Macro Analysis /
Global

Sovereign defaults in 2020: Experience and lessons

  • A record number of sovereigns (six) have defaulted on bonds this year

  • But the pandemic is not the root cause; many of them would have happened anyway

  • Issues around use of collective action clauses (CACs) and treatment of bilateral debt may have lessons for the future

Sovereign defaults in 2020: Experience and lessons
Stuart Culverhouse
Stuart Culverhouse

Chief Economist & Head of Fixed Income Research

Follow
Tellimer Research
8 December 2020
Published byTellimer Research

We've seen a record number of sovereign defaults on bonded (external) debt this year according to our records, at least in terms of recent history, although it was becoming obvious we were heading for a record even by the middle of the year. We count six countries and seven default events.

Most (four countries, five events) are in Latin America (Argentina, Belize, Ecuador, Suriname x2), with one in the Middle East (Lebanon) and one in Africa (Zambia). Zambia became the first county in Sub-Saharan Africa to default on its bonds since Covid, and the first proper African bond default since Mozambique in 2017.

Number of sovereign bond defaults by year

However, we don’t think the pandemic is to blame for this rash of defaults. While it may appear, on the surface, that there is a strong correlation between default and the pandemic, many of these defaults would have happened anyway. Indeed, Lebanon’s occurred before the global Covid crisis really began. Argentina was already heading for a strategic default, a decision that was rubber-stamped by an IMF statement in February. And while Zambia may present itself as a Covid default, as it seeks sympathy from lenders, it was more likely the straw that broke the camel’s back; the only real surprise is that Zambia lasted this long. Suriname also had pre-existing vulnerabilities evidenced by its expensive short-term financing in December last year (priced to yield 12.6%).

There may have been two defaults that may be more directly attributed to the impact of Covid. First, Ecuador. Although already on a knife-edge, and exposed by the collapse in oil prices, willingness and policy implementation under the IMF programme was strong. After all, the IMF approved the joint second and third reviews of the EFF as recently as December 2019, although it was a struggle. Three months later they were in default. Second, Belize, due to the impact of global lockdowns on the tourism market, a key driver of its economy, although investors also know Belize is a serial defaulter while other small tourist-dependent economies haven’t defaulted (eg Seychelles, the Maldives).   

For a summary of the circumstances around the defaults, see the table.

There are two points to note. First, including Guatemala’s missed coupon on the ‘26s on 3 November would make seven countries, although the payment was made during the grace period, so we don’t count it as a default here (both S&P and Fitch took rating actions in response to the missed payment). The non-payment was a consequence of legal action by a contractor in a payment dispute. Second, we also exclude defaults on other commercial debt (there are ones we know about, eg Chad reportedly sought a suspension of payments on oil-backed loans, possibly Angola too, and there may be others we do not know about or where there have been requests for loan waivers).  

That there haven’t been even more bond defaults, in the face of international calls for debt relief, especially for low-income countries, may be more of a surprise. According to the World Bank, 44 countries (60% of those eligible) have participated in the G20’s debt service suspension initiative (DSSI) to defer debt service payments on bilateral debt, of which 36 have signed an agreement with the Paris Club (see here). Participation by private creditors has been low, however, much to the official sector’s chagrin. Low take-up reflects, in part, issuer concerns about the implications for their credit rating and limitations that are imposed on commercial borrowing (see here). Only three countries are said to have sought comparable relief from commercial creditors (Zambia we know of, maybe the others include Chad and Grenada, although Grenada quickly back-tracked). So, among the six sovereign defaulters this year, five have happened outside DSSI.  

This also means that there are now three on-going bond default cases – Lebanon and Zambia join Venezuela (four if we include Suriname).

That these defaults were not a huge surprise was reflected in their ratings in advance. Four of these countries had ratings in the CCC or below category at the end of last year, the exceptions being Belize and Ecuador, which implies a high probability of default.

There are two further observations. First, two defaults (a third of the total) followed a change of government – Argentina and Suriname.

