The use of state-contingent debt instruments in a spate of recent restructurings suggests they may be delivering on their potential to resolve conflicts inherent in complex sovereign situations. By David Rothnie.
Every sovereign restructuring deal has its own unique aspects, but the recent cases of Sri Lanka, Suriname, Ukraine and Zambia share a common feature – the use of state-contingent debt instruments as a catalyst to a successful outcome.
While the use of SCDIs in sovereign restructurings is seen as a welcome innovation, they are not a recent development. Known also as value recovery instruments, they cover a group of well-established structures, from catastrophe bonds to inflation-linked paper. But the uptick in their usage is noteworthy and there is a growing sense they will provide an increasingly important feature as emerging market debt restructurings spike in the wake of the Covid-19 pandemic and Russia’s invasion of Ukraine.
They are becoming popular instruments to help resolve increasingly fractious and prolonged restructurings and provide a means by which bondholders and sovereigns can reach consensus where there is a disagreement in the debt sustainability analysis the IMF uses as the basis for restructurings.
SCDIs provide upside for creditors when predefined conditions linked to future GDP growth are met. By tying the payments of restructured debt contracts to future outcomes, SCDIs may reduce conflicts over current valuations and facilitate more sustainable agreements between creditors and debtors.
“SCDIs are a tool to bridge gaps between stakeholder assumptions about the state of a debtor economy in the future," said Sorin Pirau, portfolio manager at Janus Henderson Investors. "Different stakeholders have different assumptions, and where this leads to a gridlock, implementing a VRI (value recovery instrument) helps to bridge this gap and hopefully speed up a deal.”
No more shouting matches
In the past decade, there have been five sovereign restructurings and, with the exception of Ghana, all have used SCDIs. Banker say Ghana did not need an SCDI because there was agreement from the outset on macro projections.
Last year, Suriname became first sovereign borrower to exit default this decade after it turned to SCDIs linked to its future oil wealth. In recent years, US and European oil companies have flocked to the country, which they regard as the next big oil economy. But the IMF’s debt sustainability analysis did not take this potential into account.
To resolve the impasse, in November 2023, Suriname and its Eurobond holders reached an agreement which included a 10-year plain vanilla bond as well as an SCDI allowing bondholders to benefit from the upside potential in the country’s oil and gas sector by guaranteeing holders a defined portion of potential oil royalties. Ultimately, investors holding the defaulted bonds received a package valued at more than 100% of the claim as of the end of 2023.
In July 2024, Zambia issued two new bonds in exchange for its defaulted maturities: a vanilla 2033 maturity and another SCDI maturing in 2053, with financial terms dependent on certain macro thresholds. If these are reached, then the SCDI will deliver accelerated repayments through higher coupons, front-loaded amortisations and a shorter maturity profile.
In Zambia, the contingent instruments are called ‘B’ bonds and, as with Suriname, they came about as a result of a row about the future of the country’s economy. The B bond kicks in if the debt-carrying capacity of the sovereign improves and leads to the country being reclassified according to the IMF’s measures.
Meanwhile, Sri Lanka is nearing the end of a bitter and protracted restructuring thanks to a potential agreement which involves bondholders taking a 28% nominal haircut on US$12bn of Eurobonds in exchange for a package consisting of one conventional vanilla bond and four macro-linked bonds. MLBs are a new type of SCDI and the coupons and principal of MLBs will be adjusted up or down according to the country’s GDP performance.
Some of the impetus for greater use of SCDIs has come from the IMF, which published a working paper in 2020 calling on wider adoption of the instruments in a world where more sovereign restructurings are likely in the wake of the pandemic.
“The Covid-19 crisis may lead to a series of costly and inefficient sovereign debt restructurings. Any such restructurings will likely take place during a period of great economic uncertainty, which may lead to protracted negotiations between creditors and debtors over recovery values, and potentially even relapses into default post-restructuring. State-contingent debt instruments could play an important role in improving the outcomes of these restructurings,” it said.
From hot money to real money
But the increasing use of SCDIs in debt restructurings has also come about due to a number of factors driven in large part by a fundamental shift in the make-up of bondholder groups, with real money investors now dominating registers and becoming more sophisticated in debt negotiations.
They have started bolstering their senior ranks with former IMF officials and that has emboldened them to challenge the typically conservative macro assumptions of the IMF. For example, in the case of Suriname, a row erupted between when early in the process IMF refused to integrate fiscal revenues that would be derived from oil discoveries. Following a stand-off and the changing of the IMF mission chief, the two sides came up with the idea of using an oil warrant, based on the Brady restructuring in Nigeria.
