Do Investors Really Prefer Putin’s Booby Trapped Bonds?

Mark Weidemaier and Mitu Gulati

We have written before about the “Alternative Payment Currency” clause in some Russian bonds, the one that allows for payment in rubles if, for “reasons beyond its control,” the government can’t pay in dollars or euros (or a subset of alternative currencies). Our general take on the clause was that it is a bit odious. That’s because we viewed it as way for investors to subsidize bad behavior by the Russian government. If the Russian government gets sanctioned, investors will help it out by taking on the currency risk associated with being paid in rubles. And we were not the only ones. Jonathan Wheatley of the FT, writing in 2018, when these clauses were introduced, quoted an investor this way:

“I cannot understand why any foreigner would take the risk of being paid out in roubles,” said one London-based asset manager, adding that many foreigners were likely to buy the bonds without reading the prospectus thoroughly.

Gazprom, the Russian state-owned gas producing giant, also began using these ruble option clauses in its foreign currency bonds at roughly the same time (here). Importantly, for our purposes, it was clear to all involved at the outset that these clauses were put in place in anticipation of western sanctions in the event that Russia were to engage in misbehavior (e.g., invading neighbors).

From first principles, we would have assumed a bond with this APC clause would be viewed as relatively unattractive compared to a bond that required payment in dollars or euros. Bonds denominated in foreign currency protect investors from the risk of devaluation in the borrower’s currency. If investors are less willing to lend in domestic currency, that should make the cost of borrowing in foreign currency lower. If one looks at broad trends over time, that’s mostly what we see. Poorer and lower-rated countries do seem to pay more to borrow in local currency than in foreign currency (here). By contrast, rich, highly-rated sovereign issuers borrow pretty much only in their local currency.

Moreover, the APC clause could be invoked opportunistically by the Russian government in circumstances where it isn’t actually impossible to pay investors in hard currency. That risk is probably small for a country with a long-standing reputation for good behavior vis-à-vis its obligations to the rest of the world such as the Netherlands or Germany.  But would anyone put Russia in that category, especially Russia under Putin after its repeated and extreme violations of international obligations? A clause that allows misbehavior by a counterparty known for its willingness to misbehave should make these bonds less valuable. Indeed, we’ve seen just that with Argentina after it engages in shenanigans vis-à-vis bondholders (here).

Given these principles, here is what we would have predicted:

That Odd Sri Lankan Airline Guaranteed Bond

Mitu Gulati & Mark Weidemaier

After months of waffling, Sri Lanka’s head-in-sand government has finally acknowledged that it cannot pay its debts. The cavalry (IMF) has been called in and we guess that hordes of potential restructuring advisers are flying to Colombo to offer their services. Assuming they have done their homework, their proposals surely will consider both the government’s own debt and a Sri Lankan airline bond that the government has guaranteed.

Sri Lankan airlines used to be profitable. From 1998-2008, it was partially owned and run by Emirates. One of us recalls it being a special treat to fly on. But the government decided in 2008 to run the airline itself and, since then, it has performed terribly.  There have been corruption scandals, accusations that Emirates was pushed out after the airline refused to bump paying passengers to make room for the royal family, and reports that local banks have been strong-armed into lending and will be in trouble if the airline collapses. Perhaps it’s no surprise that it needed a government guarantee to borrow money.

Sovereign guaranteed bonds often carry a higher coupon than a bond issued by the sovereign, perhaps because the sovereign is viewed as the safest credit. But this logic seems upside down. Unlike a pure sovereign bond, a guaranteed corporate bond is backed both by the sovereign’s credit and by a separate pool of assets (e.g., airplanes). Even if the company is literally worthless, there is still the full sovereign guarantee. Obviously there will be other factors that affect price, such as liquidity (the market for pure sovereign bonds may be much larger). But in crisis, when the bonds are sure to be restructured, there seems every reason to favor the guaranteed bond.

Another reason to favor a guaranteed bond is that these often have less effective restructuring mechanisms than are found in the sovereign’s own bonds. Oddly, then, a guaranteed bond that was viewed as riskier at issuance can end up being a safer bet. Greece’s 2012 restructuring imposed haircuts of over 50% on pure sovereign bonds but most holders of guaranteed bonds got paid in full. There is even some evidence suggesting that investors had figured this out towards the end game in Greece and favored guaranteed bonds. 

Here are some of the provisions in the airline guaranteed bond that could cause Sri Lanka’s restructuring advisors a giant headache.

How to Destroy the Collective Action Clause

Mark Weidemaier & Mitu Gulati

We almost hate to post this, because it is so simple, and so fundamental, that it seems almost surely wrong. But if it’s wrong, we can’t see why. Maybe a reader can explain? Here goes.

