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Lee Buchheit is honorary professor of law at the University of Edinburgh. Gregory Makoff is a senior fellow at the Harvard Kennedy School and author of Default.
The sole objective of creditors in a sovereign debt restructuring is to give the country the bare minimum of relief sufficient to allow it to regain its financial footing.
Creditors do that to enhance the collectibility of their residual claims. After all, providing debt relief less than that required to achieve financial stability will invite another debt restructuring somewhere down the road. However, granting debt relief in excess of what the debtor needs is, from the creditors’ standpoint, just an unwarranted gift.
Including “value recovery features” in restructured debt, such as warrants that pay out if the economy starts to recover its mojo, is a popular suggestion on how to address this issue. But despite being a favourite of Washington economists for generations, they have a checkered history in the markets, among countries and in the courts.
We’ll discuss why — before sketching out what we think would be a better mousetrap — but first we need to discuss some of the main problems that dog negotiations between debt-stricken countries and their creditors.
(A longer version of this post can be found here)
The sovereign debt restructuring conundrum
The first problem is that no one really knows at the time of the debt restructuring just how much relief will be needed to achieve — but not exceed — this goal of returning the debtor to financial health.
In most sovereign workouts, the job of making this prediction falls to the International Monetary Fund (sometimes with the participation of the World Bank). As part of the preparation for an IMF economic adjustment program, the Fund’s staff will undertake a Debt Sustainability Analysis (DSA) that seeks to predict how much debt the country can reasonably be expected to carry over the near to medium term.
The second problem is that a DSA calls for a mountainous pile of assumptions: assumptions about future commodity prices, future tax receipts, future exchange rate movements, future interest rates, future trade patterns, and so forth.
When the IMF staff makes predictions about the likely state of affairs a couple of years out, those predictions are educated guesses. Three to six years out, the predictions range from speculative to highly speculative. After about six years, however, the DSA is an exercise in occult divination.
Which sets up the third problem. What happens if the DSA assumptions turn out to be too conservative?
In other words, what happens if the Republic of Ruritania’s economic future ends up being much healthier than the Fund staff had predicted it would be when they prepared the DSA way back when? If Ruritania’s creditors provide debt relief predicated on what later turn out to have been excessively gloomy DSA assumptions, they will have simply given Ruritania an unwarranted windfall.
“Value recovery features” — like GDP-linked bonds — are intended to address this third problem. Should Ruritania’s financial future end up being rosier than some dyspeptic IMF staffers thought it would be when they prepared the DSA, the value recovery feature will return to the creditors some or all of the money that they (unnecessarily) left on the table at the time of the debt restructuring.
Or at least that is the theory.
The country’s perspective
While it may be difficult to quarrel with the market’s logic for demanding a value recovery feature, sovereign debtors make the following points: Value recovery instruments (VRIs) that are triggered by future commodity prices or GDP levels will, by definition, be out of the money at the time they are issued.
In other words, the commodity price benchmark or size of GDP at the time of issuance will be lower (potentially much lower) than the trigger price in the VRI. These instruments are therefore by their nature uncertain and contingent; they may or may not start to pay off in the future. As a result, markets tend to undervalue VRIs at the time they are issued.
In practical terms, this means that the sovereign debtor will typically receive little or nothing (in the form of improved financial terms in the debt restructuring) for its willingness to include a value recovery feature in the package.
VRIs, particularly GDP-linked VRIs, can also be complicated and opaque. This invites legal risk (witness the litigious adventures of Argentina’s GDP warrants) and can trigger future debt restructuring nosebleeds (see Ukraine today).
The sovereign debtor’s main beef, however, is that when a VRI is triggered, the cash that the debtor must pay out is utterly wasted in the sense that the debtor will receive no benefit of any kind for making those payments apart from preserving a reputation for honouring its contracts.
The payments do not buy anything; they do not reduce any liability of the sovereign; they do not reduce the sovereign’s debt. It just feels like money out the window.
