The gloves are off in the sovereign debt debate

The Banker’s October cover story shows Argentina’s president Cristina Fernandez dressed in boxing gear and on the ropes – an illustration of the country’s plight following a New York court ruling that led to a technical default on its sovereign debt.

But, things move fast in the debt markets and already Kazakhstan has issued a dollar-denominated sovereign bond with clauses that should prevent a repeat performance in the unlikely event that the country defaults. Chief among these is a clause binding all investors to decisions made by a 75% majority – in Argentina’s case 90% of investors accepted 70% losses in the restructurings that followed the country’s $100m default back in 2001.

Interestingly, Kazakhstan did not have to pay a higher yield to get its bonds away under the new terms, suggesting that the market thinks it perfectly reasonable that in default cases any deal that is struck should be binding on the majority.

That is because the investors in the Kazakhstan bond were doing genuine analysis on the risk/reward equation and the likelihood of default.
This was not the case with the funds invested in Argentina who persuaded a New York judge they should be repaid in full. Described in
the industry as vulture funds, most of these investors bought the bonds at the bottom of the market in the post-default environment, and stand to make a huge profit if they get repaid in full.

As many commentators have pointed out, this makes a mockery of risk analysis and pricing as all sovereign bonds are then effectively of equal risk. It means that an investor buying a high-yielding sovereign bond would be paid for a risk they were not taking.

New bond issues will also address the pari passu question, which was interpreted in the Argentine case as meaning pro-rata payments to all
creditors. This meant that those holders who agreed to the restructuring could not receive payment if the holdouts had not also been
paid – hence the country's technical default.

In future, pari passu clauses will contain wording that specifies equal legal ranking of creditors rather than ratable payment. So some good has come from the Argentine situation. But there is a long way to go before these new conditions apply to the entire market. Most existing bonds do not contain these clauses and with emerging market turmoil in prospect as quantitative easing ends, and with vulture funds emboldened by their success, we can expect some colourful battles ahead.

Brian Caplen is the editor of The Banker.