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2020 Outlook for Sovereign Debt Restructurings

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2020 Outlook for Sovereign Debt Restructurings EMERGING MARKETS DEBT Investment Management active.williamblair.com 2020 Outlook for Sovereign Debt Restructurings Historically, a combination of high yield and minimal default risk July 2020 has led emerging markets debt (EMD) investors to enjoy strong returns— Head of Emerging Markets Debt but the impact of COVID-19 has called into question the potential Marcelo Assalin, CFA for such favorable returns in the future. Historically speaking, however, markets have overestimated the probability of default and underestimated Portfolio Managers Jared Lou, CFA eventual recovery rates. Daniel Wood Introduction Historically, sovereign defaults in EMD have been rare events, and the combination of high yield and minimal default risk has led EMD investors to enjoy strong returns. On the rare occasions that EMD issuers have felt it necessary to restructure their external debt obligations, investors have often been compensated with high recovery values, reducing their potential losses, as exhibit 1 shows. “We believe the market has already priced and identified default candidates, and recovery values are generally understated.” However, the impact of COVID-19 has called into question the potential for such favorable returns. Not only has the virus had tragic consequences for human life, but the lockdown response also has had a devastating economic impact, with sharp downward revisions to global growth. This has led to fiscal deficits and debt ratios deteriorating at a significant pace. And this, in turn, has raised concerns about the sustainability of historic sovereign EMD returns and fears of an increase in default levels. That said, we believe the market has already priced and identified default candidates, and recovery values are generally understated. In the pages that follow, Jared Lou, CFA, and Daniel Wood, portfolio managers on our team, provide insights that I hope offer a useful guide to the current environment. Marcelo Assalin, CFA HEAD OF WILLIAM BLAIR’S EMERGING MARKETS DEBT TEAM 2 | 2020 OUTLOOK FOR SOVEREIGN DEBT RESTRUCTURINGS Introduction (continued) EXHIBIT 1 Recovery Rates on Defaulted Sovereign Bond Issuers Default Year Default Country Rating at Default Recovery Rates* 1998 Russia Caa1 18% 1999 Pakistan Caa1 52% 1999 Ecuador B3 44% 2000 Ukraine Caa3 69% 2000 Ivory Coast (NR)** n.a.** 18% 2001 Argentina Caa3 27% 2002 Moldova Caa1 60% 2003 Uruguay B3 66% 2004 Grenada (NR)** n.a.** 65% 2005 Dominican Republic B3 95% 2006 Belize Caa3 76% 2008 Seychelles (NR)** n.a.** 30% 2008 Nicaragua*** Caa1 49%*** 2008 Ecuador Caa1 28% 2010 Jamaica Caa2 90% 2012 Greece C 24% 2012 Greece C 37% 2012 Belize Ca 40% 2013 Cyprus*** Caa3 53%*** 2013 Jamaica*** B3 89%*** 2013 Grenada (NR)** n.a.** 36% 2014 Argentina*** Caa2 68%**** 2015 Ukraine Ca 80% 2016 Mozambique B3 88% 2017 Mozambique Caa3 61% 2017 Belize Caa2 65% 2017 Republic of Congo Caa2 81% 2017 Venezuela Caa3 23% Issuer-Weighted Recovery Rates 55% Value-Weighted Recovery Rates 40% Source: Moody’s Investors Services, “Sovereign Default and Recovery Rates, 1983-2017,” as of July 2018. *Recovery is measured as the average trading price in percentage of the par value of the bond at the time of the initial default event, 30-day post-default for missed payments or around the close. ** NR = not rated by Moody’s at the time of default. Pricing information is not available for three other recent unrated sovereign defaults on local-currency bonds: Turkey 1999, Dominica 2003, and Cameroon 2004. ***When the trading price is not available, we calculate an equivalent measure estimating the recovery as the ratio of the present value of the cash flows of the new debt instruments received as a result of the distressed exchange versus the outstanding face value of those initially promised, discounted by an approximated market yield at the time of default. ****For Argentina, the trading-price-based recovery rate at the time of default in 2014 was 68%. The ultimate recovery as of the time of default resolution in 2016 was about 97% as the missed interest payments were repaid in full. WILLIAM BLAIR INVESTMENT MANAGEMENT | 3 Defaults Priced In, Recovery Values Understated The bad news is that we believe that in 2020, we will As a recent example, African nations have asked likely see more sovereign defaults than we have ever multilateral creditors to provide $44 billion in debt seen before in a single calendar year. On a positive note, relief while maintaining market access, which remains however, we believe the asset class is already priced to a priority for most. For those countries that have reflect this dynamic. experienced liquidity issues rather than structural debt problems, the IMF has already disbursed billions