THE FINAL WORD: Bullet bonds are making sovereign distress worse
There has been much discussion at these annual meetings about the need to reform practices for dealing with sovereign debt distress. The restructuring architecture certainly needs to be revamped, to deal with shifting creditor landscapes, higher debt loads and evolving borrowing practices by developing countries.
But we must not take our eyes off something else — the steps we can all take to make sovereign debt distress less likely in the first place.
Making governments more financially resilient is of course a multi-faceted challenge. Making debt instruments more resilient, on the other hand, is a somewhat less daunting proposition. Or at least it should be.
Innovation can create debt instruments that adapt to a sovereign borrower’s ability to repay, making a debt crisis less likely.
Already we have an active discussion about the powerful role circuit-breaking features such as climate-resilient debt clauses can play, by providing immediate and automatic breathing space to countries affected by a climatic shock, without triggering a credit event.
With their origins in the Caribbean, CRDCs are now being widely adopted by official sector lenders and must soon become common in sovereign bonds.
Work also continues on other types of contingent debt instruments that respond to a government’s payment capacity as it evolves.
Yet the focus on innovation should not make us overlook some very simple changes that could make temporary deteriorations in economic conditions less flammable.
The bullet bond, in which all the principal is repaid at maturity, has been the standard structure for Eurobond issuance since the early 1960s.
As Eurobonds came to replace syndicated bank loans as the main conduit for private sector hard currency lending to developing countries, the typically smooth, gradual repayment profiles of syndicated loans were replaced by large bullet maturities, which can often amount to a material percentage of a developing country’s GDP.
Eurobond bullet maturities are predicated on the expectation of ready access to deep markets that will allow smooth refinancing ahead of maturity dates.
While highly rated, frequent emerging market sovereign issuers can generally expect markets to remain open to them in all but the most difficult conditions, the same cannot be said for sovereigns further down the rating scale, with weaker economic fundamentals.
Such countries often face outsized bullet redemptions, since they are tempted to ‘max out’ on capital market access when it does come their way. The trouble with large bullet bond maturities is that they very frequently become an unhelpful focal point for both markets and governments, magnifying fears when there are concerns about the economic outlook.
The dynamics that emerge as investors hold back, governments dither, yields rise and rating agencies downgrade very frequently lead to a vicious circle. Fear of default can become a self-fulfilling prophecy.
Many a recent sovereign debt crisis has been triggered, if not caused, by an approaching bullet, or a wall of bullet maturities, on which the market fixates.
Beyond that, the very nature of bullets — the basic fact that they are never truly intended to be repaid — is not conducive to prudent economic planning by governments.
The reason why we have become accustomed to bullet structures for emerging market sovereign bonds is no more than market convention.
A better way
Investment banks have very little incentive to stray from the norm. They also bring out the old argument about amortising bonds becoming increasingly illiquid as they are repaid and become smaller.
While there may be some truth to this, most bullet Eurobonds issued by low rated sovereigns tend to be illiquid anyway, due to their relatively small size and rarity, even if they exceed the $500m threshold for EMBI eligibility.
Amortising structures are not a panacea for sovereign debt crises, and they will not succeed in averting defaults when a country’s debt sustainability has been fundamentally compromised.
Countries like Sri Lanka and Ghana would almost certainly have defaulted even in the absence of bullets, such was the sheer weight of their debts.
But smooth repayment profiles reduce flashpoints and do not generate the unhelpful dynamics that occur when legitimate concerns about economic fundamentals are magnified and projected on to the big screen of a looming Eurobond maturity.
Bullets can create a distraction that actually makes it less likely that the government will take corrective action.
Throughout the industrialised world, companies frequently borrow using amortising debts. It is generally acknowledged that such structures are more manageable since companies cannot print currency.
Emerging market sovereigns also cannot print the dollars or euros they need to repay their Eurobonds, so the same logic applies.
We have become lazy in our approach. It is now time for all involved in helping sovereigns — especially those further down the rating scale — to borrow from the international capital markets, to discourage them from sowing the seeds of future debt distress by opting for more manageable amortising bonds over problematic bullets.
Investment banks can play a big role in bringing about this shift, as issuers will typically take on board their views on what works for the market.
Their job could be made easier by a standard amortising bond template, which could be prepared by the International Capital Market Association.
Where there are genuine concerns about liquidity, we can come up with mechanical innovations that address this.
But we should not lose sight of the fact that the bigger prize is more sustainable capital market issues that are tailored as much to sovereign issuers’ needs as they are to market conventions.
Sebastian Espinosa is managing director at White Oak Advisory