High Stakes Finance: Sovereign Distress
Level 2 - Value Investor
Welcome Avatar! We’ve had Cap Stack here before to talk about bankruptcy and to round it out this will cover Soverign Debt. Doesn’t take much looking to find countries in disress (Turkey/Argentina - or the fake debt Ceiling Crisis in the USA). This will serve as a quick walk through related to “distressed countries”.
The glow in the eyes of a bankruptcy lawyer detailing the fallout of a company that employs thousands of people who may lose their jobs (and potentially their pensions) does not make for lighted-hearted conversation over cocktails, no matter how intellectually stimulating the case is.
There is rarely, if ever, a situation where all stakeholders in a distressed situation are “happy.” Certain stakeholders (particularly those who profit heavily at the expense of other creditors) may be elated, but we cannot picture a situation where all, or even most constituents are happy.
There will probably be at least some job loss and employee equity getting wiped out. Key executives can receive large incentive bonuses for their participation in the bankruptcy process, but being seen as the person who drove a company into the ground can be a stain on your resume (executive departures can be a sign of trouble). Some lenders will be getting wiped out or receiving less than they’re owed. Shareholders receive a big fat zero.
Others, particularly senior secured lenders, may receive a full recovery. If they’re lucky, they were so far up the cap stack they barely had to pay attention. The big winners are the buyers of distressed securities.
The U.S. corporate bankruptcy process, complex as it may be, generally does a good job of allocating unhappiness and happiness (also known as “money”) to various stakeholder groups.
Distressed countries are a different ball game. The legal framework for sovereign debt distress is complex, with no formal international bankruptcy process for nations.
The scale, complexity, power dynamics, and the very act of going up against the people who write the laws to receive what you are owed at the expense of the millions of people in that nation might rightfully scare some people away from getting involved at all.
Fear to some is opportunity for others. Despite getting burned along the way, hedge funds have continued to dive headfirst into sovereign distressed situations not knowing which end of the pool they’re on. Those that swim back up to the surface may have gone through months or years of legal battles, political maneuvering, and incurred significant expenses.
We’re Cap Stack — analysts from a lesser known side of Wall Street focused on distressed debt. We follow troubled companies and turnaround stories.
Sovereign distressed land is for the most tenacious and hard-nosed of the distressed bunch who are willing to give years of their livelihood to make them pay. Oh right, and also some of that nation’s (and potentially the world’s) largest mutual funds and wealth managers. These players, despite being among the largest owners of large swaths of debt, may not be the best prepared. Evaluating distressed debt is a very specific skill. Evaluating sovereign distressed debt is even more specific and comes with a unique set of risks.
The most famous sovereign distressed debt case is the decade plus battle between a group of hedge funds led by Elliott Management and the government of Argentina.
As Argentina’s economy spiraled in the late 90s, Elliott was quietly buying up Argentine bonds at a substantial discount on the market. Argentina defaulted on over $100 billion in sovereign debt in 2001. This resulted in bank runs, bank deposits being frozen, and public demonstrations.
Argentina went through a debt restructuring (one of many), offering bondholders a chance to swap their bonds for new ones worth around 30 cents on the dollar. In 2005 and 2010, most bondholders accepted. A small percentage, including Elliott Management, refused and sued Argentina for full repayment.
You could say it got a little out of hand. In 2012, Elliott famously seized an Argentine naval vessel in Ghana with over 100 navy personnel aboard (the story is 100% true, but a UN court ordered Elliott to release the ship a few months later since it was a military vessel).
The hedge funds argued Argentina violated the pari passu clause, requiring equal treatment of bondholders, by paying some while refusing others. U.S. District Judge Griesa agreed, ordering Argentina to pay the holdouts.
Pari Passu: Parties to a financial contract have equal rights to payment. This allows multiple lenders to have the same claim on collateral, and is a key concept in bankruptcies.
Argentina appealed multiple times but lost, resulting in a default on $29 billion of debt in 2014 for trying pay certain creditors while ignoring others (the holdouts).
