Queens of the Curve

Domingo Cavallo, Argentina’s economy minister, isn’t a man to shy away from confrontation. In recent months he has attacked Wall Street financiers for suggesting that Argentina default on its $128 billion debt, ridiculed critics of his decision to modify the country’s 10-year old currency board and lambasted anyone who doubted that Argentina’s economy could soon recover and even hit 5% growth by the end of this year.

If will power alone were enough to solve a country’s problems, Cavallo would have single-handedly sorted Argentina out within weeks of his appointment by President Fernando de la Rúa in March. Instead, the Argentine economy continues to stagnate .

By May, it looked as if the country’s very future was hanging by a thread. Only a successful $20 billion debt exchange to restructure debt maturing through 2006 would avert a deeper crisis (see story “Shedding Its Burden”). Argentina has $86.1 billion in debt amortizations and interest payments due over the next five years. Cavallo is counting on the exchange to reduce annual debt service payments by about a third, or between $3 billion and $4 billion, and keep Argentina solvent long enough to implement reform policies he says will restore growth. Cavallo is also supremely ambitious and if he does pull Argentina out of its three-year recession, he would become a serious contender in the 2003 presidential elections.

Cavallo is emphatic that Argentina will not restructure its debt. He stated in May that, “A forced restructuring in exchange for maintaining the schedule of debt service would create a massive dislocation of the Argentine economy.” In any case, he says Argentina does not need to return to the market for fresh funds to meet its international obligations for the rest of the year.

Paradoxically, Argentina is using a debt exchange – an instrument normally used by sovereigns with strong economic fundamentals to save money – to cope with its mounting financial problems. But instead of cutting its costs through an exchange, Argentina will have to pay a premium to issue new bonds and postpone debt service payments for a number of years.

Debt exchanges have become larger and more complex operations in recent years as governments and investors have both become more financially sophisticated. Governments have mainly used exchanges to retire Brady bonds, repackaged bank debt from the 1980s Latin debt crisis. Some Bradys are backed by US Treasury zero coupon bonds. Exchanging old Brady bonds for new global bonds releases this underlying collateral, creating savings for the issuer. Exchanges also strengthen an issuer’s credibility by removing the need for credit enhancement features like the use of zero coupon bonds as collateral.

Mexico carried out the region’s first bond exchange in 1996. According to figures from Merrill Lynch, the amount of Brady debt held by Latin sovereigns has dropped to $63.5 billion from $129 billion in the last 10 years. At the end of March, Argentina had $10 billion outstanding, or 25% of its original stock of Brady debt. Mexico still had $14.6 billion worth of Bradys in circulation, 40% of the bonds it originally issued. Brazil has the largest stock of Brady debt in the market, with $23.6 billion outstanding, just under half the amount it first issued.

“Debt exchanges are usually done from a position of strength, when there is a sustainable set of economic policies in place to support a new debt profile and when the investor base is growing, not shrinking,” points out Mohamed El-Erian, managing director at Pacific Investment Company, one of the largest investors in emerging market debt. “Argentina has no choice but to deal with the debt overhang so that it can create an enabling environment for growth.”

Pouncing On Wall Street
However, Cavallo at first made it all the harder to pull off a successful exchange by sowing confusion in the markets. He attacked Wall Street analysts, made a surprise announcement that he would use the euro to partially back the peso and his team mentioned vague plans to back new bond issuance with tax revenues. Argentine bond prices slumped, making an exchange even trickier to execute. The yield on Argentina’s FRB Brady bond soared to 21% in April from less than 10% at the start of the year, before settling back down to 14% in May. Then, a deafening silence from the economy ministry as preparations for the exchange advanced continued to unnerve the markets, which responded neurotically to any shred of news emerging from Buenos Aires.
Daniel Marx, Argentina’s veteran debt negotiator and now economy vice-minister, said in May shortly before the exchange was announced that, “We want to make bondholders feel that there is a valuable option given to them if we ask them to extend their maturities. This exchange will absolutely be voluntary and we will be in a position to somehow put an offer on the table.” He added, “There is both the willingness and capacity to service our debt and we will continue along that path and avoid forced situations.”

