It’s been like that recently for frontier market sovereign debt restructurings, with Zambia, Ghana, and Sri Lanka all reaching or approaching deals. These events created some compelling investment opportunities and provided valuable lessons for investors. We explore this in more detail here.
A quick recap
Since 2020, numerous lower-rated emerging market (EM) nations have lost access to international bond financing. Many were dependent on multilateral support to avoid default, but not everyone was so fortunate.
Ten countries have defaulted over the last four years. Catalysts included COVID, the Russia/Ukraine conflict, and rising US Treasury yields. Ballooning fiscal deficits and high debt levels also pushed some countries over the edge. Not all the defaulters were considered frontier nations, but most issuers have been trading in the distressed area – also known as ‘double-digit-yield territory’ – over the last three to four years.
This, though, has presented attractive opportunities for investors with the analytical experience, legal expertise, and, most importantly, patience to maximize returns. Indeed, we’ve invested in several of the defaulted and distressed credits. Many have been the big EM outperformers over the past several years.
All aboard
Back to those buses. Zambia finally reached a deal to restructure its debt four years after defaulting on its Eurobonds. Meanwhile, Ghana has announced it has reached an Agreement in Principal (AIP) to restructure $13 billion Eurobonds, while Sri Lanka is closer to finalizing terms with commercial creditors after defaulting in 2022.
Over the past several decades, we’ve had plenty of experience assessing various sovereign debt restructuring episodes. However, recent defaults have come at a time of elevated external risk and have tested investors’ patience. There are consequent risks of further delays in the Ghana and Sri Lanka deals. Nonetheless, we remain optimistic the countries will agree to terms with creditors over the coming weeks.
Distressed to impress
Several factors have driven the increased demand for defaulted and distressed bonds. When a country defaults, prices typically overshoot on the downside. This is because many investors, unable to hold defaulted bonds, are forced to sell. Uncertainty about the expected recovery value and the time it might take to complete a restructuring also weigh on bond prices shortly after the credit event. However, practiced investors in defaulted bonds will view these selloffs as potential buying opportunities.
Bonds in Zambia and Ghana were trading at distressed levels well before the credit events. We, therefore, had plenty of time to assess the bonds’ potential recovery value. To do so, we built recovery models, which include a range of different scenarios on the size of the principal haircut, the parameters of a new coupon structure, and potential exit yields.
True, the time to complete Zambia’s restructuring was well beyond the usual one- to two-year EM average. Several factors explain the longer negotiating period. The presidential election in August 2021 resulted in the victory of a market-friendly government. There were delays confirming an International Monetary Fund (IMF) program, as bilateral creditors had to provide financing assurances. Meanwhile, a bearish IMF debt sustainability analysis (DSA) report, created with the World Bank, recommended a larger haircut than Eurobond creditors were willing to accept. And then there was China. It was reluctant to restructure the debt and objected to the terms Eurobond creditors had agreed with Zambia in November 2023, prompting yet another delay.
Having a seat at the table
A major takeaway from the three restructurings is the importance of having a seat at the negotiating table. First-hand engagement allows investors to develop a more informed investment view rather than relying on frequently misleading market speculation.
We’ve seen this in Ghana. The Steering Committee (SC) is a smaller group of creditors representing a larger group of bondholders, or the ad-hoc creditor committee (AHC), in discussions with financial, legal advisors and the issuer. The SC is not necessarily the largest group of creditors but, along with the legal and financial advisors, it plays a critical role in driving the restructuring process.
SC members usually attend most, if not all, meetings with advisors and then with the issuer and advisors when the time comes. AHC meetings are more infrequent, and members often ask the SC and advisors for informal updates. For the record, the advisor information we’ve received, which we’ve shared internally and with other creditors, is public. As the deal approaches, however, the SC will have to sign an NDA (non-disclosure agreement) before exchanging views with the issuer and advisors on the proposed restructuring terms.
These meetings are often challenging, with discussions around the minutiae of restructuring. This includes whether any deal meets the IMF’s DSA parameters. This can be tricky. The initial Ghana and Zambia DSA’s were contentious. Creditors thought the IMF’s macroeconomic assumptions were too bearish, implying a weaker recovery in the bond valuations than creditors expected.
All key stakeholders – the country in default, IMF, Paris Club (which represents most bilateral creditors), China, and creditors – must find ways to accelerate the restructuring process.
Sri Lanka
Sri Lanka defaulted two years ago. While not involved in any of the creditor committees, updates suggest both sides have largely accepted the terms of the restructured bonds. This will also include a contingent instrument in the form of a macro-linked bond (MLB), which has been the main source of the delay in the restructuring.
The IMF is assessing whether the MLB complies with the DSA parameters and has yet to sign-off on the deal. One SC member has described the MLB as “complex”. This could explain why the IMF has yet to comment on the revised MLB.
Critics often oppose adding contingent instruments to debt restructurings. However, we think these are a ‘win-win’ solution. They improve the country’s capacity to service debt when it meets the payout trigger and reduce the losses that most investors suffered as a result of the default. The instruments can also expedite a restructuring agreement, enhancing capital flows into the country.
As with Ghana, Sri Lanka is allegedly close to a deal with its Eurobond creditors. One potential fly in the ointment is October’s presidential elections. In the interim, all eyes will be on the IMF.
Mainstream EM
Investors are also preparing for debt restructuring talks with Ukraine, with Lebanon and Venezuela waiting in the wings. The challenges for these mainstream EM countries are unique. Ukraine is in the middle of the war, which is arguably the worst time to restructure. Lebanon must resolve its political impasse and select a new president before it can secure a deal. This is unlikely until the Gaza conflict ends. The US, meanwhile, must confirm the legitimacy of Venezuela’s July presidential election before any meaningful talks can start.
Eurobond creditors, having learned hard lessons from the flawed 2020 Argentina debt restructuring, are now expected to insist on a cash coupon arrangement with Ukraine. Moreover, the Group of Seven (G7) will have to endorse any agreement, given its taxpayers have footed the bill for Ukraine over the last two years.1 Despite these headwinds, a restructuring agreement in 2024 remains possible. However, the clock is ticking, with the two-year debt moratorium it reached with creditors. expiring in August.
Meaningful discussions with Lebanon and Venezuela are unlikely until 2025. Nonetheless, market speculation and low bond prices (Lebanon trades around seven cents, and the Venezuela complex is in the low-to-high teens) could prompt some distressed investors to take a punt before negotiations commence.
Final thoughts
We hope the lessons learned from lengthy debt restructurings will inform the next wave of defaults. However, private sector creditors can only do so much to improve the process. Much will depend on the IMF, Paris Club, China, and the bond issuers. Unfortunately, these defaulted countries have suffered collateral damage because of the flawed Common Framework, the debt restructuring process that the Group of 20 created in late 2020.2
Policymakers in New York introduced new legislation that has yet to be formally approved but could change international bond contracts. This legislation may restrict investors' capacity to negotiate fair and equitable restructurings. A new UK government is likely to introduce something similar. Most international bonds are issued under New York and UK law so that the new rules could have a chilling effect on investors and issuers. These unintended consequences could potentially increase the borrowing costs for nations most needing private financing. This will present new challenges for issuers and investors involved in the next wave of defaults and restructurings.
1 The Group of Seven (G7) is an intergovernmental political and economic forum consisting of Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States.
2 The Group of 20 (G20) is a forum comprising nineteen countries with some of the world’s largest economies, as well as the European Union (EU) and the African Union (AU).
Important information
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.
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