For at least 20 years, reform efforts in sovereign debt markets have promoted collective action clauses (CACs) (here and here). The current version of the clause was drafted by a super-committee of senior lawyers, investors, and finance ministers – many of them people for whom we have enormous respect. It lets the sovereign bond issuer hold a restructuring vote across multiple series of bonds in a so-called aggregated vote. Before, most CACs in the market required a vote for each series of bonds. The point of the reform was to make it impossible for litigious holdouts to exclude one or more individual series of bonds from a restructuring that had garnered the support of a creditor supermajority. But—and here’s the important point—outside of the euro area, these aggregated CACs are reserved for bonds issued under foreign law. They don’t have to be. But contract reform to solve the holdout problem hasn’t seemed important for bonds governed by local law, which the sovereign can already restructure just by changing its law.

Most sovereigns issue most debt under local law. So, here’s the CAC destroying idea:

Phase 1, the sovereign restructures its local law debt (either by passing legislation or by asking bondholders to tender). The restructured bonds might or might not include new financial terms. What they definitely will now include is a modification provision substantially similar to the one that appears in its foreign law debt. However, the restructured bonds are still governed by local law.

Phase 2, the sovereign proposes a restructuring of the entire debt stock, aggregating the vote of local and foreign law bonds together.

Odd Lots Podcast: The Narrowly-Avoided Russian Debt Default

Mitu and I have posted a few times (here, here, and here) about some of the odd features in Russia's bond contracts. Perhaps the weirdest (and most odious) is the Alternative Payment Currency Event clause, in which investors effectively insure the Russian government against the risk of future sanctions. Anyway, we had a chance to discuss these clauses, and the general complications of a potential Russian default, with Bloomberg's Tracy Alloway and Joe Weisenthal on their fabulous Odd Lots podcast:

There’s a big question over whether Russia will be able (or willing) to make payments on billions of dollars it’s borrowed from investors given its current situation. Not only does the country have a history of previous major defaults, but some of its outstanding bonds are also structured kind of strangely. On this episode of the Odd Lots podcast, Tracy Alloway and Joe Weisenthal speak with University of Virginia law professor Mitu Gulati and University of North Carolina's Mark Weidemaier. They describe how odd some Russian bonds are and what might happen after default.

Should Investors Who Care About ESG Buy Russian Sovereign Bonds?

Mark Weidemaier and Mitu Gulati

Umm... no?

We can think of two models of ESG investing. (At Bloomberg, Matt Levine has a more sophisticated take; also here.) One is normative, simple, and apparently held by very few investors. It goes something like, don’t invest in “bad” activities or borrowers. A second model, apparently more common, is that investors rely on ESG metrics to inform them about potential risks and economic implications of a borrower’s ESG-related practices. As Sustainalytics puts it, “Material ESG issues (MEIs) are business issues related to environmental, social, and governance factors that may have a measurable impact on financial performance.” We confess that we don’t really understand this second model, or how it differs from an investment approach that puts risk-adjusted returns above all else. But it seems to make people feel good.

Anyway, you probably were not wondering about the link between Russian sovereign debt and ESG investing. Neither were we, because, well, why would anyone wonder about that? It seems obvious that investors buy Russian sovereign debt specifically because they do not care about ESG goals, at least for purposes of that investment. The ESG part of the investor’s brain is off doing something else while the part that chases yield buys Russian bonds. But most investors claim to care about ESG goals. And some people seem to be wondering what it means that investors who make this claim sometimes hold Russian bonds too. One way to understand this fact is to posit a flaw in ESG metrics. As the Financial Times summarizes one expert in sustainable finance, “Russia’s invasion of Ukraine has exposed the failings of asset managers and data analytics firms in their assessment of environmental, social and governance risks.” An implication is that “ESG data firms need to look at [the war in Ukraine] and ask themselves what they have missed.”

Another way to put the problem is to say that what ESG data firms have missed is that investors do not care about ESG. Yet a third way to put it is to say that investors cannot be bothered to read contracts, so you can get them to agree to the most outrageous things if you just have the chutzpah to write it down and hope they don't notice. The Russian sovereign bonds nicely illustrate both of these latter possibilities.

The Alternative Payment Currency Event Clause in Russian Sovereign Bonds

Mark Weidemaier and Mitu Gulati

A clause in recent Russian dollar and euro currency bonds – presumably written in anticipation of the possibility of sanctions from the US or the European Union -- allows payments to be made in a currency other than Euros and US dollars under certain conditions. Russia’s 2019 bond issuances in US dollars and Euros says, for example, that the Russian Federation may, under conditions “beyond its control”, make payments in an “alternative payment currency."

