The #GrieFault trade

Why Argentina’s bonds might be worth even more in default

We’re now just days away from what is increasingly being referred to on Twitter as #GrieFault — an Argentine bond default caused by court orders by Thomas Griesa. Assuming — as seems extremely likely at this point — that the default is going to happen, you can expect an outpouring of ill-informed news and commentary in the financial press. And it’s not just because the journalists don’t really know what they’re talking about. It’s also because they place far too much faith in markets.

The first law of journalism, of course, is that it’s always most inaccurate on the subject you know the most about — especially when the subject in question is (a) very complicated; and (b) often covered in a relatively cursory manner. Since Argentina’s sovereign debt crisis is pretty much the one subject I consider myself an actual expert on, I’m certain to find flaws in the Argentina coverage almost anywhere I look.

But even accounting for that, I’ve generally found the coverage of this story particularly irritating, with a handful of honorable exceptions. There’s an extra element here, which is making the reporting on this case much, much worse — and that’s the markets. In short, they’re doing the wrong thing. (When a reporter like Floyd Norris covers the case without mentioning the markets, the results can be excellent.)

It’s helpful here to boil this case down to its essentials. Argentina has two classes of external bonds: the ones it’s paying, and the ones it isn’t paying. Because it isn’t paying the latter group (the “holdouts”, who are the plaintiffs in this case), it has effectively lost all access to international capital markets for well over a decade. But it is (or was, in any case) staying current on the former group (the “exchange bondholders”). Thanks to that, it has a non-default credit rating and some semblance of a reputation for paying its debts on time. That was the promise of the big debt exchange in 2005: if we cut our debt by 70%, then we’ll be able to service it no problem. Between then and now, that promise has been kept.

It’s also important to note that the exchange bonds are the ones which trade. As a result, whenever anybody starts talking to you about Argentine bond prices or bond yields, you can be sure that they’re talking about the prices and yields on the exchange bonds, not the defaulted debt.

So here’s the problem. Financial journalists, almost without exception, tend to judge events by the effect they have on the markets. If something causes a stock or bond to go up, then it’s generally good news, while if something causes a market to go down, then it’s bad news. (Unless you’re short, of course: When Herbalife’s stock rose during Bill Ackman’s presentation last week, that was clearly bad news for the short-seller.)

This dynamic has created something of a dilemma for any financial journalist reporting on the Argentina case. On the one hand, the various court rulings, all the way up to the Supreme Court and then all the way back down again, have been unambiguously bad for Argentina, with each one clearly increasing the probability that Argentina is going to end up defaulting on its bonds. (That is, the holders of its exchange bonds, which are the ones which are traded and quoted, will not receive their due coupon payments.)

On the other hand, ever since the Supreme Court ruling the very same exchange bonds have been on an upward tear, with their yields falling to levels that Argentina hasn’t seen in years. This, needless to say, is not the kind of behavior you normally see in a bond market which is careening towards default.

The result is a severe cognitive disconnect, for financial journalists covering this story. They can report the news — which is bad. They can report the market action — which is good. Or they can try to do their job, which is to do both. At which point they’re faced with two choices. The first one is to simply observe the disconnect, perhaps with a wry aside about the mystery of market moves. No one does this. Instead, they do the second, which is to try to explain why the market has risen, even in the face of what seems like an ever-rising probability of default.

This is reasonable in theory — and, indeed, I’m going to take my own stab at doing it in a minute. In practice, however, it results in journalists recasting the news so as to make the market moves more explicable. When they do that, it sometimes results in them reporting outright falsehoods.

The deepest and most pernicious falsehood of them all — one which has been repeated ad nauseam, over the past month — is that the probability of an Argentine bond default, over the past month or so, has gone down rather than up.

What would make any reporter think such a thing? Simple: There’s a general principle which is shot through the very soul of any bond-market reporter. According to this principle, credit spreads are a way of measuring default probabilities. As a result, if the former is going down, then the latter must be going down as well.

