sovereign debt restructuring: recovery & returns€¦ · this makes the recovery process...

Sovereign Debt Restructuring: Recovery & Returns

John Hund Rice University Global Association of Risk Professionals December 2014

2 | © 2012 Global Association of Risk Professionals. All rights reserved.

We’re here to make money…or not lose it


A slightly more sophisticated view of performance


3 Counter-Intuitive Concepts

Sovereign debt is much more complex than corporate debt, primarily due to the recovery process.

We’re going to (briefly) examine 3 counter-intuitive consequences of the fact that recovery is not prescribed by a bankruptcy mechanism.

The World Turned Upside Down: What enforces payback? Strategic default is certainly possible in good states, and the motivation for repayment

(and thus lending) is murky at best.

Bail-ins are Bail-outs: Multilateral (IMF) efforts to reduce moral hazard tend to increase creditor recoveries. Bondholders might prefer that the country not get bailed out.

Buy When The Salesman Is Selling: Buying into the debt exchange is generally profitable, notwithstanding adverse selection. New creditors tend to capture the surplus from the country’s timing option.


In most credit markets, the relevant question is:

Why don’t you get paid back?

In sovereign markets, the relevant question is:

Why do you ever get paid back? (and why then, do people lend?)

Sovereign borrowing differs from corporate borrowing in the distinction between willingness to pay vs. ability to pay

This makes the recovery process critical to the pricing of these assets, as well as bringing politics back to the forefront • Leads to creditor conflicts

• Public vs. private bailout questions

• Collective action and moral hazard

The World Turned Upside Down

“Countries don’t go out of business…The infrastructure doesn’t go away, the productivity of the people doesn’t go away, the natural resources don’t go away. So their assets always exceed their liabilities, which is the technical reason for bankruptcy. And that’s very different from a company.”

Walter Wriston Citicorp Chairman (1967-1984)


If you can’t take the country to court, why do you ever get your money? Trade Sanctions/harassment But what if bondholders are private…difficult to implement via courts (Elliot

Associates)

Relatively easy to contract around

Seizure of collateral But countries move collateral around (again, Elliot)

Reputation…that is, a country tries to maintain a good history so it will be able to access markets in the future Average re-access time is about 5 years (to re-issue bonds in capital markets)

What about political change?

Serial defaulters are able to borrow again…Hello Ecuador!

Why Do You Ever Get Paid Back?

“If you owe your bank a hundred pounds, you have a problem. But if you owe your bank a million pounds, it has.”

John Maynard Keynes


All UK/US Lawsuits Against Sovereign Borrowers


Serial Default


The (very) long view


And then there’s Ecuador…


Since 1997 there have been 24 sovereign defaults… But of these only 14 were on rated bonds, and most have been relatively small

Russia, Ecuador, Uruguay, Argentina, and Greece are the only FC defaults over $5B

“Typical” path of sovereign default Missed payment/announced repudiation

Wait

IMF may or may not continue lending to country

Wait

Wait

Take it or leave it offer from country to creditors

(“There will be no other offer to redeem the defaulted securities.”)

Creditors accept (usual participation rates are above 80%)

Exchange offers are typically exceptionally complex Old bonds are switched into new bonds, with longer maturity and lower coupon

Typically a choice of currency, fixed or floating coupon

Argentina description is 458 pages…Greece “supplement” is 158 pages

So What Happens In Default?


Quasi-Par?


Recovery Rates


Is % of Par A Relevant Metric For Modern Bondholders?


Bail-in, Bail-out, who cares?

Bail-out: IMF aids private creditors by directly enhancing credit of defaulting country Country can now delay though, since it has a timing option… Argentina, for instance and Greece Bail-in: IMF promises credit conditional on settlement with private creditors Private creditors can now “hold-up” collectively, using official sanctions (Bulow &

Rogoff, 1989) Quick successful exchange leads to access to public credit Realizing this, country can offer a “generous” offer to mark-to-market bondholders

– In the limit, creditors extract all of the public credit enhancement – Exactly like debt-overhang models in corporate finance

Paradoxically, “bail-in” enhances creditor rights, and thus leads to smoother workout, but earlier…thus more money to creditors Exchange is a transparent mechanism; bondholders still get much (all?) of the promised IMF aid.


The extension of multilateral credit (bailing out) lets countries delay their restructurings…and this timing option is valuable.

Contrast this with corporate bankruptcy, where the court has (some) say in the proposed timing of restructuring offers (and creditors can offer as well).

But when should the sovereign offer the exchange?

Benefit: saving money on interest costs.

Cost: lack of access to external financial markets.

Result: Countries offer exchanges when economic conditions are improving Note: this is the opposite of adverse selection in lemons markets

But old creditors don’t get the surplus, because that would make the exchange costly in terms of debt burden

So who gets the surplus?

Generally split between country and new creditors (or old creditors who choose to hold the new bonds) Some analogies to timing options in IPO markets…except the exchange is much more coercive

But How Do We Make Money In Argentina and Greece?


Exactly What You’d Expect From A Timing Option And Coercive Exchange


Credit Rating Cycle Lags A Bit


Other Credit Metrics


200 bp Improvement in Yield on Average In First Year

On a 30 year bond, capital gain is approximately 20%

plus coupon payment

Across all exchange events, average 1-year return is

14.2% (capital gain)


Greek Debt Experience


Argentina?


Again…

Sovereign debt is much more complex than corporate debt, primarily due to the recovery process.

We’re going to (briefly) examine 3 counter-intuitive consequences of the fact that recovery is not prescribed by a bankruptcy mechanism.

The World Turned Upside Down: What enforces payback? Strategic default is certainly possible in good states, and the motivation for repayment

(and thus lending) is murky at best.

Bail-ins are Bail-outs: Multilateral (IMF) efforts to reduce moral hazard tend to increase creditor recoveries. Bondholders might prefer that the country not get bailed out.

Buy When The Salesman Is Selling: Buying into the debt exchange is generally profitable, notwithstanding adverse selection. New creditors tend to capture the surplus from the country’s timing option.

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© 2012 Global Association of Risk Professionals. All rights reserved.


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