Argentina: Don’t Cry for the Hedge Funds
In February 2020, Argentina announced an ambitious objective of restructuring over $200 billion of foreign currency backed bonds by March 31. This entails significant debt reduction for holders of Argentine debt, many of whom are distressed debt hedge funds—hedge funds that invest in debt with a high probability of default—seeking to profit from the debt crisis. While the conflicting objectives of the government, hedge funds, and other debtholders may seem to make a clash inevitable, a cooperation scheme may be the best strategy for Argentina and the distressed hedge funds to maximize their respective payoffs.
The Art of the Holdout
In 2018, Argentina went into recession while its inflation skyrocketed. Then-President Mauricio Macri’s centre-right administration implemented austerity measures to fight the economic crisis, but these measures proved to be highly unpopular and led to the installment of a new administration under centre-left politician Alberto Fernandez in December 2019. As the Fernandez government came to power, it had the unfortunate task of rebuilding an economy crippled by inflation and dealing with a debt crisis. With only $8.9 billion in net foreign reserves, Argentina has to service over $200 billion of foreign debt and an additional $44 billion International Monetary Fund (IMF) loan coming due in the next two years. This foreign debt consists of two large bond tranches issued from 2005 to 2010 by the government of Cristina Fernández de Kirchner and those issued by Macri from 2016 to 2018. If significant debt relief is not achieved, it is almost certain that Argentina will default on its debt and be shut off from the international bond market. Argentina’s deteriorating financial position is further exacerbated by the IMF’s refusal to renegotiate the terms of its refinance its loans unless Argentina significantly reduces its leverage. Without the IMF’s support, it is almost certain that Argentina will default on the $60 billion of payback obligations it faces in 2021.
Investors have fled Argentine bonds throughout these unfortunate developments: Argentine bond prices have dropped more than 60 per cent within the last twelve months. In contrast, distressed debt hedge funds have rejoiced at this opportunity. An alliance of 20 hedge funds have been purchasing Argentine bonds at very low prices with the intent of using a “holdout” strategy to increase their returns. In a holdout, a creditor refuses to renegotiate the terms of the debt in the hopes that the struggling debtor will acquiesce and pay them in full.
If a debt crisis is a sovereign bond investor’s nightmare, holdouts are the bond issuer’s nightmare. A holdout is a classic Prisoner’s Dilemma: if every creditor chooses to holdout, no one gets paid and the sovereign’s economy collapses under the debt burden. However, if most creditors have negotiated to provide debt relief, there could be a lucrative payout for the few that do holdout.
The Sovereign’s Got Potential
Argentine bonds can be split into two categories: the “Kirchner” bonds issued by the former Kirchner administration in 2005 to 2010, and the “Macri” bonds issued by the Macri administration from 2016 to 2018. Both of these groups feature a holdout defence mechanism known as the Collective Action Clause (CAC); so long as a predefined supermajority of bondholders—85 per cent for Kirchner bonds and 75 per cent for Macri bonds—agree to a restructuring proposal, CAC allows all bonds within a voting pool to be restructured. There are two different types of CAC structures: single-limb and double-limb. While over two-thirds of the bonds, the Macri bonds, are issued with the more advantageous single-limb CAC, $87 billion of the bonds are Kirchner bonds with a double-limb CAC that still have significant holdout potential.
Consider a tranche of Kirchner bonds, denominated in U.S. dollars, due in 2038. Any given bond can only be restructured with 85 per cent approval from the holders and if there is two-thirds approval within the tranche. If a hedge fund can obtain one-third of the total face value of the tranche, then they have the ability to veto any restructuring plans and elect to holdout. With this position, the holdout is not just their share of the debt: they will be able to prevent the restructuring of the entire tranche. This is also why a wide pricing differential currently exists among the different Argentine bonds: bonds with higher CAC thresholds command almost a 50 per cent price premium over similar bonds with lower CAC thresholds.
Argentina is facing the challenge of managing reacting to these activist hedge funds. The current administration previously took a stance against holdouts when it passed a law has taken a stance against holdouts, as evidenced by a law that made the act of paying holdout creditors illegal—a law repealed in 2016 under international pressure. It also has the support of the IMF, which has recommended significant debt relief from Argentina’s private creditors. Private creditors generally lack legal remedies against sovereign countries, and are therefore at a disadvantage in negotiations with Argentina. However, Argentina’s self-imposed repayment schedule and the urgency of receiving IMF’s refinancing make the prospect of a stalemate with hedge funds disastrous for the country. Both parties appear to be in a deadlock that they cannot escape. If they holdout, hedge funds are exposed to a high probability of being unpaid indefinitely; yet if they relent, they risk losing significant bond value upfront. If it is uncompromising with holdouts, Argentina risks missing its deadlines and worsening its relationship with the IMF; on the other hand, relenting consists of paying hedge funds using the cash that it is desperately strapped for.
