The recent cascade of country defaults has brought back into fashion complex securities, born in the 1980s, which aim to accelerate restructuring.
The revival of so-called “State Contingent Debt Instruments”, which attract investors with new bonds promising payments if the country meets certain economic or fiscal targets, has helped countries like Ukraine or Sri Lanka to resolve difficult debt negotiations.
Some experts believe these instruments can help cash-strapped countries persuade bondholders to accept the potential losses needed to get countries back on track with their debts.
“When CDIAs are used to resolve a fundamental disagreement about a country’s prospects […]I really believe it is a transaction accelerator,” said Pierre Cailleteau, managing director of Lazard’s sovereign advisory group, who has advised the governments of Sri Lanka, Suriname and Zambia on the reorganization of their debt.
Privately, other debt experts worry that their use could drive up term borrowing costs by making some investors reluctant to buy the bonds when they later trade on the market. Future debt tensions could be more difficult to manage, they warn.
COMPLEX BUT FASTER
Authorities in Ukraine, Zambia, Sri Lanka and Surinamese did not immediately respond to a request for comment.
The Global Sovereign Debt Roundtable – an initiative bringing together representatives of countries, private lenders, the World Bank and the G20 – will discuss CDIA at a meeting on the sidelines of the fall meetings of the International Monetary Fund and the World Bank, Wednesday.
Ukraine, whose rapid wartime debt rescheduling defied predictions, used CDIA as part of a package to convince investors in August to swap their defaulting bonds for instruments more recent ones, including a GDP-linked bond, which would provide more returns to investors if the economy grew faster than expected.
Economic growth is a common indicator, but CDIA payments can also be linked to natural resource revenues or tax revenues.
These bonds differ from most sovereign bonds, called “plain vanilla”, which pay a predetermined amount of interest over their life before final repayment.
But CDIAs can be a double-edged sword. Investors are increasingly at odds with the International Monetary Fund’s economic projections, said Sergei Strigo, co-head of emerging markets fixed income at Amundi, Europe’s largest asset manager.
“The only way for investors to get some recovery is to use these contingent instruments, but that’s not necessarily the best way to do it, in my opinion, because it’s very complicated,” Mr. Strigor.
Zambia took almost four years to complete its restructuring and Sri Lanka is still finalizing a deal with bondholders, more than two years after defaulting on its debt. When they default, countries lose access to capital markets and funds for investments, whether in infrastructure or education.
BRIDGING THE GAP
CDIAs are not new; Latin American countries first used them in Brady bonds in the late 1980s, after the region’s debt crisis. Argentina issued GDP-linked warrants in 2005, Greece used them as part of its 2012 restructuring, and Ukraine added them to its 2015 restructuring.
History gives a mixed picture of their success.
Researchers at the Bank for International Settlements, who looked at Argentina, Greece and Ukraine in a report published in 2022, found that governments faced a “high and persistent” premium. The mark-up required by investors, beyond the liquidity and default premium that affects other issuer obligations, is between 4.24% and 12.5% on contingent instruments over the five years following the emission, noted the BIS.
THE COURTS AND THE ABSENCE OF A CEILING
Design flaws also marred earlier SCDI instruments.
Hedge fund allegations that Buenos Aires manipulated payment data and calculations have embroiled Argentina in protracted legal battles over its 2005 GDP warrants, while cash-strapped Ukraine money, must pay billions of dollars for GDP warrants that have not capped investor payouts.
These problems helped shape new instruments. Zambia’s 2024 bond, linked to its debt capacity – an assessment of how much debt a country can carry before the burden becomes too heavy – as well as exports and tax revenues, will depend on IMF statements, rather than government statistics.
Experts say designers of new instruments also need to make sure they qualify for benchmarks, such as JPMorgan’s widely followed Emerging Markets Bond Index (EMBI). This is essential to keep investors interested in purchasing these instruments and to keep the cost of public debt low.
Ukraine’s GDP warrants, for example, were not eligible for the index, but the bonds it launched in August are.
Still, CDIAs come at a “price” for borrowers, said Stefan Weiler, head of CEEMEA debt at JPMorgan, one of the banks that participated in the Ukrainian debt sale.
“It creates a level of uncertainty for governments that is not really helpful,” Weiler said, adding that kyiv had little choice given the enormous uncertainty surrounding its restructuring.
“Sophisticated investors probably like this situation because the risks of mispricing of the product (by markets) are higher – there is an opportunity to make a return on investment,” he added.
Sri Lanka, which has not yet officially implemented its restructuring, could serve as a test case. The recently announced agreement would include macro-linked bonds that would link debt repayments to the achievement of IMF growth targets, adjusting principal and coupon payments up and down and providing greater room for maneuver in times of distress.
But the country’s recent higher-than-expected growth forecasts have raised questions about how the payments will evolve.
Mr. Cailleteau, from Lazard, is optimistic.
“If we succeed, it will probably set a standard in terms of the intellectual approach to the issue,” he said.
