Sovereign Defaults in Foreign Currency and Restructuring of the Debt
Keywords: Fixed-Income Investment, Sovereign Bonds in Foreign Currency, Sovereign Default, Debt Restructuring, Collective Action Clauses
In the context of bond markets, governments may seem to be reliable borrowers at first glance. Although they are so compared to corporations, they do go default as well. Default can happen due to several reasons such as:
• Financial distress.
• Lack of liquidity.
• Political upheaval.
• Strategic decisions.
• External sanctions that cause an inability to pay the maturing debt.
Default is declared when the bond issuer government cannot meet its debt obligations in time and in full. The question is: What happens after default occurs?
How about just refusing to pay? This is almost impossible because refusing to pay would result in a total catastrophe, including consequences such as getting banned from international finance, seizure of assets abroad, deprivation of foreign investments at all, and so on. There is no government that can endure such severe consequences, without ending up in complete misery.
Having touched on the consequences of refusing to pay, let us move to what happens in real practice. In most cases of defaults, the defaulted state suspends its debt obligations and begins negotiations with the creditors to restructure the debt. In this post, we are going to delve into the process of restructuring. We will continue to this topic by two upcoming posts about recent examples of restructuring and recent defaults with ongoing negotiations.
The Occurrence of a Default
First, let us look at how often a default occurs.
When a government fails to pay any debt obligations of their bond contracts within the grace period (depending on the contract, mostly around 2 weeks), the bond issuer government is considered as being in default, such that, credit rating agencies downgrade the rating to default. Depending on the specific contract, in case of a failure of even a single coupon or principal payment, the country is considered as being in default regarding all series of bonds, which is called cross-acceleration of default. The acceleration of default can be conditional on a threshold amount of a payment failure. For instance, when Russia defaulted in 2022, this threshold was $75 million, which is pretty low.
In many cases, if a government fails to pay any of its bond obligations until the end of the grace period, it defaults on all of the debt obligations, including other types of debt, such as bilateral and multilateral (such as Paris Club) loans, and has to negotiate with all of them. It is important to note that the notion of comparable treatment applies to the restructuring of different types of debt, and creditors have the right to object to the restructuring conditions of a different type of debt, as happened in the case of Zambia’s default where the bilateral creditors rejected the restructuring of bond obligations, obliging Zambia government to offer worse conditions to bondholders. We will go into more detail in our future posts about recent examples of defaults on foreign currency.
Negotiations
When a government defaults, the negotiation process is likely but not necessarily to be supported by the IMF to construct a sustainable restructuring. Creditors holding the bulk of bonds such as index funds, mutual funds, exchange-traded funds, or hedge funds constitute creditor committees to pursue restructuring negotiations. The time between the event of default and the beginning of negotiations can vary between a few days to several months. Negotiations concentrate on the following three adjustments:
• Lengthening the maturity dates for either principal or interest amounts falling due or providing a grace period (amend and extend).
• Reducing the interest rate on the debt (coupon adjustment).
• Reducing the principal amount of the debt owed (principal haircut).
Most sovereign debt restructurings use mixes of these options to achieve the necessary relief. Offers are made by both sides, where both parties try to reach the best outcome. When the deal gets closer, the government puts the offer to the vote where approval of some sort of majority (varying between 50% and 75%) is required to come to an agreement that would bind all of the bondholders, regardless of their vote. This process is due to Collective Action Clauses (CACs) which exist in almost all sovereign bonds issued since 2014. There are chances that the offer is refused even in the case of a fair deal. This might occur due to the hold-out behavior of some funds that seek to block a restriction agreement and then buy the rest of the outstanding bonds at a very low price. Then they use litigation tactics and try to get the full par value and accrued interests. The hold-out behavior is only beneficial for investment funds with a high capacity for litigation tactics at the expense of all remaining bondholders. The likelihood of a hold-out is higher in the setting of series-by-series voting, since it is easier to constitute a blockade at the voting of a single series, leading to the blocking of the whole restructuring process.
To prevent such blocking, two different options of CACs rather than series-by-series voting have been implemented which are:
a. 2 limb voting. First limb series by series, second limb aggregated pool.
1st limb: Bondholders are supposed to vote to accept or reject separately for the restructuring of each series of bonds.
2nd limb: Bondholders accept or reject the offer for the aggregate pool of all defaulted bonds.
Requirement for an agreement on restructuring which would bind all bondholders: At least 50% of votes accept the restructuring in the first limb, for each series, and 67% or 75% (depending on the provisions in the bond contract) of the votes accept the restructuring in the second limb (aggregated pool).
b. 1 limb voting, aggregated pool.
Requirement for an agreement on restructuring that would bind all bondholders: 67% or 75% of votes must accept the restructuring. EU requires single limb CAC for the bonds issued after 01/01/23.
Governments can also manipulate the voting pools to achieve their desired results. However, if the creditor committees do not agree at all in the first place, the manipulation tactics would not work. However, if there is a discrepancy between the approach of creditors, this can work, as it did for Argentina in 2020. To illustrate with the imaginary series of bonds A, B, C, D:
- Aggregated pool, results: A and B 75% in favor, C and D below majority.
- Pool only A and B, and agree on restructuring.
- Aggregated pool for a slightly better offer than the last one (A and B)
- A and B will agree almost 100%, offsetting the hold-out seekers in C and D.
- Let’s say C agrees with 60%, and D with 10%, pool A and B and C; and then finally offer slightly better for all and offset hold-out seekers in D.
Considering the different CAC clauses and the tactics that can potentially be used by governments in default, we can say that currently, the hold-out problem shouldn’t be as much of a big deal as it was in the past. Nevertheless, the suspension of coupon and principal payments for long periods necessitates negotiations to be completed as fast as possible, which might not be an easy process, even without the holding-out bondholders.
Thank you for reading. See you soon at our next post about recent restructuring examples!
(We note that none of the comments in this post are investment advice.)
References
Chekir H., Cueva S., and González J. A. (2024). “Lessons From the Ecuador 2020 Debt Restructuring Case”, Finance for Development Lab. Policy Note №15.
Luckner, C. G. V., Meyer, J., Reinhart, C. M., & Trebesch, C. (2023). Sovereign Debt: 200 years of creditor losses. IMF.
https://gov.sr/restructuring-of-bondholders-finalized.
Sovereign Debt Restructuring: Overview | Practical Law (westlaw.com)
