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Friday, October 5, 2012

99-year bonds instead of a haircut!

I have argued many times before that a haircut of sovereign debt after only a few years of crisis is the wrong instrument for a PSI or OSI. There are better ways to essentially accomplish the same thing.

It is quite noteworthy that when talking about debt sustainability, everybody always talks about the level of debt. That may be correct in the case of corporations because corporations have to compile balance sheets and once the equity has been eroded due to losses, debt must be forgiven (or converted to equity) if automatic bankruptcy is to be avoided.

Sovereign states don't compile balance sheets and they recognize incomes/expenses on a cash basis (and not on an accrual basis).

Thus, the level of sovereign debt is relevant only to the extent that it causes cash interest to flow through the budget or if the debt were due for payment. Put differently (and as a theoretical example): if all of Greece's debt werde due some time next century and if all of it carried an interest rate of 0%, a near limitless amount of debt would be sustainable at least for the next 100 years or so.

If Greece cannot sustain the present level of debt (and all indicators would suggest that), then the answer is not to forgive it via an OSI. Instead, the answer would be to structure the OSI in the form of very long-term bonds with interest capitalization for at least 10 years. Typically, one would opt for a 99-year bond but one could also opt for an Evergreen Bond.

What is the difference? The difference is that the creditors maintain their full legal claim. That is probably not worth anything today but it may become worth something in the future. An example is in this FT article: Greek bonds whose maturities were restructured earlier this year until 2023 are now trading around 28% of nominal. Only 4 months ago, they were trading at 14% of nominal. Whoever bought at 14% and sold at 28%, doubled his investment in 4 months' time!

No one negotiating a 99-year bond today will be alive to witness its payment in 99 years. Thus, the value of that bond will never depend on the likelihood of it being paid but, instead, on the likelihood of getting paid some interest.

Since interest is capitalized for the first 10 years (in my example), the first interest payment will be in year 11. Thus, it is unlikely that the bond will trade at substantially more than 0% during the first ten years. This also means that investors could buy the bonds for not much more than a handshake.

Now, if investors pay out not much more than a handshake but receive a full interest payment, they have made a huge return. Thus, as year 11 approaches, investors will assess the likelihood of an interest payment in year 11. Assuming that Greece has not fallen into the Aegean by that time, the likelihood is that Greece will be able to pay at least some amount of interest in year 11. Investors will assess the amount of interest they expect to receive and then make a calculation how much they are prepared to pay for the bonds to achieve an acceptable return.

Remember the following formula: if you buy something at near-zero and you get some interest payment, your return is near-infinite!

Greece will be smart to always pay at least some interest on those 99-year bonds because it is to Greece's advantage to have a market in those bonds. And this could be a very interesting market for speculative investors! Beginning in the late 1980s, a secondary market developed for distressed Latin American debt and many investors earned extremely high returns on their investments.

Whether the ECB holds a Greek bond with a maturity of 2023 or 2123 is a moot point. In the case of a haircut, politicians have to explain to their voters why they, once again, had to forgive Greece debt. In the case of a 99-year bond, politicians can tell their voters that they have not forgiven Greece a cent of its debt.

Being able to tell voters that no cent of Greece's debt was forgiven is more than just a moot point these days!

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