From next year, European countries will resemble emerging economies in a new way: sovereign bonds they issue will include collective action clauses (CACs). These allow a supermajority of bondholders to agree to changes in bond payment terms, which then apply to all bondholders. CACs became popular following Argentina’s default in December 2001 and even more so after the financial crisis of 2008. German Chancellor Angela Merkel and French President Nicolas Sarkozy, meeting in the French seaside resort of Deauville amid the escalating eurozone debt crisis in 2010, agreed to make them de rigeuer for sovereign bonds European countries issue under U.K. law from 2013.
In theory, CACs should give an added layer of protection to bonds issued by Greece, Spain and other eurozone members. In practice, however, the history of CACs in emerging markets suggests they may not always assure a smooth process in potential future restructurings. Inevitably, sovereign debt restructurings remain unique and unpredictable. Thus, investors will have to continue to be selective and use a bottom-up analysis to assess sovereign credit risks.
Holdouts and free-riders
Sovereign debt restructurings have long been complicated by the possibility that individual bondholders could hold out for better terms – the so-called “free-rider” problem. This reflects the legal tradition that bondholder rights are individual rather than collective.
Legally, any restructuring had to be negotiated with each bondholder individually. Even when a majority of bondholders agreed to restructuring terms, an individual bondholder could refuse to do so, thus delaying the restructuring process and drawing the issuer into costly litigation.
These risks have been greatest when the bondholder base was geographically dispersed or comprised of both individual and institutional investors – and CACs have not improved the situation. Figure 1 highlights recent cases in which CACs failed to streamline the restructuring process. When the number of holdouts was more than 25 percent, it took 15 months to 42 months to complete the restructuring negotiation and was accompanied by deep haircuts. The restructuring of sovereign bonds in Argentina, Dominica and the Seychelles all had one thing in common: a fragmented group of retail and isolated institutional investors which represented more than 40% to 50% of total bondholders. In all three cases CACs failed to stop holdouts.
Other factors that adversely influence restructuring include a lack of transparency, political uncertainties, IMF programs that go off track, and the size of proposed haircuts. These factors played an important role in the recent case of Greece, which underwent a restructuring through Private Sector Involvement (PSI). It initially proposed a haircut on its sovereign bonds of 21% in July, 2011, only to hike the haircut to 79% in March, 2012, when the PSI was completed. Other problems focused on Greece’s external sovereign bonds, where a bond denominated in U.S. dollars that matured in May was paid in par, while other Greek bonds denominated in euros were subject to a haircut. An additional and controversial complexity was the role of the European Central Bank. It did not participate in the PSI and was exempt from taking a haircut. At its recent meeting, the ECB issued a statement that in future purchases of government bonds, its role would be pari pasu to other creditors, rather than a preferred creditor.
Not surprisingly, factors such as these tend to depress sovereign bond prices. As Figure 2 shows, bond prices tend to fall beginning about 10 months prior to restructuring and continue to decline for about another six months after restructuring; then prices tend to rally. This pattern may result from a) a fall in sovereign ratings as restructuring places bonds on a temporary default status, b) a decline in the discount rate assumed in the debt exchange, and c) expectations of an improved debt-sustainability trajectory and debt-recovery rates following the restructuring.
This pattern doesn’t always hold, however: ongoing litigation in Argentina and an uncertain economic outlook in Greece depressed liquidity in their bond markets, preventing a rebound in bond prices.
Lessons and implications
Sovereign debt restructurings are unique and unpredictable. In general, the longer the restructuring process, the greater the uncertainty for the investor. Investors have to carefully assess the terms of debt exchange, the number of holdouts and the risk of potentially different treatment for official creditors. In addition, analysis of the debt composition is essential to determine the share of foreign-currency, floating-rate and short-term debt.
On balance, the introduction of CACs in European government bond markets in 2013 is positive for investors. But the history of emerging markets and Greece shows that there are no short cuts: Investors must continue to be selective and use bottom-up analysis to assess credit risks.
It’s a striking change from the pre-financial crisis era when most developed market government bonds were regarded as “risk free”.