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Catalonian Bonds, Anyone?

posted by Mark Weidemaier

Joint post by Mitu Gulati and Mark Weidemaier.

Sovereign bonds issued under the government's own law are supposed to be riskier than bonds issued under foreign (typically, English or New York) law. The logic is simple: Local-law bonds can be restructured with the stroke of a legislator's pen; with foreign bonds, it's not so easy. One would expect that difference in risk to show up in bond yields, which should be higher for local-law bonds, especially in times of uncertainty. There's quite a bit of research to back up that intuition (e.g., Bradley et al. (2017), Nordvig (2015), Chamon et al. (2014), Clare & Schmidlin (2014), Choi et al. (2014)). 

Catalonian bond yields have been rising, thanks to jitters over the secession vote. But Nicolas Schmidlin, a fund manager (who worked on this topic as a graduate student and wrote the paper linked above), noticed something odd about bond yields.

As overall yields rise, one would expect the yield differential to increase between bonds governed by local law and bonds governed by foreign (in this case, English) law, reflecting the judgment that foreign-law bonds are safer in times of uncertainty. But that's not what is happening. Here's a simple yield curve, courtesy of Nicolas, with English-law bonds in red and Spanish-law bonds in blue.

Yields

 One interesting aspect of this puzzle is that the local law in question is Spanish law. If Catalonia were to secede, it is not entirely clear what would happen to the designation of governing law in these bonds. Conceivably, the bonds might be treated as subject to laws passed by a Catalonian legislature--somewhat akin to how bonds payable in a government's own currency can be repaid in a new currency if the government adopts one. But a more likely outcome, we think, is that the bonds will continue to be governed by Spanish law, subject to the authority of unhappy legislators in Madrid. In a sense, this would convert the bonds from "local" to foreign law (in the sense that Catalonia can presently influence the development of Spanish law but will lose much or all of that ability if it secedes).

In any event, the issues surrounding state secession are uncertain--both about when there is a right to secede and about how debts are allocated post-secession. (For instance, in addition to its own debt, would Catalonia remain responsible for a share of outstanding Spanish government debt? If so, how much?) There's a nice story and podcast about the general topic on the BBC, titled How Do You Start a Country?    

Comments

Hi Mitu and Mark. Knowing Mitu, I was waiting for a Catalan post. Two quick ideas on your post. First, I am not sure the foreign law-yield equation works clearly concerning Eurozone member states. The reason is that, as you know well, all member states must incorporate standardised collective action clauses. The incorporation is mandatory, and the more likely interpretation is that you cannot pass a national law that retroactively changes the bond in a manner that is inconsistent with the Euro CAC. Hence, the applicable law risk is smaller. In my opinion, a new restructuring a la Greek is not a possibility any longer. The second point concerns the back up for the Catalan bond. Spain´s legal framework prioritises the payment to of international bonds, and there is a national scheme to finance subnational entities to achieve this goal: in other words, the central government transfers funds to the Catalan government to pay its bonds. This explains why the yield of the Catalan bond has not risen too much (at least not to the level of junk bond, which would be expected for the bond of a country undergoing such turmoil and uncertainty: don't forget that Catalonia has lost its two largest banks and all of its listed corporations -with one exception-, and this has happened only in a week).
It is so great to have Mitu on credit slips. Fun lies ahead.

The really interesting parallel is Russia-Ukraine: when a geopolitical foe owes you a lot of money.
Catalonia owes a lot of money to the rest of Spain. Like a lot. 70 billion euros just in emergency loans, which makes the 3 billion Ukrainian bond thing look like childplay.
Catalonia is dead broke and will be in even worse shape on its own (among other things, because the Spanish market will be closed for Catalan exports and because Catalonia will be run by communistic politics). That is, Catalonia can´t and won´t repay what it owes Spain.
What can/should Spain do in order to collect? That´s the truly tasty bit here.

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