Much is at stake in Argentina. If Ecuador’s default in 1999 and its restructuring last year was a nightmare, a similar experience in Argentina would be much worse. Argentina was until recently Latin America’s largest borrower and its bonds still account for 23% of JP Morgan’s benchmark EMBI index of emerging market bonds. Furthermore, the International Monetary Fund and the US government have considerable political interests and prestige at stake in Argentina, where they have poured billions of dollars in official support. In the first half of the 1990s, Argentina demonstrated how successful free market reforms could be. Failure now could discredit orthodox economic policies. Ominously, trouble in Argentina is also weakening Brazil, where presidential elections are due next year.

Agreement
The president of a foreign bank in Buenos Aires summed up the confusion in the markets: “There is an agreement to do an exchange, but Cavallo cannot dictate the rate he wants and the banks do not want to go down in history as the guys who gouged Argentina when it was down,” he says. “There has to be a deal, because there is no alternative.” Anything less than a market rate on new bonds would make a voluntary scheme very difficult to execute. Yet if investors judge the rates to be unsustainable and the exchange fails, an imposed debt restructuring may become inevitable. However, bankers in Buenos Aires point out that local investors, banks and pension funds all hold large amounts of government paper. They have a vested interest in participating in the exchange and helping the government avoid default.

The crisis in Argentina has obscured the fact that countries in better financial shape are borrowing less and concentrating more on better managing their existing liabilities. “In some cases liability management is as important as capital raising, if not more,” says El-Erian. “Long-term investors have an interest in a sovereign normalizing its yield curve that expands its investor base over time and [has] a common interest in the [sovereign] buying back debt when it is being unfairly priced by the market.”

Daniel Gleizer, international director at Brazil’s central bank, says, “The cute thing about [debt exchanges] is that they have the ability to meet a lot of objectives simultaneously, set the benchmark for the private sector, smooth out the profile of the debt and achieve net present value savings with one transaction.”

Debt exchanges are likely to be successful when they are clearly communicated to bondholders. Argentina’s $4.2 billion exchange of short-dated global and peso-denominated bonds in February took place in volatile conditions but was still widely regarded as successful. Argentina was clear in its objectives to smooth out its amortization schedule and relieve itself of its near-term debt repayments. Richard McNeil, managing director and head of Latin American debt capital markets at Goldman Sachs in New York, says, “Transparency is the best policy for debt management.” The deal pushed out amortizations beyond five years and saved the country $3.6 billion in repayments over the next four years.

That deal was the first of three planned restructurings agreed with the IMF as part of Argentina’s $39.7 billion bailout package signed last December. Investors initially expected a ¤1 billion debt exchange because euro-denominated bonds are the second- largest chunk of shorter-term debt in Argentina after local market bonds. But communicating with the disparate group of European retail investors holding Argentine bonds, many of them denominated in pre-euro currencies, was too complex and time consuming to execute at a time of extreme volatility.

Argentina mandated seven banks to handle the $20 billion exchange. It chose Salomon Smith Barney, JP Morgan, Credit Suisse First Boston, HSBC, Banco Santander Central Hispano, BBVA Banco Francés and Banco Galicia to exchange a series of local bonds and some dollar-denominated global bonds with a face value of $66.7 billion maturing through 2006 for new longer-dated bonds with a maximum maturity of 30 years.

Growing Speculation
Cavallo left the market in the dark until just before announcing the offer, in part due to US regulations that forbid issuers from communicating sensitive information to the market ahead of a transaction. The Argentines also kept quiet because they and their bankers had to make sure they have a watertight legal structure for the exchange to ensure as smooth an execution as possible. However, others say this lack of information simply increased the scope for speculation, which made it harder to bring yields down faster and reduced the chances of a successful a voluntary exchange.

