In many ways the bond market ushered in the modern era of finance and created the awe and ire of the speculator who strikes it rich. When Nathan Mayer Rothschild allegedly made a fortune in British government bonds when there was serious doubt that the British would defeat Napoleon, and then the tide turned at Waterloo, he showed that there was serious money to be made in bonds.
As I shared on the Cash Chronicles IG Page today, there was a fascinating study published by researchers at the Kiel Institute for the World Economy and Harvard’s Kennedy School of Government that showed that returns from all defaulted sovereign bonds beat the return of the S&P 500 over the period from 1995 to 2016. The return on defaulted bonds did not beat the return of US equities over a longer period though from 1815 to 2016, however defaulted sovereign bonds did outperform US Treasuries over that period.
Source: NBER
To do this study the researchers did something that not many academic researchers have done over the years: they took the point of view of the investors in the bonds rather than the country that is defaulting. They mentioned that much of the research previously has been very “binary” in the sense that there are those nations that default and there are the ones that don’t. Once a country defaults it’s almost like researchers just chuck it into the bin of defaulter nations and you never hear about it again until that country comes back to the bond market down the road.
What Contributed to This Performance?
Taking the point of view of the investor after a bond defaults though is much different. Defaults can happen in different ways. Sometimes the borrower may still pay the coupon and many times they will swap the debt for new debt. These factors were important in the returns described above. The researchers noted that:
⁃ Even in principal default, many borrowers still pay the coupon in full or in part which push up returns
⁃ Almost all defaults are solved by a debt exchange of old into new debt at a discount with an average haircut of 44%
⁃ In the majority of cases, investor losses are partial and they recount their pre-crisis investment within 5 years after the default.
It makes sense that because of the above, many bonds don’t trade just above 0 after a default, it’s because they are expected to be renegotiated but that there is a lot of uncertainty involved, hence why they would require a much higher return.
For those that don’t know the terminology a “haircut” it the loss that investors take on the write down of a bond. For example if a bond worth $100 defaults and the investor is offered a new bond worth $66 that means he or she took a $34 “haircut”
Building the Data
To find these conclusions the researchers built the first ever default database. They likely had to do many hours of painstaking research on every sovereign bond that defaulted over the past 200 years to get things like the terms of any new debt and compiling whether interest was paid.
Data on the bonds that have not defaulted is pretty easy to come by but I am sure it took many weeks or months of tracking down information to be able to compile this.
The authors also justify why they look at the period specifically from 1995 to 2016 and that is because in the 70’s to the early 90’s syndicated loans from banks became more important for sovereign borrowing than the bond markets were.
Source: NBER
So it seems that after a break in the 70’s to the 90’s sovereign bonds defaults are back. It made me curious though, what defaulted sovereign bonds are there out now and can one even invest in them?
The Canadian Database
Maybe this inspired the data collection of the Canadian Central Bank because I was able to track down a once yearly updated spreadsheet available to the public which breaks down which countries have defaulted as of 2018 on bonds that foreign private investors can hold. The list is repeated below:
- Nauru – $154 million
- Belize – $526 million
- Republic of Congo (Brazzaville) – $492 million
- Mozambique – $803 million
- Zimbabwe – $59 million
- Venezuela – $17.96 billion
- El Salvador – $6.3 billion
Curiously they also include Puerto Rico in this database which totally skews the total above. If you include Puerto Rico’s $52.5 billion in defaulted bond debt then the total marketplace currently of defaulted sovereign debt is $77.8 billion.
The Puerto Rico case is considered more of a municipal default in the US but they don’t control their own money supply which may be why the authors included in these statistics.
Could You Buy Even if You Wanted to?
This is clearly not for the risk averse, you would need to be prepared to be represented in court or delegate this to a professional who would manage the default issues for you. For many this then comes down to hedge funds or “vulture funds” that buy up defaulted debt and then attempt to join the restructuring negotiations in order to generate a return.
As this FT article points out, even if you did want to do it yourself, you would likely have to approach a big broker like a Citi or JP Morgan and ask them to buy one of these bonds on the secondary market. If they can find it, it will need to be in denominations of at least $100,000 and above, an option that only the richest investors have.
In addition, it’s not like this is the stock exchange, these investments likely don’t change hands often and are thus very illiquid.
Having a point of reference is key in terms of price though, so armed with the fact that the average haircut is 44%, when bonds enter the territory of 56 cents on the dollar, they may actually be attractive at or below that price.
Take the case of Puerto Rico, in this article which describes some of the vulture funds holding Puerto Rican debt, they claim that one fund bought the senior debt, which may be swapped at 54 cents on the dollar, for 15 cents on the dollar, which would offer a fantastic return, albeit at the price of higher taxes and costs for ordinary people on the island.
Conclusion
This is a fascinating topic and I am interested to see more research into this topic as well as how this may start to make the field more crowded. Only time will tell if defaulted bonds become the new hot investment.
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