Sri Lankan eurobonds have fallen sharply in November amid plummeting reserves, an inadequate policy response, and a broader EM selloff (with the EMBI falling 2.6% in total return terms in the past three weeks). The SRILAN 6.85 03/14/2024s now sit just below our target price of US$60 from our recovery analysis in July. However, with economic conditions also deteriorating sharply over that period (reserves have fallen from US$4bn to US$2.3bn, as one illustration, despite the US$787m SDR allocation), it seems appropriate to update our recovery analysis and associated target price.
In July, we found that nominal haircuts of 30% (base case) to 50% (worst case) would be required to reduce the PV of public debt to 70% of GDP by 2026, which we used as a crude restructuring benchmark. We also assumed a maturity extension and interest grace period of 3yrs (base case) to 5yrs (worst case) and coupon reduction of 25% (base case) to 50% (worst case) would be sufficient to set reserves on an upward trajectory.
With reserves dropping sharply since and a high level of uncertainty surrounding Sri Lanka’s external financing pipeline, and with the IMF set to publish an updated Article IV and Debt Sustainability Analysis (DSA) by year-end (which would likely form the basis of any potential restructuring and will provide a more nuanced look at Sri Lanka’s debt relative to sustainability thresholds), we keep our base and worst case restructuring scenarios intact for the time being for the sake of simplicity.
However, with deteriorating economic conditions in Sri Lanka and the ongoing EM selloff, we update our scenario probabilities and exit yields to arrive at an updated target price for the bonds. We combine our homegrown and IMF-backed reform scenarios into a single “no default” scenario (given that it is increasingly unlikely default can be avoided without an IMF programme), and retain our base and worst case restructuring scenarios, resulting in the three scenarios outlined below:
Scenario 1 – 20% probability: Sri Lanka avoids default through homegrown or IMF-backed reform programme.
Scenario 2 – 40% probability: Sri Lanka defaults in mid-2022 and agrees on credible, IMF-backed reform programme.
Scenario 3 – 40% probability: Sri Lanka runs reserves closer to zero and delays reforms, resulting in more punitive restructuring, and fails to stick to the present, or a credible, reform programme.
From a default probability of 65% in our July analysis, we now assign an 80% probability beyond mid-2022 given the ongoing drop in reserves and tepid policy response. While efforts to secure ad hoc financing may enable Sri Lanka to pay its US$500mn eurobond maturity in January, and possibly even its US$1bn maturity in July, this will only delay the inevitable without a major policy shift. Further, even if policymakers see the light and request an IMF programme, it isn’t clear that there is a way to credibly put debt on a sustainable trajectory without restructuring, so the end result may still be default.
For illustrative purposes, we equally weight our base and worst case restructuring scenarios at 40% each. In our base case, the recovery value would be US$57 for the SRILAN 6.85 03/14/2024s (which we continue to see as the most attractive entry point). Meanwhile, the worst case results in a recovery value of just US$31 for the SRILAN 6.85 03/14/2024s. Conversely, if default is avoided, we see the SRILAN 6.85 03/14/2024s rising over time to US$101. Weighting by probability, we arrive at a new target price of US$55 for the SRILAN 6.85 03/14/2024s, down from US$60 in July.
Our base case recovery value of US$57 and target price of US$55 for the SRILAN 6.85 03/14/2024s are below the current price of US$58.72 by just c3% and c6%, respectively, and are thus approaching the price at which an upgrade to Hold could be justified. However, with default looking increasingly inevitable, the worst-case restructuring still presenting serious downside risk, and higher-yielding credits like Sri Lanka performing especially poorly in the current risk-off environment, we prefer to wait until our new target price has been reached before upgrading.
While CBSL Governor Cabraal has continuously reiterated that Sri Lanka will meet its debt obligations, and has laid out plans to boost reserves from US$2.3bn to US$3.5bn by year-end via US$1bn of bilateral loans, US$300mn each of multilateral and syndicated loans, and US$1bn of swaps, this strategy is not sustainable, especially with US$5bn of external public debt service in 2022, per World Bank estimates ($3.7bn principal and US$1.3bn interest, of which US$1.5bn and US$860m, respectively, for eurobonds).
And while the removal of yields caps has finally led to reduced monetisation of the budget deficit (with T-bill auctions now fully subscribed since mid-October), this has come at the cost of an increased interest burden for the government. Further, accumulated imbalances from monetisation earlier this year have pushed inflation to 9.9% yoy in October and the LKR as high as 245/US$ in the parallel market this month, which will push up the external debt stock when the currency eventually capitulates.
We maintain our Sell recommendation on Sri Lankan eurobonds, excluding the SRILAN 5 ¾ 01/18/2022s (which we think could be paid out of reserves, but with decreased confidence compared to July) and the SRILAN 5 ⅞ 07/25/2022s (which likely represent D-Day for default, barring significant reforms, but could still be paid if Sri Lanka is able to secure ad hoc bilateral funding to effectively “bailout” bondholders). Beyond July 2022, however, barring a significant shift in policy, we still think default is inevitable.
We will conduct a more thorough DSA and restructuring scenario analysis upon the release of the IMF Article IV, which is due by the end of the year, and will consider upgrading to Hold in the meantime if the SRILAN 6.85 03/14/2024s hit our target price of US$55.
Sri Lankan budget falls flat (again), November 2021
Sri Lanka reserve crash in one chart, November 2021
Sri Lanka: Good and bad news for bonds, November 2021
Plummeting reserves push Sri Lanka closer to default, October 2021
Sri Lanka: Imbalances to remain despite policy shift, September 2021
Sri Lanka’s food and currency “emergency”, September 2021 (Malik)