of Argentina, Lebanon, and Zambia (and to a lesser extent dollars under Rapid Financing Instruments (RFIs) to help Ecuador) were all pricing in a relatively high probability countries combat the pandemic by alleviating pressure of default before COVID-19 affected financial markets. on potentially problematic financing gaps. Each of these countries already had debt sustainability problems. While exacerbated by the negative impact Defaults Remain Rare of the coronavirus, these problems would have likely led Sovereign defaults remain rare and recovery rates to sovereign restructuring anyway. relatively high, offering EMD hard currency investors attractive return potential. The main reasons are Since the COVID-19 outbreak, Suriname, Belize, strong interest in retaining market access and strong and Angola in particular have all begun to price in a high support from multilateral organizations. probability of default as well. Moody’s, for example, estimates that from 1983 to Despite an elevated number of restructuring candidates, 2019, the sovereign default rate on bonded debt was only there are reasons to be optimistic about the potential 0.73%, as exhibit 2 illustrates.1 Median recovery rates impact on future asset-class returns. First, Suriname, have been about 52 cents on the dollar, implying that Belize, and Angola collectively represent less than 1% of EMD sovereign credit spreads historically have offered the total value of the J.P. Morgan EMBIGD. Second, investors a very attractive risk premium relative to we believe few other emerging markets will be forced into historical credit losses. restructuring. Third, we believe potential recovery values will be higher than the market is currently pricing. Moreover, sovereigns want the ability to run fiscal deficits and need access to capital markets to fund them. They There are a few reasons for this optimism. A sovereign also want to act as a benchmark for companies within default with a low recovery value can adversely affect their borders to grow and access financing abroad. When a country’s ability to access international capital markets, a country is in default, these goals become problematic. expose the country to litigation, and impair its citizens’ standard of living. Therefore, it is generally in a sovereign A Good Opportunity issuer’s best interests to reach a benign settlement Despite economic hardship brought on by the pandemic, agreement with creditors. we believe sovereign credit offers a very attractive opportunity set with respect to risk and reward. We IMF and Multilateral Support believe that investors are being overcompensated for Investors can also be comforted by the multilateral the risks, despite a higher-than-normal default outlook support a sovereign issuer is likely to receive in order to in 2020. improve current and future debt sustainability. This support comes through financial aid, and arguably more importantly, technical expertise and policy improvement. An IMF program’s stamp of credibility generally reduces some of the uncertainty of economic policy, which can help motivate investors to invest. 1 Source: Moody’s Investors Services, “Sovereign Default and Recovery Rates, 1983-2019,” as of May 2020. 4 | 2020 OUTLOOK FOR SOVEREIGN DEBT RESTRUCTURINGS Defaults Priced In, Recovery Values Understated (continued) EXHIBIT 2 Historical Default Rates AVERAGE DEFAULT RATE 1983-2019 RECOVERY RATE 1983-2019 RECOVERY RATES HAVE BEEN RISING 0.73% 52% 63% Moody’s estimates that the The historical recovery rate The median recovery rate from average default rate over the period for emerging markets sovereigns over 2015 to 2019 was 63%. 1983 to 2019 was 0.73%. this period was 52% • The coronavirus crisis should result in a temporary increase in default rates. • Multilateral and bilateral support limits the scope for widespread technical defaults. • We believe default rates should converge toward the long-term average in the medium term. Source: Moody’s Investors Services, “Sovereign Default and Recovery Rates, 1983-2019,” as of May 2020. EXHIBIT 3 Median Recovery Rates on Defaulted Sovereign Bond Issuers 90% 80% 70% 63% 60% 52.0% 49.0% 50% 46.5% 40% 30% 20% 10% 0 1998 to 2005 2005 to 2010 2010 to 2015 2015 to 2019 Source: Moody’s Investors Services, “Sovereign Default and Recovery Rates, 1983-2019,” as of May 2020. WILLIAM BLAIR INVESTMENT MANAGEMENT | 5 Our Experience With Historical Sovereign Defaults Despite the favorable outlook we have for EMD returns, “Understanding the political and as mentioned above, we believe there will be a record level of restructurings across the asset class over the next economic motivations of a particular two or three years. regime regarding capital market access Moreover, the process of restructuring can be long and is very important in determining complex. There are many complexities investors
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