Second, none of these defaulting countries had a live IMF programme at the time, although that might be in part because debt restructuring (PSI) was a prior action for continuing IMF support in some cases (Argentina and Ecuador, as existing programmes went off-track) or new IMF support in others with unsustainable debt burdens either before Covid (Lebanon, Zambia) or after (Suriname). Ecuador negotiated a new programme during its temporary standstill. Lebanon, Suriname and Zambia are essentially trying to do the same, although with varying degrees of success so far. Of the six, only one (Ecuador) now has an IMF programme. While therefore the IMF may appear 'absent', we think it is playing a key role behind the scenes, although its role in the Argentina restructuring may have dented its credibility.

Value of sovereign bond defaults by year

Historical context

The number of bond defaults comfortably exceeds what we’ve seen over the last decade. Since the GFC, there has been on average c1.3 defaults per year. We had seen 3 each however over both 2016 and 2017. And the number of defaults (and the principal value to which it covers) is much higher than we saw during the GFC (when there were just two - Ecuador and Seychelles).

One reason why we may be seeing more countries in default (or distress) compared with the global financial crisis (GFC), or the general experience over much of the past decade, is that the universe of countries with bonded debt is simply much bigger than before, after all the issuance from new markets that haven’t previously issued (frontier markets), which by definition tend to be smaller, more vulnerable countries. That is, we didn’t see so many defaults during the GFC as the frontier universe was much smaller back then and the issuers that did exist at the time were generally more established in the market. Most of today’s frontier bonds were issued in 2012-14, a period when frontier issuance exploded – we reckon there were some 14 debuts over this period, c40% of all frontier debuts since 2007 (if we date the birth of the frontier bond market to 2007, marked by debuts from Ghana and Gabon). And, as the typical debut is a 10-year tenor, most of the bonds haven’t come due yet.

Of course, the problem with that line of reasoning is that only two of the six defaulters this year are frontiers that have issued since the GFC (Zambia debuted in 2012 and Suriname debuted in 2016). The other four (Argentina, Belize, Ecuador and Lebanon) have had a market presence for a much longer time (they are not new kids on the block who don’t know any better), although three (Argentina, Belize and Ecuador) are serial defaulters.

In fact, the strong willingness to pay of frontier sovereigns during this crisis, and therefore lack of defaults, should be a strong signal in support of the asset class.

Frontier bond issuance - number of debut issuing countries by year

Who’s next?

One way to look at this is to look at sovereign ratings. There are nine countries with ratings in the CCC-rating bucket or below, across the three main agencies, excluding this year's default cases and Venezuela (see table). The probability of default for a country in the CCC territory is quite high. The one-year implied probability of default for a country rated in the C-CCC category is 26.5%, according to Fitch (the default probabilities for the other agencies may differ).

Of these nine, the most likely default candidates in our view are Laos and the Maldives. We assign a much lower probability of default in the cases of Sri Lanka and Mozambique (we have Buys on both). We think Angola should be ok unless the IMF programme goes off-track and/or oil prices plummet again.

Countries with CCC ratings (or equivalent) and below

But nor do we expect a wave of sovereign defaults, or a systemic crisis. The defaults we’ve seen have mostly been well flagged and are idiosyncratic, and, for every Argentina or Belize, there are many others that demonstrate a much stronger willingness to pay or ownership over an economic adjustment programme. That said, as noted above, frontier markets face a funding cliff over 2022-24 with a heavy maturity profile, as that is when a lot of the bonds that were issued in the first wave come due.

Lessons from default

We highlight some market trends or other features of the default experience this year. Crucially, this year has seen a test of the existing financial architecture in terms of the use and design of collective action clauses (CACs) and the treatment of bilateral debt, which may have lessons for the future.

