NYU Stern School of Business | Full-time MBA, Part-time ...



Marketbrief

Introducing the Emerging Markets Bond Index Plus (EMBI+)

• The EMBI+, an extension of our EMBI, tracks all of the external-currency-denominated debt markets of the emerging markets

• Well-defined liquidity criteria ensure that the index

provides a fair and replicable benchmark

• Daily historical levels are available from December 31, 1993

Overview

The J.P. Morgan Emerging Markets Bond Index Plus (EMBI+) tracks total returns for traded external debt instruments in the emerging markets. Included in the index are U.S. dollar-and other external-currency-denominated Brady bonds, loans, Eurobonds, and local markets instruments. Thus, the EMBI+ expands upon our EMBI, which covers only Brady bonds, extending the market benchmark to most strategic investment opportunities readily available in the emerging markets (see Exhibit 1).

The EMBI+ is the fourth in our family of emerging markets indices. It covers the external-currency debt markets. Our original emerging markets index, the EMBI, covers only Brady bonds and has more restrictive liquidity criteria. The LEI, our Latin Eurobond index, covers Eurobonds of over US$100 million in size, but only from Latin America. Finally, the South Africa Bond Index (SABI), our only local-currency index, is completely separate from all of the other indices.

In addition to serving as a benchmark, the EMBI+ provides investors with a definition of the market for emerging markets external-currency debt, a list of the traded instruments, and a compilation of their terms. The EMBI+ currently includes 49 instruments from 14 countries, with a total face value of US$175 billion and a market capitalization of US$98 billion. This market capitalization equals about 3% of the non-U.S. portion of our world government bond index.

The EMBI and the EMBI+ are highly correlated (.98), and thus their monthly returns are quite similar (see Exhibit 3). Due to the added country diversification, the volatility of the EMBI+ is usually lower than that of the EMBI. In the 18 months ending June 30,1995, the EMBI+ returned - 11.33% in U.S. dollars.

Since the EMBI+ covers external-currency debt, we have defined emerging markets countries according to the ability to repay external-currency-denominated debt and have chosen a credit ceiling of BBB+/Baal. Corporates from these countries are also eligible, since rating agencies limit corporate external-currency debt ratings to the country's sovereign credit ceiling.

In this publication, we describe the origins and history of the emerging markets, explain our methodology for constructing the EMBI+, and analyze the index's current composition.

History

We include several asset types in the EMBI+: Brady bonds, loans (performing and nonperforming), U.S. dollar local markets instruments, and Eurobonds. Brady bonds, which currently make up the largest segment of the market, are bonds that have been restructured from defaulted commercial bank loans. The loans in the index are of two types, defaulted loans awaiting a (Brady or other) restructuring and performing loans, which trade more as bonds. Currently, the only U.S. dollar local markets instruments in the EMBI+ are Argentine instruments. The last asset type, the Eurobonds, is the newest one, representing the primary market for issuance by emerging markets countries.

Nonperforming loan market

Two of the asset types in the EMBI+, loans and Brady bonds, are structurally related. With the exception of Russia Vneshekonombank loans, all of the nonperforming loans in the EMBI+ have been restructured or are awaiting a restructuring into Brady bonds. These loans were either previously restructured loan agreements or unstructured loans, pools of which were formed for the purpose of trading.

Trading of these loan pools among their original commercial bank creditors began to pick up around 1987. In 1988, Mexico conducted the first loans-for-bonds exchange, in which loans were exchanged for discounted "Aztec" bonds, the first such securitization in the market. Later that year, Brazil restructured some of its bank debt into par "Exit" bonds and negotiated new bank lending in the form of "New Money" bonds. Although Mexico's and Brazil's arrangements preceded any formal Brady agreements, the bonds that resulted were traded, along with Brady bonds, in the Brady market that formed two years later.

Brady bond market

The first formal Brady plan (named after former U.S. Treasury Secretary Nicholas Brady) was negotiated by Mexico and implemented in March 1990. Although the details of subsequent Brady deals have differed, they have largely followed the blueprint laid down by Mexico. Negotiations have usually proceeded in tandem with a country's discussions with the IMF and other multilateral institutions. The IMF's role has been to advise each country regarding economic policy in order to ensure that its economy is healthy by the time of the exchange. The goal of past Brady plans has been to make the country's debt more serviceable by lightening its debt load through both principal and/or interest forgiveness and longer maturities. An added benefit has been the securitization of the loans into bonds, thus broadening the investor universe and lowering future financing costs. The use of collateral, usually financed by the multilateral agencies, has been intended to attract buyers by ensuring that principal and certain interest payments would be made.

