About that sovereign debt restructuring sweetener . . .  | USAEMALL.com

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Ben Heller and Pijus Virketis are portfolio managers at HBK Capital Management.

Lee Buchheit and Gregory Makoff have suggested the accelerated paydown of sovereign debt as the superior, sweeter alternative to the various “upside instruments” — warrants and macro-linked bonds — used in many recent debt restructurings, with mixed success. 

It’s a good idea, and in fact we’ve mulled similar mechanics in previous restructurings. But we want to point out one important extension of the idea, as well as one important limitation.

The extension is to combine early payment with a corporate restructuring concept so far completely missing from sovereign practice: non-incurrence.

Debt isn’t an alien spaceship that one day lands unbidden on the front lawn of the finance ministry. Most countries get into trouble after many years of irresponsible policies and serial borrowing. When creditors offer debt forgiveness or delayed payments, they face the perverse prospect of catalysing a recovery, which allows the resumption of yet more issuance!

Non-incurrence covenants would bar such behaviour until the claims of existing creditors are at least partially seen to.

By the same token, one of the main assumptions of stabilisation programs relates to when and under what conditions “market access” might be restored. In reality, regained market access may come sooner and with greater abundance than foreseen in the IMF program. If an issuer takes advantage of it, that represents another way creditors may have left money on the table, and worse yet, they might now be exposed to greater credit risk.  

One way to operationalise a “debt brake” is to do what Buchheit and Makoff suggest: stipulate in the terms of restructured debt that if a country can place new obligations beyond some baseline amount, it must use the excess to service the old debt first, reaping all the benefits their Alphaville post lays out.

That said, the sweetness mustn’t go to our head. The reality is that oftentimes the acceleration of cash flows simply can’t beat the restoration of at least part of the creditors’ claim. That’s because of the interplay of two factors.

First, the IMF’s Debt Sustainability Analysis might demand a hefty debt haircut when there’s substantial uncertainty about the future path of the economy. If things turn out well, simply quickening cash flows can’t return enough net-present-value to creditors to make up for the loss, especially since the IMF usually sets an ironclad payment envelope for the first five or even 10 years.

Second, the prevailing level of EM bonds yields might be outside of an “optimal zone”, where the NPV impact of cash flow acceleration is maximised. Unfortunately, yields are quite high today, so rearranging heavily-discounted payments in the long term (eg from 20 year maturity to 10 years) will restore little NPV. 

Since we served on the creditor committee for Sri Lanka’s debt negotiations we’ll use the deal announced on July 3 to illustrate the limitations that using pre-payment alone as a value recovery tool can run into when NPV adjustments might need to be substantial.

Below are the stylised cash flows and NPV embedded in the baseline and in the highest contingent upside cases. We then ask the question that the Buchheit and Makoff idea naturally raises: if we wanted to match the NPV value of the agreed-upon upside case, how much of the principal cash flows would we need to accelerate from the longest scheduled maturity to the shortest payment date still acceptable to the IMF?

As it turns out, a lot — 83 per cent!

Why? Because this particular deal (like most current restructuring deals) doesn’t have an extremely long final maturity, while the IMF program and post-program window stretch out quite far. The result is that even with a fairly high exit yield, the NPV uplift from acceleration of final repayment is low, because the acceleration only amounts to four years.

The latest wave of sovereign debt restructurings should make it clear to everyone that it’s difficult to find a once-and-for-all adjustment of cash flows that can satisfy everyone. The market has also learned, though, that it must craft contingent instruments and features with great care, as the examples of backfiring value-recovery instruments in Argentina and Ukraine have demonstrated.

Acceleration of cash flows and mandatory contingent prepayments can function as a very safe way to return value to creditors in case the IMF’s debt restructuring parameters turn out to be far too conservative.  

It would work particularly well when most of the creditor concession comes in the form of extension of maturities at low coupons. It could work in even more situations were the IMF to allow additional cash flow within program and post-program windows when a country does much better than it feared.

However, some situations do engender too much permanent relief (ie large haircuts) and too much forecast uncertainty relative to the prevailing interest rate environment to provide adequate recompense to creditors in case of large outperformance.  

The market should both embrace pre-payment approaches as a form of value-recovery and as a way to prevent countries from going straight back on a debt binge — but not to the exclusion of continuing to work to improve other forms of equity-like contingent instruments.