“Alternative payment currency” in the US dollar issuance is defined as “Euros, Pound sterling or Swiss francs or, if for reasons beyond its control the Russian Federation is unable to make payments of principal or interest (in whole or in part) in respect of the Bonds in any of these currencies, Russian roubles."

What's unclear is what makes a reason “beyond the control” of the Russian Federation in case it finds itself "unable to pay" in the specified currency. Presumably the fact that Vladimir Putin has forbidden something does not make it beyond the control of the government; he can choose not to forbid it. But could Russia plausibly argue that it is unable to pay because of western sanctions, and these are beyond its control?

Are Russian Sovereign Bonds Now Worthless?

That is the question Mitu and I discuss in the latest Clauses and Controversies episode. We were prompted by a Bloomberg story quoting Jay Newman (formerly of Elliott Associates), who expects Russia to default and points out that its international bonds lack waivers of sovereign immunity. But this doesn't mean investors can't sue. To the contrary, investors probably can convince courts in New York and other places to accept jurisdiction and enter favorable judgments. It won't be quite as easy as in cases where the bond includes a waiver of jurisdictional immunity and related provisions, such as appointing an agent for service of process, that ease the path to the courthouse. But it's certainly do-able.

The harder problem is finding attachable assets. Having a waiver of the sovereign's immunity from attachment and execution makes things much easier, but it's possible to attach assets even without a waiver, and especially so when the foreign state lacks the support of the U.S. and most other governments.

It turns out that Russia's international bonds have all kinds of interesting clauses. Some are very investor-friendly, including a super-broad pari passu clause. Some aren't investor-friendly at all, such as a very short, three year prescription clause. And others are just weird, including a clause in a subset of bonds that potentially allows the Russian government to pay in roubles. We discuss all of these in the podcast.

Maybe investors won't line up to sue the Russian government. But if ever there was an opportunity for distressed debt funds to be on the side of the angels, this is it. So perhaps this will be the assignment we give students in our sovereign debt classes to work on for the rest of the semester:

Your client is Rick Blaine, manager of the New York based hedge fund Ilsa Capital.

A few things you should know about Rick.

He is rumored to have run guns for the anti-Franco side in the Spanish Civil War.  He never drinks Vichy mineral water. And he hates thugs of all types and nationalities.

Ilsa Capital owns positions in each of the Russian Federation foreign currency/ foreign law bonds that are outstanding as of March 1, 2022. 

Rick wants to join the fight in the Ukraine but his employees have persuaded him that he can do more for the cause by increasing the financial pressure on Mr. Putin. For this he needs your counsel.

Rick assumes that the Russian Federation, in light of the painful financial sanctions being imposed on it by the EU and USA, will stop paying interest on all of its US dollar and euro-denominated bonds.

His question to you is simple — “once they default, what can we do to cause trouble?” Rick is very popular in the hedge fund industry and has assured you that once you design a strategy, Rick is more than happy (in his words) to round up the usual suspects.

Rick does not like to read lengthy documents from lawyers. Hence, please keep your memorandum to under ten pages (double spaced).

Clauses and Controveries: From Commercial Bank Loans to Blue Bonds

Mark Weidemaier and Mitu Gulati

After a short hiatus (we like to say we are between seasons), the Clauses and Controversies podcast has resumed. This week's episode, From Commercial Bank Loans to Blue Bonds, features Antonia Stolper from Shearman & Sterling:

Sovereign debt markets have evolved significantly over the years, from syndicated bank loans, to bonds, to the current infatuation with ESG lending. Antonia Stolper (Shearman & Sterling) joins us to talk about the evolution of sovereign debt practice over the course of her eminent career. We also talk about Belize's recent debt restructuring, where some say creditors agreed to significant additional reductions in exchange for promises by Belize to invest the savings in environmental conservation projects. Antonia helps us understand what actually happened in this deal and what its implications might be for future sovereign restructurings.

More on Belize: Marine Conservation is Nice; Deeper Haircuts Are Better

A couple of additional thoughts on Belize’s debt workout, especially the relatively novel aspect involving the pre-funding of a marine conservation trust. The deal has featured prominently in the financial press lately, with great coverage in the FT (here by Robin Wigglesworth and here by Tommy Stubbington), Bloomberg (here), and elsewhere. For details, see Mitu’s posts here and here. Mitu has a relatively optimistic take, which I’m mostly on board with. It would be wonderful if countries could both ease debt burdens and increase investment in marine conservation and other forms of sustainable growth. It would be even more wonderful if investors paid for some of this by granting significant debt relief. But even if that’s what happened with Belize—and I’m not entirely sure that it is—the Belize deal may not be replicable at a scale that would matter.

