Sovereign debt defaults and restructurings are not rare occurrences. A large number of them has taken place throughout history, both in developed and emerging markets. Indeed, between 1978 and 2010, a total of 180 bond and bank loan restructurings have been carried out by sovereigns globally, according to a 2015 National Bureau of Economic Research (NBER) paper authored by UCLA professor Sebastian Edwards.
During a sovereign debt restructuring, creditors are asked to exchange an old security for a new one with less favorable financial terms. The new paper usually features some combination of lower principal, reduced coupons, and a longer maturity when compared to the old paper, imposing a loss in net present value (NPV) terms to investors. This NPV loss, usually called "haircut," can be computed by discounting income streams of old and new securities. The so-called "exit yield," or interest rate at which the new securities trades in the secondary market the day of the debt exchange, is often used for discounting purposes. Fig. 1 presents haircut summary statistics for all modern sovereign debt restructurings. The sample's average haircut is 37%, with a fairly large standard deviation of 27%.
Argentina is set to become the latest country to undergo a debt restructuring, following an unexpected result in the 11 August primary elections. Alberto Fernandez, opposition candidate likely to win the presidency in the 27 October elections, has recently stated he will carry out a debt restructuring comparable to that of Uruguay of 2003, one which imposed a very modest NPV loss on investors of less than 10%. The fact that Argentina, a country which has imposed one of the harshest NPV losses on creditors in history – 75% during the 2005 restructuring – is now talking about implementing one of the most market-friendly debt exchanges ever, should at least raise eyebrows.
We need not forget that the IMF – the largest external creditor of Argentina at the moment – will have a say in Argentina's restructuring. The institution will be asked by Argentina to be paid back much later and at lower rates than originally agreed upon. The IMF will itself therefore likely demand "private sector involvement," or efforts (read NPV losses) by private sector creditors to help put Argentina back on a sustainable debt path.
Figure 1 - Sovereign debt restructurings are not rare events
Histogram of haircuts (in %), and summary statistics, 1978-2010
In short, investors should expect Argentina to conduct a full-fledged debt restructuring, not simply a "reprofiling" affecting only debt maturities but leaving bond principals untouched. The exact extent of NPV losses Argentine creditors will experience is extremely difficult to handicap at this point, considering the country lacks a medium-term macroeconomic plan under the current uncertain political environment. But losses comparable to those of Uruguay in 2003 are probably wishful thinking, with the 37% average haircut of the last 40 years representing a more accurate starting point to anchor expectations, in our view. The good news is that Argentine sovereign bonds in US dollars, trading at an average price of 47 cents on the dollar, are discounting fairly dire restructuring conditions.
All this talk of defaults and restructuring should not, however, deter investors from buying dollar-denominated emerging markets (EM) sovereign bonds in a well-diversified manner. Despite these episodes, the asset class has been one of the best-performing fixed income segments globally over the last 15 years, delivering solid risk-adjusted returns.
Alejo Czerwonko, Emerging Markets Strategist Americas, UBS Financial Services Inc. (UBS FS)