How Are So Many EM Sovereigns Issuing New Debt?

Mitu Gulati and Mark Weidemaier

We have been working on building a dataset of sovereign bonds and their contract terms. Given the economic fallout of the Covid-19 pandemic--close to 100 countries have approached the IMF for assistance--we would not have been surprised if few low- to mid-income countries had issued sovereign bonds in recent months. Instead, there have been large issuances by Guatemala, Paraguay, Peru, Chile, Philippines, Hungary, Mexico and others. 

Take Mexico, one of the biggest players in the sovereign debt market. The country has been badly hit not only by Covid-19 but by brutal drops in oil prices, tourism, and remittances. These developments surely increased the need to borrow in dollar/euro bond markets, but we would have expected investors to balk, or at least to demand punitive coupons. But that doesn’t seem to have happened.

What explains investors’ continued willingness to lend? Might they have drunk the bleach-flavored Kool-Aid and decided that there will be no deep and sustained economic downturn? Possible, we suppose, but unlikely. More plausible explanations include (i) that financial markets are so awash with QE money that investors have few places to go for yield and (ii) that investors may be betting that countries will be bailed out by an official sector desperate to prevent widespread defaults on sovereign debt.

But, because we are interested in the terms of sovereign bonds, we also wondered if investors were demanding extra contractual protections against the risk of non-payment. That would be a sensible precaution given the likelihood that many countries will be unable to make payments. Indeed, colleagues working on M&A contracts have documented a trend towards including risk-shifting clauses that explicitly address pandemic-related events (for a recent paper by Jennejohn, Talley & Nyarko, see here). With superb research assistance from Amanda Dixon, Hadar Tanne, and Madison Whalen, we wondered whether we would find a similar trend in the sovereign bond markets.

Sovereign bonds could address the risks of pandemic-related events in at least three ways, two of which would shift risk to investors and one of which would put the risk on the borrower.

First, bonds might include force majeure clauses (often referred to as “act of god” clauses) shifting the risk of non-payment to investors for the period of the crisis. For instance, the contract might specify that, if the pandemic worsened, the country could suspend payments to bondholders in favor of supporting domestic health care. Some Caribbean sovereign issuers use a similar clause to shift the risk of hurricanes to investors (see here, here and here, for articles by two of the architects of the Bajan hurricane clauses, Andrew Shutter and Jim Ho). From hurricane clauses, it’s a relatively short step to pandemic clauses. Presumably, drafters would want to include provisions to ensure that funds were spent on the pandemic response rather than on a new Learjet for the president (here). 

Second, bonds might begin linking payments to GDP, as has been urged for years by a number of scholars and practitioners (e.g., here and here). If countries needed a push to adopt GDP-linked bonds, the current pandemic strikes us as a good one. A ready-to-use template has already been designed by Allen & Overy sovereign debt guru Yannis Manuelides and others (here).

Third, assuming that investors do not want to bear the risk of pandemics, one might imagine we’d see investors explicitly disclaiming this risk. For example, as we have discussed on Credit Slips recently (here, here and here), sovereigns may currently be able to invoke necessity and other defenses to excuse non-payment during the crisis. A bond might explicitly state that the defense is not available.

With the help of our RAs, we looked at every post-Jan 1, 2020 issuance of a sovereign or quasi-sovereign bond for the types of clauses mentioned above. We find nothing, nada, zippo. Nothing along the lines of the changes that our academic colleagues found in the M&A area. We also looked at a smattering of corporate low and high yield bonds and found nothing there either. In short, the pandemic has thus far produced no change whatsoever in sovereign bond contracts.

It is not as if sovereigns are immune from the economic effects of the pandemic. Indeed, the risk disclosures for these bonds make very clear that the pandemic is a significant adverse risk. Yet under current law, it is uncertain what will happen if the risk materializes. Will the sovereign be able to invoke necessity and other defenses against creditor claims to payment? Courts and arbitration tribunals will have to answer this question without explicit guidance from the contracts.

The explanation may have to do with the slow pace at which bond contracts get revised as compared to M&A contracts (here). Or maybe, as mentioned earlier, the explanation is simply that everyone involved is counting on a giant bailout if things go south. But of course, in a world where virtually every economy is in a downturn, there won’t be much money available for bailouts.