On Oct. 1, Ecuador became the first country to default on its Brady Bond obligations, the Third-World debt backed by U.S. Treasuries and named after former Treasury Secretary
The run-up to this event is a study in how to pain markets. On Aug. 31, the government deferred a $96 million coupon payment for 30 days on two Brady Bond tranches, the unsecured PDIs and the secured discount bonds, while it sorted out its payment situation. On Sept. 26, Ecuador's President Jamil Mahaud announced the country would pay the coupon on the PDIs, which are not secured by U.S. Treasury strips, synthetic bonds that are broken into separate principal and interest payments. Creditors would be asked to tap the strips collateral on the discount bonds.
By Friday, creditors had rejected this proposal, demanding full payment on the bonds. This, of course, triggered cross-default provisions on Ecuador's other Brady Bonds (the Par Bond) and its Eurobonds. The default may inaugurate a new era of sovereign bond debt, one that is far riskier. And, according to
Moody's Investors Service
, it will plunge Ecuador into "a maze of legal complications."
Why Not Pay?
Ecuador claims that it simply does not have the money. Brady Bond debt, at $5.9 billion, is equivalent to 36% of GDP; total debt, at $14 billion, is equivalent to 115% of GDP. The government says foreign debt service has become an unsupportable burden on the country and that it desperately needs to restructure its debt. Given the weakness of the domestic banking sector (and its exposure to domestic debt), the government chose to attempt to restructure its foreign bond debt.
However, Ecuador failed to present bondholders with a restructuring plan before it attempted to try a fancy maneuver to partially tap the collateral, which is held in trust at the
Federal Reserve Bank of New York
. Bondholders, naturally, did not care for this kind of partial payment and decided to force Ecuador's Brady Bonds into default. Further, by singling out Brady Bond holders, and worse, a single type of Brady Bond, Ecuador violated one of the unspoken rules of the sovereign debt world: Treat sovereign creditors equally and avoid the appearance of favoring one type of investor. Remember, when Russia defaulted on its debt, domestic creditors suffered far more than foreign creditors, with the banking system more or less collapsing. Russia continued to service its Eurobond debt.
Ecuador must now come up with a debt restructuring proposal, something it clearly wasn't doing for bondholders when it began its strange maneuvers to avoid paying. The government had previously signaled that it wants to buy back and/or swap the Brady Bond debt for new bonds (doubtlessly with some type of debt forgiveness). In creditors' favor is that Ecuadorian banks are now heavily exposed to the Brady Bonds, meaning that a very unfavorable (to creditors) restructuring would likely heavily damage Ecuador's banking system. Against the creditors is the simple fact that Ecuador has very limited resources to service its international obligations and that passage of key reforms necessary to get the
International Monetary Fund
aid still appears to be uncertain, particularly after the Sunday resignation of Economy Minister Ayala Lasso, who was close to opposition parties.
The IMF is very likely to become the only creditor for Ecuador as the private sector will become unwilling to lend the country funds. Also, creditors can begin legal action in U.S. courts, which govern the instruments, to try and seize Ecuadorian assets, virtually shutting the country out of international markets. It is in Ecuador's interest to reach a quick and amicable settlement with creditors before whatever remains of the country's financial system completely shuts down.
What Does This Mean for Brady Bonds In General?
Investors may now become increasingly skeptical regarding the sovereign debt market and its previously assumed seniority to other sovereign debt, such as bank debt and official credit. The market, which is clearly not prepared to deal with such sharp distinctions between collateralized and uncollateralized sovereign obligations, will now have to reckon with the total debt picture of a country rather than simply its bond debt. Investors willing to invest in emerging-market sovereign borrowers may see collateralized Brady Bonds as relatively unattractive as their generally lower yields (than sovereign global bonds and eurobonds) may not be justified given the Brady's now higher than previously assumed degree of country risk and possibly newfound legal complications.
Further, this may also mean the emerging-market class of debt, particularly for Latin American debtors, is now riskier than previously believed. The apparent encouragement of the Ecuador default by the official creditors (IMF, World Bank) will make investors leery of other, larger and wealthier debtors (Venezuela, Brazil, etc.). Despite apparent support for Argentina and Brazil from official creditors, private sector creditors may now question the commitment of other highly indebted emerging-market borrowers to service their international obligations. All that needs to happen to really crush the emerging-market sovereign debt market is another country attempting to imitate Ecuador and restructure its Brady Bonds.
Will that happen? Venezuela, Russia, Brazil and even Argentina will watch the outcome of the Ecuador situation closely. That does not mean they will try to restructure, but it does mean that investors may become increasingly worried that they will, which could interrupt a much hoped for resumption of investor flows in 2000.
Scott Grimberg is the emerging-market fixed-income strategist for Miller Tabak Roberts Securities. At the time of publication, he held no positions in the instruments discussed in this column, although holdings can change at any time. The opinions expressed in this article are Grimberg's and do not necessarily reflect those of Miller Tabak Roberts Securities. While he cannot provide investment advice or recommendations, he invites you to comment on his column at firstname.lastname@example.org.