Negotiations over the terms of Brady agreements have typically centered around the "menu" of bond options to be made available, the possible buyback of loans ahead of the exchange, the treatment of interest arrears, and the timing of the exchange. All of these factors have weighed heavily on the prices of the loans, since by the time of these negotiations a loan's price reflects the expected Brady terms.

The timing of the exchange has generally been set after the country has reached an agreement in principle with the banks. Usually, a date when the underlying loans will cease trading has been set prior to the exchange date, so that the interest arrears can be completely settled before the exchange. In some cases (as with Brazilian MYDFA and Ecuadorian Consolidation loans), interest arrears have been partially settled through the issuance of bonds before the formal Brady exchange date. In other cases, arrears have been settled in cash at the time of the exchange.

In general, around the time each loan ceased trading, a market developed in when-, as-, and if-issued (w/i) Brady bonds. Concurrently, in some cases a much less liquid market developed in loan "participations." An investor buying a participation from an original holder of a loan typically received the rights to any interim cash flows on the loan and to the bonds for which it was to be exchanged. Finally, on the exchange settlement date, creditors and participants received the newly issued bonds, with w/i trades settling the same day.

The menu of possible Brady bonds evolved with each new Brady agreement, as negotiations yielded new instrument variations and types. Each bond type has been designed both to benefit the country in some way (e.g., allowing principal reduction via discounted exchange, interest reduction via below-market fixed coupons, or new lending) and to offer the investor something in return (e.g., collateral or market interest rates). The earlier agreements, completed during the falling interest-rate environment of 1993-94, saw an emphasis on fixed-rate bonds, while subsequent agreements have seen a shift to floating-rate bonds.

For new investors, one of the most confusing aspects of the Brady market is the nomenclature, which has developed along with its bonds. In many instances, similar types of bonds have been given different names. For example, bonds issued for interest arrears have been named simply "PDI bonds" (Past Due Interest bonds) but also "IDU bonds" (Interest Due and Unpaid bonds) and "EI bonds" (Eligible Interest bonds), as well as “FRB bonds" (Floating-Rate bonds). A list of previous Brady agreements and their resulting bonds can be found in Exhibit 4. (The specific terms and conditions of each bond are available in the Emerging Markets Debt Directory, December 30, 1994. General information on the Brady market can be found in The Brady Market, June 17, 1994.)

U.S. dollar local markets instruments

Currently, the only local markets bonds eligible for the EMBI+ are Argentine dollar bonds. The Argentine domestic debt market comprises mainly restructured government obligations. Some of the restructurings were voluntary, while others were compulsory. Like Brady bonds, all of the resulting instruments have a perfect servicing record, regarding both principal and interest.

Argentine BONEX 89 bonds resulted from the compulsory exchange of large private time deposits for Treasury-issued bonds as part of the country's 1989 Convertibility Plan. BOCONs (Bonos Consolidationes) resulted from the consolidation and transformation of unpaid government debts into bonds with 10-to-15-year tenors. Pensioner BOCONs originated from pension debts accrued in 1991 and 1992, and General Debt BOCONs from both debts to general suppliers and corporate tax-loss carry forwards. Bonos del Tesoro (for example, the BOTE and BOTE II bonds) were part of another set of public-sector restructurings. (For further information, see Argentina: domestic market overview, August 19, 1993.)

Russian Ministry of Finance bonds will become eligible for the EMBI+ when their settlement becomes more transparent, preferably through Euroclear.

Performing loans

There is only one performing loan in the EMBI+, Moroccan Tranche A loans. Morocco restructured its commercial bank loans in 1990, opting not to do a Brady exchange since the country was current on all payments of these loans. This loan has a perfect servicing record.

Eurobonds

We use the term “Eurobond” here to include specially directed Eurobonds, such as Yankee bonds, and Global Registered bonds. Eurobond issuance by countries that had previously rescheduled debt or (like South Africa) had otherwise been excluded from private international capital markets is a relatively new form of financing in the post-debt-crisis emerging markets. While restructured debt has resulted in a concentration of creditors from within the group that originally held the defaulted loans - and has relied on them to distribute the issues among a wider investor base - Eurobonds have been directed initially at a wider range of investors. Also, unlike the Brady market in which the issue sizes are very large, the typical Eurobond is $100 million or less in these countries. Issuance over $300 million is rare, with only a very few "jumbo" ($1 billion) issues having been made. This dispersion of creditors and issues has tended to lower the liquidity of individual issues, so that the actively traded set of Eurobonds is very limited.

