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Sovereign defaults are not as scary as they seem

06 March 2020 | Markets and Economy

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Commentary by Nick Eisinger, fund manager, emerging market sovereign credit

To some investors, the prospect of sovereign debt default is daunting, and it’s not hard to see why. Emerging market debt investors currently face a number of unnerving headlines: the prospect of an imminent default in Lebanon, a large restructuring in Argentina and a lengthy wait to determine what, if any, recovery will emanate from Venezuela.

When I started investing in government debt, one of the first things I was told was to steer clear of defaulting countries, and that remains sound advice. But there are nuances to this, and history tells us that sovereign defaults are rarer than the financial media suggests—and less terrifying.

Sovereign default or debt distress can attract a lot of attention but as a share of all tradeable sovereign debt in the global system, outright defaults are low. Even set against the universe of emerging market debt (local and hard currency) where debt distress tends to be more frequent, it’s still pretty small.

Moody’s rated sovereign bond defaults1

Source: Moody’s.

Furthermore, focusing solely on sovereign debt distress risks missing the full picture. There are many countries with strong payment records, yet which have experienced systemic banking sector or currency crises. While the sovereign may not default in a banking crisis, it can certainly feel (and trade) that way, such as in Spain or Italy in 2010. In short, your portfolio can be at risk just as much from a systemic financial crisis as from a sovereign crisis.

Financial crisis or sovereign default crisis?

While it’s generally best not to own sovereign debt in a default, much depends on the price of the bonds. This is particularly important for sovereigns, where recovery rates have historically been quite high. In instances where you believe the recovery rate will be higher than the price at which the debt currently trades, there can be an attractive risk-reward trade-off in owning some of these bonds. One reason for this is the stronger credit profile that would usually be associated with a country after restructuring its debt.

The various factors that can pull sovereign issuers towards default are complex and differ across countries; a common contributor is excessive leverage. Understanding these dynamics requires an assessment of both a sovereign’s ability and willingness to repay its debt. This is rather different to the default assessment for a corporate, where the focus is on its ability to repay. This is because governments have a wider range of tools at their disposal to manage stress than corporates. For example, a sovereign can have its central bank buy its bonds, it can force a ‘captive’ domestic banking sector to buy its debt, it can request assistance from the International Monetary Fund and, of course, it can raise taxes to improve its solvency.  

Recovery rates on selected defaulting sovereigns

Country

Year

Recovery, % of par

Russia

1998

18

Argentina

2001

27

Jamaica

2010

90

Greece

2012

37

Argentina

2014

68

Ukraine

2015

80

Mozambique

2017

61

Venezuela

2017

28

 Source: Moody’s and Bloomberg.

Corporates have none of these tools available to them. This means that for corporate bonds—especially those with higher yields—the timeframe leading up to a default can be much shorter than for sovereign defaults, where the process is usually lengthy, partly due to the tools outlined above. For example, when Venezuela defaulted on $65 billion of debt in 2017, it had displayed material signs of debt distress for a long time, giving the market time to prepare. By contrast, when the high-yield bonds of mobile phone distributor Phones 4 U defaulted in 2014, markets had much less time to react. Bonds which had been trading near par one week before quickly fell to around 30 pence in the pound.

Corporate bonds: shorter lead-times to default

'Phones 4 U', 91/2% April 2018 bond, cash price 

Source: Bloomberg.

Fear of sovereign default should not necessarily cause investors to avoid the debt of countries facing crisis altogether. There is usually a price for distressed bonds at which it makes sense to buy, and as we’ve seen, it can also take a long time for a sovereign to default. Equally, there may be solid reasons to add exposure to a sovereign in the immediate aftermath of a debt restructuring announcement, or market speculation of an upcoming one. Opportunities like this can allow you to benefit from a range of technical factors that can cause bonds from the same issuer to behave very differently. It’s also possible to take advantage of the often lengthy periods before an actual legal restructuring takes place. If you can buy bonds at 30 cents on the dollar and receive a coupon payment or two before actual default takes place, that can often be a good investment.

That’s not to say you should be complacent about sovereign debt default risk. A key part of our role as bond fund managers is to seek to protect our investors from major risk events. An investor’s capacity to hold distressed bonds, even at attractive prices, is driven by prudent, risk-adjusted and forward-looking risk management. This can help to avoid concentrated and correlated positions or add risks that may be dominated by one or two factors. It also means that there will usually be scope to benefit from the asymmetry of distressed debt opportunities, potentially boosting investment performance.

[1] The Moody’s data show the number of sovereign defaults as a share of the total number of sovereigns they rate. They don’t show a weighted default rate to the overall emerging market debt universe (local and hard currency). For example, in 2018 Barbados defaulted on $3.5bn of debt against a total emerging market debt market of around $11 trillion.

 

 

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