GDP warrants were also used in Ukraine in 2015. However, there is a crucial difference. Warrants, which are a form of VRI, are not fixed-income instruments and therefore are not index-eligible, whereas SCDIs are. This distinction enables real money investors to own them in their portfolios and produced the catalyst for SCDIs to solve a gridlock in restructurings.
“Argentina's 2020 restructuring was the catalyst for a recomposition of creditor committees, and led Suriname, Zambia, Ghana, Ukraine and Sri Lanka sole creditor committees to enjoy a combination of real money funds and hedge funds," said Eric Lalo, head of sovereign advisory at Rothschild & Co. "This created a very different dynamic when discussing with the IMF.”
According to Lalo, the emergence of SCDIs as a more powerful tool dates back to the first sustainability-linked bonds that were issued by Uruguay and Chile a couple of years ago. At the time, there was a lot of discussion around whether those instruments would become index-eligible because the cashflows were fixed subject to contingency.
“There was a worry among real money investors until JP Morgan included them in its EMBI index. All other index providers followed suit. This resulted in extensive innovations in the field of SCDIs,” said Lalo.
Bankers say the unique feature of the Sri Lanka SCDI, which will be index-eligible, is that it provides for both upside and downside – downside protection for Sri Lanka in the case the economy contracts more than was anticipated by the IMF but also upside in the case it performs better than envisaged.
For example, in the case of Sri Lanka, the 10-strong bondholder group comprised nine real money accounts and just one hedge fund. “That has changed the dynamics and that is why state-contingent bonds may become a standard in case there is a difference of opinion with the IMF on the macro framework that sustains the debt sustainability exercise,” said Lalo.
This was a direct response to the 2022 Argentina debt restructuring, when there were three creditor groups fighting against each other. Since then, real money investors have looked to gain greater control.
While SCDIs are index-eligible and can therefore by used by real money investors, GDP warrants, which are classed more broadly as VRIs, are not.
In September, Ukraine agreed a restructuring plan that included an SCDI linked to future GDP growth based on the assumption that the economy will improve once the conflict ends. When Ukraine issued GDP warrants in 2015, Franklin Templeton owned half of them, but because they were not index-eligible sold them at a steep discount and they were bought by hedge funds.
Hedge funds remain essential to the restructuring ecosystem for their flexibility and nimbleness. As Lalo points out, this change has its roots in the 2022 Argentina debt restructuring, when the three sets of creditors battled against one another in a painful drawn-out process. Now, asset managers use their firepower to squeeze so-called vulture funds, which are aggressive litigators that cause greater delays, out of the process.
No panacea
While international creditors like SCDIs for their index-eligibility and their status as a tool for resolving lengthy restructuring processes, they are by no means a panacea. While they have been talked about for a long time, they remain relatively rare in their application, and where they have been used, they constitute a relatively small part of any restructuring solution. The 2020 IMF working paper noted: “Fixed-income investors have typically steeply discounted these “equity-like” instruments given their nonstandard designs, illiquidity and idiosyncratic risk profiles; hence, they have often provided poor value for their cost to borrowers.”
In the case of Sri Lanka, the negotiations of the MLBs were one reason why the final restructuring plan has still yet to be agreed. Pirau said: “There are so many factors that go into negotiating SCDIs and where they sit within a restructuring. Where the stakeholders – the debtor country and the creditors – don’t have experience in managing or understanding these kinds of instruments, they will need time to build up this expertise.”
They do not necessarily suit the needs of every creditor. “International bondholders are more focused on maximising a recovery, whereas local banks are more on minimising accounting losses," said Lalo. "Therefore, the debt treatment is very different and generally local groups have zero interest in contingent instruments. It is not their focus because their primary objective is not to destroy their balance sheet with big haircuts that could be compensated by potential upside coming from the contingent element.”
In the case of Ghana, the B bonds will only kick in when GDP hurdles are met, so the question of liquidity has not yet been answered. Sri Lanka’s MLBs could prove to be a test case, as they are the major instruments in the restructuring.
As SCDIs evolve, bankers hope that they can do more than patch up rows between creditors. Guyana is a case in point. The country issued climate resilience bonds which paid out when the country was hit by hurricanes over the summer. The result is that the country averted a default. Ever since the common framework was introduced in 2020, restructurings have become more protracted and complex, with the result that prevention is now seen as being better than the cure. As climate change creates uncertainty around the future of economies across the world, SCDIs could become a more common feature. GDP linkers have been talked about for years, but they could become a powerful instrument to prevent restructurings rather than simply a tool to resolve creditor conflicts.
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