The election of Mauricio Macri in 2015 aimed to usher in economic reform, part of which included settling with the holdouts. In 2016, Argentina agreed to a $4.65B cash payment, equivalent to 75 percent of the total outstanding payment, to its main holdout creditors. After 15 years of fighting, Elliott had received over $2.2B for the ~$600mm of principal it owned (bought at a discount). If you’re curious as to how the amount ballooned to such a size, look no further than FRANs.
FRANs, short for "floating rate accrual notes" were a type of bond issued by the Argentine government.
The key characteristic of FRANs was their floating interest rate, which was determined based on the market yields of other fixed-rate Argentine debt. As the country faced higher perceived risk, the interest rate on FRANs would increase, providing higher returns to investors to compensate for the elevated credit risk.
As Argentina became less creditworthy, the interest rate on FRANs would adjust periodically. When the FRANs matured in 2005, the interest rate had reached 101% per year. Argentina wasn’t paying anyway, and it may have gone unnoticed if not for the group of holdout hedge funds who fought to the bitter end in courts.
The huge profits earned by holdout creditors in an otherwise dark era for Argentina sparked a global debate about sovereign debt restructurings.
Sovereign debt restructurings have sweeping implications that go beyond debtor and creditor. There is no bankruptcy code that applies to sovereigns, not even their own. At the same time, sovereigns issue debt that is legal, valid and binding in some jurisdiction.
Sovereigns can kick and scream about their economic woes, the financial system at stake, and make all sorts of emotional appeals. The crux of the matter from a legal perspective is: you borrowed the money, you pay it back.
Of course, we’re here talking about situations where sovereigns can’t pay everything back. In these situations creditors and sovereigns have no choice but to negotiate a solution. Sovereigns know that they can’t leave their debts unsettled if they want to tap debt markets, and creditors know they can’t just fly around the world seizing assets that happen to float outside of a country’s territory if they want a reasonable recovery.
History is spotted with sovereign debt defaults, particularly in emerging economies.
What about when a leading economy gets into trouble?
U.S. Debt Ceiling
Here is the story of the U.S. Debt Default... Not.
The U.S. Debt Ceiling song-and-dance happens every few years. The debt ceiling has now been raised a whopping 90 times since 1959. It has become something of a tradition for Congress to spend months of their time (paid for by taxpayers) on the same old debate.
It raises an obvious question: why not just get rid of it?
The U.S. has been gorging on debt at an accelerating pace over the last 40 years. The debt ceiling has not made Congress a more prudent spender. It’s like when you were a kid and your dad gave you $20 to go to the movies and said “bring back the change.” Both of you knew the change wasn’t coming back.
Why does the debt ceiling even exist?
Ironically, the debt ceiling came about as a result of making it easier for the government to take on debt, not harder. Before WWI, Congress would approve bond issues manually. Giving the U.S. Treasury Department more flexibility to manage the debt made sense as the U.S. grew. This change brought in place debt limits, which eventually became the ineffective tool to control debt we have today. Since it’s generally well accepted that the U.S. debt ceiling will be raised to meet obligations, any attempts at using the debt ceiling to make substantive demands by one political party are unlikely to be fruitful. While rising debt may be unpopular amongst voters, missing interest payments over a technicality and sending the U.S. and the rest of the world into a financial spiral is going to be viewed as far worse.
There’s a difference between what people think the debt ceiling means, and what it actually means. What people care about is controlling excessive government spending to reduce reliance on debt more broadly. The debt ceiling is a separate issue, and one that revolves around the technical implications of how markets would react to a delayed payment. The U.S. is unlikely to truly default on its debt over a limitation it has full control over. It does, however, provide traders and the financial media with some firepower to try and drum up volatility.
The U.S. has never defaulted on its debt, but many other countries have. Some are even teetering on the edge of bankruptcy today. These stressed or distressed credits can provide attractive coupons and strong rebounds upon an economic recovery. Distressed sovereign debt has outperformed in 2023. Investing in the bonds of an economically at-risk country requires a deep understanding of past and present sovereign distress. It’s for people interested in pushing the edges of their knowledge of economics, politics, finance, and law (but don’t go too far).