Negotiations to finally bring an end to Sri Lanka’s long-running $13bn debt default could result in an innovative new type of bond that would link payouts to economic growth and governance reforms, a long-held aim of emerging market bond investors.
The bankrupt south Asian nation and its creditors have agreed in principle to replace the debt, which it stopped paying in 2022 following a currency crisis, with so-called macro-linked bonds that would track the country’s recovery.
The inclusion of GDP-tied payouts into bonds that could be included in major indices is a big step forwards in trying to develop debt structures that will lure international investors back to riskier emerging market nations desperately in need of financing, say analysts.
The Sri Lankan proposal “sets a precedent to embed the contingency” into a bond that could be simple enough to be included in indices, said an independent observer of the discussions.
“For this new wave of instruments to be good for everybody, you need to have one decision point and certainty afterwards” about levels of payments, they added.
The government of President Ranil Wickremesinghe, who faces an election towards the end of this year, said last month that it would continue talks on the bond proposals “with a view to reaching common ground in the next few weeks”, in a sign that a deal may be close.
In return for taking a roughly one-third haircut on their original debt, creditors have proposed a new $9bn bond with payments adjusted higher or lower in 2028 depending on the average US dollar GDP that Sri Lanka achieves.
The country has put forward other ways of setting GDP-linked payments and is also assessing a creditor proposal for a separate governance-linked bond. This would cut coupon payments if the country raises tax revenue collection as a share of GDP and passes anti-corruption reforms.
As they emerge from defaults, countries such as Ukraine and Uruguay have handed out equity-like warrants, which promise extra money based on factors like movements in the price of commodities that the country produces or GDP, as a way of getting creditors to swallow debt losses.
But these instruments, which can be difficult to price and trade, have often ended up on the market scrapheap.
Sri Lanka’s proposed bond could break new ground because “it is not a warrant — it is an adjustment to an existing bond that would take effect from 2028. That is the difference with earlier versions,” according to Thilina Panduwawala, senior macroeconomist at Frontier Research, a Sri Lankan advisory firm.
The proposals will still have to overcome scepticism among some investors stemming from the chequered history of attempts to link payouts to volatile economic factors, especially GDP.
Earlier this year, Argentina had to deposit hundreds of millions of dollars with a London court in order to appeal against a ruling that it must pay creditors €1.3bn for using the wrong GDP data for warrants it issued after its chaotic 2001 default.
Last month, El Salvador raised eyebrows when it sold a bond with a warrant that would pay out even more on top of a 12 per cent yield if it fails to secure an IMF bailout in the next 18 months.
Nevertheless, some see macro-linked bonds as the way to tempt back investors who have fled the riskier end of the sovereign debt market in recent years in favour of the high interest rates on offer in the US and other developed countries.
Proponents of the new type of bonds believe they can bridge this divide and prove attractive to both creditors and debtors.
“It will be a very bad sign for our market if we don’t” adopt these bonds, one investor in emerging market bonds said. “Recoveries will be low, and people will feel badly used, and that this isn’t really tenable as an asset class,” they added.
In the lowest growth scenario being proposed for the macro-linked bond, Sri Lanka’s US dollar GDP would average $78bn per annum over the three years. That would mean bondholders having to take a further haircut of more than one-third, meaning they will have lost more than half their original claim.
However, if GDP averages about $90bn, the restructured bond’s new payback amount will instead rise by one-quarter. According to provisional central bank data, GDP had possibly already recovered to $84bn in 2023.
“It’s not really out of reach at all,” Panduwawala said. “As long as we don’t see another [large currency] depreciation over the next few years, we are likely to end up in the higher US dollar GDP scenarios.”
The proposal for a governance-linked bond was less contentious so far, they said, although the government still had to provide feedback on how big such a bond should be, which will affect index eligibility.
However, the potential reduction in the coupon on offer for carrying out reforms was not much of an financial incentive in itself, Panduwawala said. But it would mean that if a future government veered off course, “opposition and civil society will be able to point to a specific cost”.
In the meantime, Sri Lanka’s debt restructuring will have to survive the potential upheaval that comes from the country’s elections later this year, before the bedding in of any new kind of bond that might help reboot demand for the debt of poorer but fast-growing economies.
“Some in the opposition will want to review the restructuring deals if they are in power,” Panduwawala said. “There is that question whether, post-election, there will be friction between a potential new government and bondholders.”