A New Argentinian Cooperation Scheme
Restructuring is usually a zero-sum game; there is a finite amount of loan value to be split among participating parties, and a better outcome for one always means losses for another. However, the payoff matrix becomes complicated by the sheer number of different parties that exist. While debtors play against creditors, individual creditors also compete amongst themselves. Individual creditors can claim value in the amount of their investment and also by taking a greater share from their peers.
Argentina and the hedge funds could cooperate by choosing to pay off obligations to the hedge funds at the expense of other investors. The hedge funds would use their positions to vote for Argentina’s proposals of extending the maturity on the foreign debt. By doing so, the hedge funds will get a better payoff while preventing other investors from being paid. For hedge funds, this involves a guaranteed upside and is relatively easy to execute as they will receive more of their principal back. For Argentina, the hedge funds’ support would be paramount in saving valuable time as it rushes to meet the IMF’s timeline, as the Kirchner bonds held by the hedge funds are the most difficult to restructure due to their higher CAC threshold. Overall, Argentina will achieve the same amount of debt relief, to the satisfaction of both Argentina and the hedge funds.
However, even if the hedge funds own the entirety of the $87-billion Kirchner bonds, they are still vastly outnumbered by the $200- billion Macri bondholders. With the CAC vote threshold for Macri bonds at 75 per cent, if the terms are obviously unfair, it will be extremely unlikely for Argentina and the hedge funds to successfully pass their proposal through other creditors. Moreover, Argentina is also bound by its covenants to treat creditors fairly—this will be the first sovereign restructuring where the new “Uniformly Applicable” (UA) covenants become involved. UA mandates Argentina to offer every bondholder within a tranche voting pool the same treatment. As long as a cooperating hedge funds’ bonds are being restructured in the same group as another investor, they must receive the same financial instrument from the restructuring.
Keep the Money Rolling In
Due to the unique dynamic of this restructuring, UA may aid this cooperation scheme. By nature, this debt crisis is driven by liquidity: Argentina simply does not have the cash to cover the $44 billion IMF loan maturing in the next two years. With a debt-to-GDP ratio of 93 per cent, Argentina has the economic ability to pay off its debt, and therefore does not need to prioritize principal reduction. Rather, it must prioritize pushing out the maturities of the debt in the coming years to minimize the strain on liquidity. This indicates the bonds maturing in 2021, for example, are of a significantly higher priority to restructure than a bond maturing in 2033. All the Kirchner bonds mature between 2033 and 2038 and are therefore secondary in priority. This allows for a clever scheme as follows:
Argentina creates a voting pool where 75.1 per cent of bondholders are cooperating Kirchners and 24.9 per cent are Macri bondholders with debt maturing between 2021 and 2024. It then offers to exchange all debt within this pool for a new set of bonds maturing in 2038. On an net present value basis, the cooperating bondholders will be taking on a minimal or no loss, as their original bonds either mature close to or in 2038; for their counterpart in this pool, losses could be massive (the 2021 bonds would lose 35 per cent of their face value, assuming a discount rate of just 6 per cent). The CAC forces those voting against the proposal to accept the terms enforced by Argentina and the Kirchner bond holders.
Even assuming a 0 per cent participation rate from Macri bondholders, $29 billion of Macri bonds can be forcefully restructured in this manner. With a 50 per cent participation rate, this increases to $87 billion—equivalent in value to all outstanding Macri bonds due before 2028. Effectively, this strategy would relieve Argentina of short-term obligations and push them out to a more manageable timeframe, solving the country’s liquidity issues.
These calculations assume that general bondholders will be defensive against the cooperation scheme. In reality, while the cooperation scheme will decrease other bondholders’ NPV, particularly those with near-dated bonds, maturity extensions are typically preferred to principal reductions from an investor’s standpoint. This is due to the higher potential upside from market price increases as Argentina’s economy recovers in the future. By cooperating with the administration, the distressed debt hedge funds can also allow Argentina to adopt a restructuring mechanism that may be preferable for other investors as well.
Instead of restructuring different bonds on an ad hoc basis and where the less important Kirchners may present a holdout risk, this cooperation turns the table around. Now, Argentina can wholeheartedly focus on restructuring the bonds with the highest priority, with the Kirchner bondholders assisting them in the process. Improvements in Argentina’s near-term liquidity also increases the likelihood that the IMF continues extending relief credit to the country as it works to strengthen its economy.