A better designed VRI
A better VRI mousetrap would be one that: (i) rewards Ruritania’s creditors for the sacrifices they made at the time of Ruritania’s debt restructuring; (ii) provides a positive benefit to Ruritania in return for making VRI payments; and (iii) reduces legal and operational risk through simplicity of design and drafting.
Most sovereign debt is in the form of bonds, and most modern investors in sovereign debt are mark-to-market institutional holders. As a result, while investors care deeply that their securities go up in value, they’re less concerned with how they go up in value.
There are two ways to enhance the market value of a debt instrument: increase its cash flows or decrease the time period over which that cash is paid.
Traditional VRIs take the first approach: they call for additional cash payments if the country outperforms the IMF’s DSA assumptions. We argue for the second approach. If the country outperforms the assumptions on which the debt restructuring was based, the consequence should be an acceleration of the timing of already-scheduled cash flows.
Such an acceleration will improve the market value of the bonds without forcing the country to increase the overall amount of its cash expenditures.
A value recovery feature can be designed that would require the sovereign — if and when the trigger for making the VRI payments is reached — to apply those monies to a mandatory pre-payment of the new bonds issued as part of the country’s debt restructuring.
In accordance with standard market practice, such prepayments would be applied in inverse order of maturities, meaning that they would be applied first to retire the final amortisations of the new bonds. The determination of whether such a pre-payment is required in any given year — and the amount of that pre-payment — can be made separately for each year during the life of the value recovery feature.
Wins all around
A mandatory pre-payment of this kind would convey five immediate financial benefits to mark-to-market holders of the new bonds:
💥 First, Ruritania’s new restructured bonds will probably trade for a long time at a heavy discount because the country will be recovering from a bout of severe financial distress. This happens whenever the discount factor applied by the market to value a sovereign debt instrument is higher than the cash coupon on that instrument.
A pre-payment of a portion of the principal of such an instrument immediately repays — at par — a claim that the mark-to-market holder has been holding on its books at a discounted value.
Here’s a simple example: if the new bonds are trading in the market at 60 cents on the dollar (a 40 per cent discount) and Ruritania makes a partial pre-payment of principal as a result of the embedded VRI feature, the holder will realise an immediate 40 point gain on that prepaid amount. (The pre-payment obligation could be suspended during any period when the restructured bonds are trading above par.)
💥 Second, making prepayments in inverse order of maturities would reduce the average weighted life of the new bonds. In a normal yield curve environment, this should improve their market value.
💥 Third, the holder of the new bond will — to the extent of the partial pre-payment — be receiving its money back earlier than expected. This permits a holder to reinvest those funds.
In any situation in which the coupon rate on the restructured debt is less than the market rate for an investment in a debt instrument of a similarly rated issuer, the holder will realise a pick-up in the cash flow on the amount of the reinvested pre-payment.
💥 Fourth, a pre-payment reduces the aggregate size of the country’s stock of external debt. This improves its overall debt dynamics and, all other things being equal, should therefore improve the market value of the remaining stock of bonds.
💥 Fifth, the market has readily available tools to evaluate bonds with maturity uncertainty — such as the callable bonds that have long been part of fixed income markets. For example, Bloomberg terminals can easily evaluate bonds with maturity uncertainty resulting from a scenario-dependent shortening of maturity (“yield-to-worst”).
From the standpoint of the country, a mandatory pre-payment value recovery feature is much preferable to a traditional VRI, even if the amounts paid under both are the same. The cash paid on a conventional VRI is wasted; it reduces the sovereign issuer’s international reserves without conveying a benefit of any kind.
In contrast, each dollar paid under a mandatory pre-payment value recovery mechanism reduces the sovereign’s debt, decreases the amount of future interest payments the sovereign must make on that debt instrument and improves the sovereign’s general debt dynamics leading to lower borrowing costs in the future.