Fears grew that local banks would not be able to take as many of the new bonds as originally planned. Standard&Poor’s downgraded nine Argentine banks to B/C from B+/C in May on concerns that a debt swap would inadequately compensate local banks and expose Argentina’s stable banking system to more risk. Furthermore, the banks’ deposit base continued to shrivel in May, further reducing their liquidity.

Roger Scher, head of Latin America sovereign ratings at Fitch, the rating agency says, “If bondholders are not penalized in any way by the exchange and a sizable amount of debt is swapped so that the debt service burden is substantially lightened, then this could help stabilize Argentina’s sovereign creditworthiness in the coming years.” El-Erian agrees. “If the process is flawed, the ability for the asset class to attract bond financing is diminished,” he says. “Investors will migrate to [the US] high yield [market].” There at least they are guaranteed an established legal process for corporate workouts.

Since Mexico carried out the region’s first bond exchange in 1996, the pool of Brady bonds has diminished steadily. According to figures from Merrill Lynch, the amount of Brady debt held by Latin sovereigns has dropped to $63.5 billion from $129 billion in the last 10 years. At the end of March, Argentina had $10 billion outstanding, or 25% of its original stock of Brady debt. Mexico still had $14.6 billion-worth of Bradys in circulation, 40% of the bonds it originally issued. Brazil has the largest stock of Brady debt in the market, with $23.6 billion outstanding, just under half the amount it first issued.

As the pool of available Brady debt diminishes, debt exchanges become increasingly expensive to carry out. Sovereigns normally execute exchanges when yields are low. Brady bondholders increasingly hold onto their debt in the hope of making a competitive bid in the exchange and extracting more compensation for the trade from the sovereign. As a result, Latin sovereigns are becoming more innovative and targeted in their approach and are timing their exchanges skillfully. And they are beginning to apply this expertise to exchange other forms of debt such as local market bonds and international bond issues placed with investors in global markets.

The generally longer maturities and larger size of new global bonds make them more liquid on secondary markets and help reduce a sovereign’s borrowing costs. “What started as pure Brady-for-global [exchanges] is evolving into the full gamut, including tender offers, buybacks, open market repurchases, exchange formats,” says Michael Schoen, managing director at CSFB in New York.

Latin sovereigns have executed around $40 billion in debt exchanges over the last five years, mainly of Brady bonds, according to Emerging Marketsware, a database of emerging market debt. Brazil, Mexico and Argentina exchanged $9.6 billion in the first four months of this year. Mexico was the first Latin sovereign to exchange $1.75 billion in Brady bonds for a 30-year global bond led by Goldman Sachs in 1996, six years after it first converted its defaulted bank debt into Brady bonds.

Pimco’s El-Erian says there are clear cases when an exchange benefits both the country and investors. Such was the case with Brazil’s $2.15 billion and Mexico’s $3.3 billion ‘par-for-par’ exchanges in March, both lead managed by Salomon Smith Barney and CSFB. The Brazilian swap was designed to save money for the country and to enable banks that didn’t mark these securities to market to participate in the exchange. “There are clear cases where it is a win-win situation and gives relief to a country and benefits investors,” says El-Erian.

However, debt exchanges don’t always need to take place when market conditions are favorable. The Mexican and Brazilian exchanges in March occurred when contagion from Argentina was weakening the real and the Central Bank raised interest rates upwards for the second time this year. Brazil’s “C” bond, the benchmark Brady bond and the most liquid emerging market bond and a good indication of investor sentiment, has fallen 3.75% in the first five months of this year from 77.37 to 74.47. The real has slid 16% since January.