This simple assumption, based in the way that bond markets generally work, underpins nearly all of the bad reporting on Argentina, which is to say, most of the reporting on Argentina. “If Argentina’s credit spreads are coming down,” say the reporters, “then that means Argentina’s default probability is coming down”. They then contort themselves into all manner of logically improbable and/or factually erroneous positions, trying to explain how a series of court decisions, all of which have made Argentina’s default probability go up, have in reality made it go down. And every time Argentina’s bonds rise in price, they will trot out another headline about how “Argentina Bonds Rise on Debt-Negotiation Hopes” or somesuch. (That’s a real headline, by the way, from Thursday, but I’m not linking to it because I don’t want to pick on any one publication or reporter. Virtually every financial outlet has written something similar.)

The way that most market reporting works is that you start with a market move, you then look at the news, and then finally you try to work out some kind of coherent explanation of why the news might have caused the move. After the Supreme Court decision on Argentina, for instance, the price of Argentine bonds moved decisively upwards. We can therefore draw a pretty strong causal relationship: this isn’t a case of a more-or-less random news event being used to try to explain a more-or-less random move in market prices.

But what, exactly, is the causality here? Why would these particular court decisions have resulted in Argentina’s bond prices going up, and its credit spreads going down?

The naïve way of looking at this question is to say simply this: “if the spread on Argentine bonds has gone down, that means the probability of default has gone down. And if the spread on Argentine bonds went down sharply after the Supreme Court decision, that means the Supreme Court decision reduced the probability of an Argentine default”.

I’ve seen reporting along such lines, but such thinking doesn’t pass a basic laugh test. Argentina has been making steady coupon payments on its exchange bonds ever since 2005, with no problem. Absent a court ruling preventing it from making such payments, it would surely continue to make such payments. No one doubts the country’s willingness to pay: indeed, it has already transferred the full sum of the coupon payments to the bondholders’ trustee, Bank of New York. And yet its ability to pay has, thanks to the US judiciary, been suddenly and sharply reduced. As a result, its default probability is now extremely high, and a full-blown payment default is likely to arrive as early as Wednesday.

Nevertheless, one should never underestimate the market journalist’s ability to believe the highly improbable, in the service of drawing spurious causal relationships. Like a drowning man grasping at a twig, the market reporter will reach for anything whatsoever, if it could help explain a change in bond prices.

Which in turn explains the single biggest howler, repeated ad nauseam in the coverage of this story — the patient and ubiquitous explanation that Argentina has every reason to avoid a default, because if it defaults, then it will lose access to international capital markets.

This is extremely silly on two levels. First, let’s assume that Argentina has some kind of access to international capital markets right now, which it would lose in the event of default. And let’s say that the cost of default, in terms of loss of market access, would be very high. Even granted both those hypotheticals, we still haven’t found an explanation of why Argentina’s default probability would have gone down since the Supreme Court ruling. Wouldn’t the cost of default be exactly the same, before and after the ruling?

And of course both those hypotheticals are wrong: you cannot lose what you do not have. Argentina never had access to international capital markets before the court rulings, and indeed hasn’t had such access in well over a decade. Yes, there’s a good chance that settling with the holdouts might mean renewed access to international markets. But that, too, has been true for many years: nothing has changed on that front, either.

So what’s the actual cost/benefit calculation, for Argentina? Judging by the country’s actions over the past decade, it’s abundantly clear that the Argentines have until now considered the cost of settling with the holdouts to be significantly greater than any benefit from doing so. The two sides have remained very, very far apart, for reasons both political and economic.

In the new world, however, the world created by the various US court rulings, the calculus will have changed. That’s because if Argentina chooses to remain in default to the holdouts, it will also have to go into default to the exchange bondholders. What would the costs of such a default be? We’ve already seen that loss of market access isn’t really a cost of default, since Argentina doesn’t have market access anyway. And while sovereign bond defaults are often extremely damaging politically, it’s hard to see this one hurting Argentine president Cristina Kirchner, especially since it’s very easy for her to blame US judges for the whole thing.

Indeed, there might even be a benefit to default: Argentina could stop making its coupon payments for a while, and use the money instead on desperately-needed projects back home. After all, there’s not much point in shipping money to the Bank of New York if the Bank of New York is enjoined from turning that money over to its rightful owners.

