake economic reform in the area of public finances, inflation, capital markets, currency exchange rates and free market macroeconomic policies.

In the early 1990's, the investor base for the Brady Bond programmes was primarily flight capital from Latin America squirreled in the private banks of Geneva and Miami. In fact, $10 billion of Mexican money held in offshore accounts was repatriated into Mexican Brady Bonds by the local elite. After the Gulf war, Chairman Greenspan slashed interest rates to 3 per cent as America struggled with the aftermath of the realestate, junk bond and leveraged buyout (LBO) crisis. This made high yield Brady debt a natural magnet for the New York bankers. Chase Manhattan, once the largest lender to Latin America jumbo sovereign loans in the 1970's, became a leading global player in Brady Bonds in the early 1990's. Soon enough, hedge funds and even foreign banks such as ANZ Grindlays Merchant Bank (the fabled Minerva House team, now Ashmore) or West Deutsche Landesbank created enormously profitable niche businesses in emerging market debt. PIMCO, the world's largest bond fund empire out in Newport Beach, California, built up a $10 billion emerging market debt portfolio, run by Dr. Mohammed El - Erian, an economist from Cambridge University, Salomon Brothers and the IMF. The world's major hedge fund kings, led by the billionaire George Soros of the Quantum Funds in New York, hired emerging market debt specialists to run their hugely profitable Brady Bond trading desks. In 1989, I finished my Wharton MBA thesis on the Brady plan under Dr. Arminio Fraga, a young Brazilian don who had just got his Ph.D from Princeton. A year later, Dr. Fraga was the managing director for Brady Bond trading at Soros Fund Management in midtown Manhattan.

New issue volume, liquidity and depth of the emerging market debt skyrocketed in the 1990's. London emerged as a rival to New York, primarily for Russian, Central Europe, South African, Arab and Southeast Asian sovereign bond trading. While Latin names still are 50 per cent of the tradable market for Brady's, Eurobonds and sovereign loans, this is now an authentic global capital market. Ina sense, the market is the offshore mirror to the US high yield corporate bond market. Most key emerging market debtors such as Russia, Brazil or Turkey are still not rated BBB by Standard and Poors, Moodys or Fitch, the minimum threshold for an investment grade "credit rating" Nor has the evolution of the Brady Bond market been without its share of financial crises and hike stakes global monetary panics. In December 1994, when Mexico devalued the peso amid a succession of steep interest rate hikes by the Federal Reserve, the panic sell off known as the "tequila effect" was felt across Latin America when Boris Yeltsin defaulted on Russian ruble debt in August 1998, the Third World sovereign debt market was hit by a financial neutron bomb, as leveraged hedge funds were forced to sell collateral Brady Bonds to meet margin calls, leading to a chaotic transmission of risk and panic across the world.

However, the market has matured since 1998. It is no longer dominated by hedge funds, Wall Street proprietary desk traders or flight capital but by institutional investors - often the biggest names in global finance - from the United States, Europe and the Far East. This is the reason why even Argentina, the biggest sovereign default in the history of global finance, had nowhere near the traumatic impact of Mexico in '94 or Russia in '98. Lower contagion risk, lower leverage and volatility of returns, tighter - bid offer spreads, rising sovereign creditworthiness, higher new issue volumes, more market makers and crossovers investors make this asset class an extremely valuable niche of the Euromarkets.