Supreme Court Ruling On Argentine Bonds: Will an EM Bond Crisis Occur?

 

After a long series of appeals the Supreme Court has agreed today with lower courts that Argentina must pay its defaulted debts to holdout investors who refused to accept a partial settlement years ago. The Wall Street Journal ran an article about it.

The implications for Emerging Market bond investing is that Argentina may respond by defaulting and this may make global investors less confident of EM bonds. If Argentina defaults to evade the Supreme Court order they would probably simply break the terms of the bond indenture for recently issued bonds that were issued as a settlement and simply pay them through its local Argentine offices instead of through New York, thus evading the U.S. courts.

There are two classes of Argentine bond investors: holdouts who never settled with Argentina over the 2001 default and those who did settle at a huge 62% discount. Those who settled get paid through U.S. banks in the U.S. The lawsuit is about forcing those banks to pay equally to the unpaid holdout parties and to the parties that settled with Argentina. This “equal payment” is called pari passu which means step-by-step which means that if one person takes a step (towards getting a payment) then the other person moves along at the same pace. This means that the parties who settled can’t be paid unless the holdouts get paid at the same time which means the holdouts essentially forced Argentina to choose between paying them in full or defaulting on the party that settled. This is a very rare court case where the concept of pari passu was used.

A default would remind EM bond investors how risky EM bonds are. Argentina has a wonderful economic potential yet it was unable to avoid a massive default and devaluation in 2001. Many EM countries have a political culture that is anti-property rights and anti-foreign creditor. Developed country investors need to be aware that foreign EM courts and legislatures may not protect bond investors the way they are protected domestically.

In Mexico there was a case where a bond issuer defaulted and the local stockholders in control of the company issued more classes of preferred stock and converted it to debt thus creating more debt which enabled them to have a majority of the outstanding debt so that they could get in control of any votes by creditors. This hurt the original bond holders. In domestic courts such nonsense would never occur. There is a huge difference between EM versus domestic “Below investment grade” bonds. Investors in Developed countries look at the huge 345% of GDP total debts in the U.S. and assume that since EM countries have a lesser percentage of debt that they must be a safer place to lend money to. However a much larger proportion of EM debt is domestic “Below investment grade” and there is a greater risk of hidden unjust legal maneuvers that could jeopardize creditor’s rights. Additionally the richer a country or a person is the greater ability the borrower has to repay large amounts of debt. For example, a high income person can afford to spend a smaller percentage of income on necessities and thus more on debt service than can a low income person with minimal resources and big debts. Many EM countries are highly dependent on a debt fueled boom which if it collapsed would mean they couldn’t repay their debts. Debts in Developed countries (except for the 1997-2007 housing bubble) are usually carefully underwritten so there is less risk of a massive credit collapse. I think it is naïve to assume that the best countries to invest in debt are those with the smallest debts, although it is true that one should avoid countries with the largest debt to GDP ratio which means the U.S. is one of the best Developed countries. Just because a country has a small debt to GDP ratio doesn’t mean the entire resources of a country will be seized by courts and handed over to a wealthy foreign investor. What counts are the assets contractually tied to the debt issuer and the legal strength of those contracts. If a banana republic uses rigged courts to enforce lawsuits against failed creditors then the ratio of GDP to debt is irrelevant. However, excess debt would of course increase the risk of default.

If you want to invest in “B” or “BB” paper (junk bonds) your best choice would be through domestic mutual funds that invest domestically. These funds are far easier and less costly to sell that individual bonds.

Investors need independent financial advice about the risks of investing in Emerging Markets bonds. I wrote an article “Is Emerging Market debt riskier than it appears?"

 

About the author

Don Martin, CFP®

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