None of this logic has any appeal to market reporters, however, since it all points in the wrong direction. So let’s instead try to work out a more plausible explanation of why Argentine bond prices might have risen of late — one based in fact, rather than fiction.

One way of looking at the case is as a great example of what happens when an unstoppable force meets an unmoveable object. Argentina is determined to stay current on its payments to the exchange bondholders; it’s also determined not to pay the holdouts. One of these two things will have to give. Up until now, Argentina has been able to have its cake and eat it: it has been able to pay Peter without paying Paul. Finally, the day of reckoning has come. What’s more important: being a paid-up member of the respectable international financial community, or spiting the holdouts?

Really, there are only two options here: either Argentina settles with the holdouts, or it defaults. Let’s take the first option first — that Argentina settles with the holdouts. In that case, the holdouts make an enormous sum of money — but the exchange bondholders make a lot of money too. All of Argentina’s bonds would revert to the status of performing debt, and the country would at a stroke regain its access to international capital markets. The country’s spreads would come in sharply, since all its legal travails would be behind it.

If you believe, then, that Argentina is going to sign some kind of last-minute settlement with the holdouts, then it might make sense to bid up the country’s bonds.

Would Argentina actually do such a thing? It has very good reasons not to. For one thing, a settlement would be extremely expensive: while the plaintiffs in this specific case are only owed a couple of billion dollars, the holdouts as a whole are owed some $15 billion, and if you pay one, you’re probably going to have to pay them all. What’s more, the exchange bondholders all have something called Rights Upon Future Offers, or RUFO, which entitles them to anything the holdouts get. If you add RUFO obligations onto the amount of money that Argentina would have to pay the holdouts, you soon end up in the hundreds of billions of dollars — money Argentina simply doesn’t have.

But here’s where things get interesting. Normally, bonds are instruments with downside but no upside: you either get the contractually-agreed interest payments, or you don’t. There’s no way of getting more than the debtor bargained for. In the case of Argentina, however, there are two ways in which the exchange bondholders might end up getting not only their coupon payments, but money on top as well.

The first is that RUFO clause. Obviously, Argentina doesn’t have the money to pay out the exchange bondholders in full according to that clause. But if Argentina is paying out billions of dollars to vultures who deserve much less than they’re getting, and if those payments create a massive parallel legal obligation to the bondholders who cooperated with the country and did everything they asked, then it’s not unreasonable to expect that Argentina might end up paying something to the exchange bondholders, if doing so would wipe out any RUFO obligations. (There’s lots of talk of the settlement with holdouts taking the form of bonds which would somehow manage to skirt RUFO obligations, but if that happens, you can be sure that some determined lawyer, working on behalf of exchange bondholders, will nevertheless sue Argentina and ask for the same terms that holdouts got.)

The second way that exchange bondholders could get more than 100 cents on the dollar is, paradoxically, if there is a default. The minute that Argentina goes into arrears on its coupon payments, the clock starts ticking. From that day onwards — and actually, that day has been and gone already — bondholders are owed not only those coupon payments but interest on those coupon payments. And the interest accrues at the standard statutory rate of 8% — a massive number, these days.

So here’s a reasonable explanation for why Argentina’s bonds have gone up: the buyers believe that Argentina will default. And that then, eventually, it will cure its default. And that in curing its default, it will pay out interest on past-due coupon payments at a very attractive 8% rate. So the bondholders are very happy to wait for their coupons: in fact, the longer they wait, the happier they are.

Argentina, in other words, might well have become a very high-priced distressed-debt trade. The people buying the bonds aren’t coupon clippers: they’re sophisticated distressed-debt funds, who have strong stomachs and can happily weather a period during which they’re not getting paid any money.

Do I know that the buy-default trade — the idea that bonds are worth more in default than they would be if they were still current — actually explains the price action in Argentine debt? No, it’s just speculation. But at least it’s speculation which makes a certain amount of sense, given Argentina’s clear willingness to pay the exchange bondholders in full. It certainly makes a lot more sense than the idea that Argentina’s default probability has gone down.