Sovereign Contingent Bonds: How Emerging Countries Might Prepay for Debt Relief

Executive Summary

Emerging countries have been in the midst of a crisis that is not of their own making. A great majority of these countries are navigating the crisis fairly well. Others are struggling, and a few have defaulted on their external bond debt in which our Emerging Debt strategies are invested. Meanwhile, there has been somewhat successful broad-based debt relief for the poorest countries on debt they owe to developed world governments. However, private sector involvement in “blanket” debt relief has proven difficult, due to a number of constraints. Moreover, we know from experience that sovereign debt restructurings are costly to both debtors and creditors. In this paper, we propose a simpler solution than others that are circulating in the market for building in contractual methods to help countries deal with short-term financial distress brought on by a global crisis or a country-specific event. We believe a simple payment-in-kind (PIK) structure borrowed from high yield debt markets could be an effective, simple, low-cost, and self-policing solution. The liquidity relief provided by a PIK option embedded in bond contracts could augment other relief supplied by multilateral and bilateral creditors.

The Context and the Problem

Emerging countries are in the midst of another epic crisis that is not of their own making. These “once-in-a-lifetime” global crises are appearing with higher frequency, seemingly once every 10 to 12 years. The world seems more vulnerable to these crises because of globalization and interconnectedness among peoples and nations. Moreover, crises at the individual country level have become more frequent just as the investable universe for our Emerging Debt strategies has expanded and is approaching 100 sovereigns. These more localized crises are often the result of the age-old reason of poor policymaking, likely made more severe by the ever-increasing threat of climate change.

This latest crisis of global demand, brought on by the lockdown policies designed to fight the coronavirus, has generated familiar calls for debt relief for those emerging countries that have limited resources and weak public health infrastructures to deal with the pandemic. Prior to the crisis, warnings were being sounded about the rising debt load in the emerging world that would reduce policy options for countries if a crisis were to occur.1 As the crisis intensified, some well-known economists called for a blanket debt moratorium for all sovereigns, except those rated triple-A.2 Many others have called for blanket debt relief for poorer countries. The G-20 successfully called for debt relief for the poorest countries on debt they owe to developed world governments (usually concessional lending via export-import banks and the like).3 This plan – the Debt Service Suspension Initiative – which was envisioned to include private sector creditors, including bondholders, required beneficiary countries to seek debt relief from private creditors.