Argentina had big news today. After three years of focusing on paying off its debt and trying to get its economy in order after the biggest default in history, the government announced its first issuance of dollar-denominated bonds since its 2002 financial crisis. Similar to when a guy celebrates paying off his credit cards by going out and charging a big screen TV, Argentina’s friends have reasons to be concerned.

The last five years of Argentina’s economic history have been less than calm. Suffice it to say that unemployment rose to 30 percent, bartering replaced cash transactions, and country went through three presidents in one week.

In 2002 the government lost the ability to repay its debt and defaulted on over $100 billion in payments, many of which were supposed to be made to the U.S. and other G-7 nations. So, after all this very recent turmoil, what exactly is this new bond offering and what should investors consider when buying Argentine debt?

First, the basics. Take Betty Bondholder, an investor interested in buying a bond. By writing a check to purchase sovereign debt, Miss Bondholder gives a government cash to pay off its obligations in the near term. From this perspective, it is easy to see why Argentina wants to sell the bonds. They can use Betty’s cash to pay off their stack of IMF loans from the last crisis and finance the necessary economic infrastructure that will help the country become stronger and more stable in the future.

In return for this much-needed cash, Miss Bondholder gets a piece of paper that says that Argentina will repay the loan principal plus interest sometime in the future according to a fixed schedule. She might choose to hold on to the bond until it matures, (i.e., until the date when all of the interest and principal is planned to be paid off). Or, she may intentionally plan on selling it at a later date. This can be a good play if she thinks that interest rates are on their way down, making the contract pegged at a relatively high coupon rate (in the case of a fixed coupon bond), for example, attract a higher selling price in the future.

People in the U.S. have a habit of attaching adjectives like “safe” or “risk-free” to government bonds, especially when compared to other investment alternatives like stocks. This is because we tend to think of U.S. Treasuries, which have the fortunate characteristic of almost zero risk of default.

These words don’t stick so well to Argentine bonds, as we see from the 2002 experience.

Considering Argentine debt isn’t exactly “risk-free”, it’s probably helpful to have a general understanding of what exactly happens to bonds when a financial crisis occurs.

First, as news spreads that a government might be in trouble (i.e., approaching default), the agencies that attach credit rating letters to countries start making changes. Firms like Standard & Poors, Fitch, and Moody’s start incorporating the bad news into their models and crank out labels like Cs ("really vulnerable") instead of CCs ("kind of vulnerable"). These kinds of changes are usually high-profile and published widely in newspapers, etc. Other potential buyers of the bonds see the rating changes as an indicator of higher risk, and will demand a higher return on the investment to compensate for that added risk. So, if Miss Bondholder now wants to sell the bond to someone else, she’s going to have to sell it at a lower price. This means she’ll probably lose money on her investment.

But what if Betty Bondholder intends to hang on to the bond until maturity? As long as she keeps getting her predictable payments, she gets what she paid for, right?

Well, if things get really bad those payments may not be so predictable. In many cases, a government will foresee that it will not be able to make its payments either at all or without significant hardship. So, governments may choose to restructure.

What does restructuring mean? This means that a government may renegotiate its debts to get either a lower coupon rate or a longer maturity. Either way their goal is to ease their pain by lessening the individual payment. In this situation, Betty Bondholder will likely get a letter telling her that she has an “option” to trade in her piece of paper for another one with the not-so-great terms. Option may not be the right term, as most often the choice is to either go for the new deal or hold on to something that she knows will be defaulted soon.

How bad the terms of the restructuring might be for our investor will depend on how well the original bond was collateralized, and the shape of the Argentine economy at the time of default. If the bond is backed by U.S. Treasuries (as are Brady bonds, used in many restructurings for the past several decades), the investor may end up getting a large chunk of their money back. If the new bond has special features like the ability to use it to pay taxes, or to meet reserve requirements (in the case of banks), the value to the holder is higher. If there is no collateral, or if the investor can’t take advantages of some of the other features, the restructuring will be more painful for people like Betty.

It should be noted that there exist “vulture firms” that intentionally hold on to the original bond or even voluntarily buy up a huge amount of the original bond when default approaches. Their plan? To sue the government once the restructuring is initiated. Often, although the government eventually stops making payments according to the original bond contract, the creditors will sue the government for breaking that contract. Legal terms sometimes ensure that vultures get paid first before any payments can be made on the newly restructured loans, so the “recovery rate” for the vultures can actually be high if the lawsuit works out. It’s a lot of work, but technically it provides certain people with an option to maintain something close to what they were originally going to get with the bond.

These are all factors that investors should consider when testing out the Argentine waters this time. Despite the country’s rocky recent past, investors appear to be jumping all over this new offering. Perhaps this is due to the high yields the bonds are providing. Let’s just hope that those yields are high enough to make up for the possible headaches that lay ahead.

Posted by Michelle Smith on July 19, 2005 07:52 AM