The plan is for Belize to repurchase and retire its outstanding international bond. Reports suggest that negotiations over the repurchase price were stalled at around 60 cents on the dollar. Ultimately, investors agreed to take 55. In return for that concession, Belize will prefund a $23.4 million trust to support future marine conservation projects. One potential takeaway is that investors agreed to the additional 5 cent reduction after being presented with the debt-for-nature idea, perhaps in part because intense media coverage created pressure to demonstrate their ESG bona fides.

The first point to note here is that the additional 5 cents per dollar is very large in comparison to the concessions investors seem willing to make to achieve ESG goals in other contexts.

Might PBA Creditors Take a Lesson From the Black Widow?

Mark Weidemaier and Mitu Gulati

We’ve had lots of interesting responses to our earlier post on debt restructuring shenanigans engaged in by the Province of Buenos Aires. Many on the creditor side are miffed. Two issues raised by these responses seemed worth another post. So here we go.

Why not use the Black Widow Strategy?

At first, we didn’t understand the reference. But Google helped. Black Widow is the new Marvel movie starring Scarlett Johansson, who is suing Disney because it, and its subsidiary Marvel, did not do an exclusive release of the movie in theaters before selling it on the new Disney Plus streaming service (here). Instead of suing Marvel for breach of contract, she is suing Disney for tortious interference with contract. This is a standard move for parties bound, like Ms. Johansson, by an arbitration clause they would prefer to avoid. By suing a related third party, they get to proceed in court—unless the third party can argue that it is a third party beneficiary or otherwise entitled to invoke the arbitration agreement.

Why mention tortious interference in the context of the Province of Buenos Aires’ recent exchange offer? Tortious interference is an old common law tort action. It is typically brought against a non-party who induces one of the contracting parties to breach. Since it is a tort, one has to show causality and, in some circumstances, also that the non-party not only interfered but did so with some improper motive or by some improper method. (And defining what counts as improper has proven difficult). A senior lawyer who hated Ecuador’s original exit exchange in 2000 once commented that he was inclined to organize a tortious interference action and believed he would win. The logic then and now is that, by inducing participating creditors to vote to impair the rights under the contract they are exiting, the issuer is inducing a breach of that contract.

But we are less confident that tortious interference is a helpful way of thinking about behavior like PBA’s.

Why Are Creditors OK With The Province of Buenos Aires’ Dodgy Use of Exit Amendments?

Mitu Gulati and Mark Weidemaier

For the most part, the financial press has not scrutinized the details of the ongoing restructuring by the Province of Buenos Aires (PBA), which is nearing completion. The details are worth considering. Some aspects of the exchange offer might have crossed the line between good and bad faith and might have been subject to legal challenge. But this turns out be an uncertain area of law.

The basic transaction is structured as an exit exchange, and this technique raises some legal uncertainties even if we ignore the dodgy particulars of PBA’s restructuring. A debtor in financial distress needs to negotiate a debt reduction with its creditors. The debt contracts allow creditors to consent to reduce the amounts owed them, but only on condition that a majority or supermajority vote in favor. Let’s say, hypothetically, this requires the support of 90% of creditors. And let us say that the debtor has managed to persuade only 60% of creditors to support its restructuring proposal. So the debtor would seem to be out of luck.

Enter the exit exchange.

(Why) Are ESG Sovereign Bonds (Such) Scams?

Mark Weidemaier and Mitu Gulati

Environmental, social, and governance (ESG) investing is all the rage, with heaps of money pouring into sovereign and corporate bonds intended to finance efforts to meet climate-related goals and other worthwhile objectives. We have been skeptical of these commitments for some time, mostly because we aren’t persuaded investors care about much other than yield. And in fact, yields on ESG bonds seem to be a bit—but only a bit!—lower than yields on non-ESG bonds (the so-called “greenium”). As Matt Levine pointed out a couple of days ago, it’s not obvious how socially responsible investing will affect investors’ returns. But we are a little bit suspicious of the market for sovereign ESG bonds.

In part, we’re suspicious for the usual reasons. The basic transaction structure is that the bond issuer says it will use the proceeds for some beneficial environmental or social purpose. But the commitments are often defined so vaguely that it is hard to verify compliance. This is a pretty standard complaint, and a lot of smart people are thinking about how to define “green” investments and develop verification tools. But we’re suspicious for a more fundamental reason: The contracts are absolute b.s. Many issuers don’t commit to anything at all, or so the documentation suggests.