  1. Use of consent solicitation, but no panacea. One feature of sovereign behaviour this year we observe has been the growing use of consent solicitations as a tool to seek to defer debt service payments. Does this innovation signal a new trend, and is it a good thing or not? Consent solicitations are not new; Belize amended the payment terms of its dollar bond via consent solicitation in 2017 rather than issue a new bond in an exchange. But the use of a consent solicitation to effect a standstill (formalising a default and removing the imminent threat of litigation) seems to us to be a new feature of the sovereign debt landscape. Previously, it seemed to be the case that sovereigns in distress would just default and bondholders would generally not seek immediately to accelerate or litigate while they negotiate (eg Barbados, Venezuela, Mozambique, Ukraine, Grenada). But consent solicitation to defer payments was tried by the Province of Buenos Aires in January, followed by Ecuador, Belize, Suriname and Zambia (albeit with mixed success – it failed in Buenos Aires and Zambia) and it may be no coincidence that it often involves the same advisors. In the absence of a formal standstill mechanism, using a consent solicitation to defer payments may be attractive and more efficient than the alternative, it buys time and can provide a bit of certainty, minimising some of the downside from a technical/payment default. If the market is moving in this direction, it may therefore be a good thing. But consent solicitation is a means to an end and is no panacea. We think it is only a good thing if the sovereign uses the time it buys wisely, to engage in good-faith negotiations and come up with a credible and coherent economic programme. In the sovereign cases this year, consent solicitation to defer payments has often been a first step, with three of those cases a prelude to a restructuring. If, however, it is used opportunistically, merely to avoid a default and defer policy decisions, without leading to serious good-faith engagement with creditors, it is only a distraction from the fundamental issue (eg compare and contrast Ecuador and Zambia). Moreover, if it fails, rather than provide certainty, it does the opposite, as investors focus on whether the next coupon payment will be made or not. In addition, consent solicitations that also seek to waive an event of default can reduce bondholders’ leverage, so investors will want to be confident about the process before giving up these rights.  

  2. The use and (perceived) abuse of CACs

    i. Redesignation. It's not clear to us, when ICMA's model aggregation clause arrived in bond documentation in 2014, that it was envisaged that issuers could then change the voting pool to manipulate the results to get the answers it wants through opportunistic use of redesignation provisions and then use the threat of further restructuring offers (Pac-Man strategies) to eliminate holdouts. But this is what Argentina did (see here). While strictly permitted under bond contracts, Argentina’s approach is seen as not being in the spirit of CACs and could set a dangerous precedent. Argentina and Ecuador may have sought to appease investor concerns by including anti-redesignation and Pac-Man clauses in their new bonds, which impose some constraints on the issuer, but it is not clear whether investors value these protections yet. Mongolia is the only country we know of so far to have adopted Argentina and Ecuador-style anti-redesignation and Pac-Man clauses in its bonds (and over 20 EM sovereigns have issued foreign bonds since early September – which mainly use the old wording that has evolved out of ICMA’s model clause). More broadly, while we should be wary of making policy in reaction to the behaviour of one errant debtor, the saga may require consideration of best practice and further refinements to bond documentation.

    ii. Coercion. Ecuador’s treatment of non-tendering holders could set a bad precedent for other restructurings, especially those countries looking to restructure bigger bond stocks (see here). Unlike in previous restructurings, although non-tendering holders (holdouts) can be expected to be crammed down (dragged along) if required participation thresholds are met, Ecuador ensured that such holders would not receive the same package as everyone else and were discriminated against (although a legal challenge by a group of bondholders to this effect was rejected by a US court). Again, this may not be in the spirit of CACs. Using CACs in the way exit consents have been used in the past, in a sovereign debt context, may be seen as coercive. This may also require consideration of best practice and further refinements to bond documentation.

  3. Dealing with bilateral debt. The G20 Common Framework for debt treatments beyond DSSI, endorsed at the Leaders’ Summit last month, should be a positive step forward in terms of the treatment of bilateral debt in sovereign debt restructuring and strengthening creditor coordination. This gap in the architecture has been evident for some time with the emergence of non-traditional bilateral creditors, especially China (as we’ve written before, Venezuela might have presented a test case, the Republic of Congo was a test case but on a small scale, and now we have Angola and Zambia). But little is known about how the new approach will work in practice – the devil will be in the detail. That it seems to be only directed at DSSI-eligible countries, at least for now, also appears to be a limiting factor, while the call for comparability of treatment from the private sector is only what the private sector has been doing anyway.

  4. The official sector is still fixated on the risk of holdouts and litigation, a legacy of the Argentina experience (although this fails to recognise Argentina’s own role in perpetuating this saga and that litigation is an essential way to uphold contracts and property rights).

  5. Don’t throw the baby out with the bath water. More generally, while each crisis tends to throw up new challenges, and calls for changes to the international financial architecture, for private creditors, it is not clear if this implies anything different to what they have been doing anyway, with best practice codified in the IIF’s Principles for Stable Capital Flows and Fair Debt Restructuring, endorsed by the G20 some 15 years ago.

Sovereign bond defaults in 2020