The most actively traded Eurobonds tend to be large issues that trade in tandem with the Brady market. Thus, the set of Eurobonds currently in the EMBI+ is very limited and, while fairly representing the traded Eurobonds suitable for inclusion in an index, vastly underrepresents their total amount outstanding. (Only issues from Argentina, Mexico, and South Africa, representing 6% of the total emerging markets Eurobonds outstanding, are in the index at present.)

Methodology

In constructing the EMBI+, which dates from December 31, 1993, our objective was to create a benchmark that would accurately and objectively reflect returns from price gains and interest income on a "passive" portfolio of traded emerging markets debt. To do so, we adapted the methodology used originally to construct our flagship index, the Emerging Markets Bond Index. The methodology required the most adaptation when applied to loans, especially those that had undergone a conversion into Brady bonds, included in the EMBI+; for these, an additional set of assumptions was necessary to determine returns.

The EMBI+ is constructed as a "composite" of its four markets: Brady bonds, Eurobonds, U.S. dollar local markets, and loans. These steps are followed in the construction:

1) A daily total return for each single instrument is computed.

2) For each market, an arithmetic, market-capitalization-weighted average of the daily total returns of the constituent instruments is constructed.

3) An arithmetic, market-capitalization-weighted average of the four markets’ average daily total returns, calculated above, is constructed. The result is a composite return for the overall EMBI+ market.

Single-instrument total return

The total return calculation for a single instrument is a means of representing the economic benefit of holding the specific security. In its simplest form, it is based on the “cash in/cash out” notion—i.e., what is paid for the security at the initial purchase and what is received at its sale. Of course, most fixed income securities pay some form of coupon along the way (except in the special case of EMBI+ nonperforming loans), and some pay amortizations. For the calculation of total returns, this cash is reinvested in the instrument when received.

Our treatment of loans requires a special set of assumptions. Generally, the life of these loans had three phases: (i) trading as a single loan or loan pool; (ii) when it ceased trading as part of the loans-for-bonds Brady exchange process; and (iii) once it became a Brady Bond.

While a loan traded, we treated it much like a bond, tracking its price movements and crediting it any interest income paid. Once the loan ceased trading, its value became a function of the return of the bonds into which it would be exchanged. In some cases, loan “participations” traded, allowing the investor, via the loan creditor, to participate in any cash income and then the ultimate loan-for-bond exchange. Although this market was not active, we priced “synthetic” participations via the actively traded when-, as-, and if-issued (w/i) market to determine the loan's value during this period.

Once these w/i bonds were issued, the determination of total returns became more straightforward. The EMBI+ takes into account all existing trading conventions, day-count bases, ex-periods, and multiple series to give the most accurate reflection of changes in instrument value.

Market indices

Our means of calculating the total return on a basket containing various instruments is an extension of our single-instrument framework. To hold a passive portfolio, one would buy the instruments in the same proportions in which they are available for purchase. Each proportion is a function of both the amount outstanding (which we will assume equals that portion of an asset's outstanding amount that an investor can easily purchase) and its price. These two factors, when multiplied together, equal the asset's market capitalization.

Index rebalancing is done on the last business day of each month, such that the next month's composition reflects the changes. There are two kinds of "rebalancing events": changes to the list of included instruments and active changes in the amounts outstanding. These events do not affect portfolio value. When a rebalancing event occurs, it is as if the investor sells the entire portfolio at the day's closing (bid) prices and then immediately reinvests the proceeds in the new portfolio in proportion to the new market values based on the same (bid) prices. This results in a shift in the relative weights but not a change in the overall portfolio value.

Composite indices

Composite indices are very similar to market indices, but at one level higher. Each market's daily return is weighted by its market capitalization, and then these weighted returns are summed. This method allows for cases in which one or more of the markets are closed while others are open.

For a full explanation of the methodology used to create the EMBI+, see the Emerging Markets Bond Index Plus: Methodology, July 12,1995.

Choosing instruments for the EMBI+

Instruments in the EMBI+ must initially meet four eligibility criteria. First, an instrument must have a minimum of US$500 million outstanding. Second, an instrument must meet a BBB+/Baal or below rating requirement, designed to define "emerging markets" in the context of external debt markets. Third, the instrument must have more than a year remaining to maturity. Fourth, the instrument must be able to settle internationally, such as via Euroclear.

Once the eligibility requirements are met, liquidity criteria, similar to those used for the Emerging Markets Bond Index, are applied to the instruments. Because our objective was to create a broader index than the EMBI, we expanded the EMBI liquidity ratings, which are based on screen quotations and bid/offer spreads, to include another, lower-liquidity rating (L5). With the addition of the new rating, we have shifted all liquidity thresholds one level lower.

The five EMBI+ liquidity ratings are:

L1 Benchmark Average bid/offer ................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download