Mexico’s Exchange Expertise
“Mexico led the charge on liability management,” says Richard Madigan, a fund manager at Offitbank. “It is probably the largest champion of managing and reducing its Brady debt stock in the last few years.” Madigan says these exchanges showed that Mexico “doesn’t need to rely on the underlying credit enhancements [for Brady bonds] to raise capital and it gave them a far cleaner profile for them to price [new] sovereign debt.”

Alonso García, general director of public credit at the Ministry of Finance in Mexico, says that prior to the country’s 1996 Brady exchange, the government financed itself by issuing debt on the international capital markets. The $1.75 billion exchange in 1996 was a departure from this general funding strategy. He says this allowed Mexico to develop a strong and liquid yield curve, or “pure Mexican risk instead of a blended [Brady] risk.”

He says “liability management helps us purify our yield curve and improve the liquidity of our bonds that lowers our borrowing costs.” Although investors like good liability management, he says they “are rewarding us for good economic policies.” Mexico’s economy has grown around 20% since 1996 and grew 7% last year. The peso appreciated by nearly 5% in the first five months of this year.

In June 1999, Mexico arranged a $23.7 billion financial package from multilaterals to ensure a smooth political transition after last year’s presidential elections. A series of lines of credit with multilateral agencies has vastly reduced the country’s need to finance itself in the international capital markets. “Many issuers are in the position where the market dictates terms to them, but Mexico is in a position of strength,” says Richard McNeil at Goldman Sachs in New York.

With all of its funding requirements met for this year, Mexico is now free to resume its habitual strategy of mounting opportunistic liability management exercises such as the $3.3 billion Brady swap it executed in March. “We don’t have a particular schedule,” says García. “We are constantly monitoring the market for opportunities.” Mexico frequently and rapidly buys back blocks of Brady debt from bondholders in exchange for reopening new global bonds.

For instance, a private block trade of Brady debt on May 8 – the day S&P downgraded Argentina – was executed in a matter of hours. Rachel Hines, managing director and head of Latin America debt capital markets at JP Morgan says, “We had a good understanding of who the holders [of Brady debt] were and we did not want investors to move the market so we went in and out of the market in two hours.” Mexico exchanged $1 billion of Bradys for new bonds in a reopening of a 10-year, $1.5 billion bond Mexico issued in January. This deal gave Mexico net present value savings of $60 million.

García says Mexico is always on the lookout for opportunities to tidy up its debt. Last September it bought back $159 million in Swiss franc-denominated, 30-year Brady bonds. Mexico offered a 22% discount for the paper and any accrued and unpaid interest. Most Mexican Bradys are dollar-denominated, but it also issued Bradys in European currencies, yen and Canadian dollars.

Mexico has even executed local market exchanges. Last year it issued larger, longer-dated paper in exchange for short-dated local market Udibonos, or inflation-indexed bonds. “We did this with the idea of improving liquidity and concentrating maturities on existing issues,” says García.

Brazil Wastes No Time
Brazil is a latecomer to the Brady exchange game but has quickly gained considerable expertise. Its first exchange in April 1999 of Brady bonds for a $3 billion five-year global bond led by Salomon Smith Barney and Morgan Stanley Dean Witter, raised $2 billion in cash and retired $1 billion in Bradys. This was a landmark deal for Brazil as it marked the end of the real crisis.

Since then, Armínio Fraga, president of the Central Bank of Brazil, and his team of young former investment bankers and economists have brought a series of deals to the market that demonstrated impressive skill and imagination. The previous generation of academics and bureaucrats that ran the central bank was suspicious of market-based deals and avoided exchanges. Brazil is more orchestrated and deliberate in its approach to doing debt exchanges and avoids swooping into the market unannounced as Mexico sometimes does.

“We like our exchanges to be well-defined and announced so we can go to the market from a position of strength,” says Gleizer the Brazilian central bank. “We think long-term when we think of our investors. We want to be a good credit and we are conscious of our secondary market performance.”

Brazil is constantly striving to purify its yield curve. “Each issue is in itself an attempt to improve the profile of the debt,” says Gleizer. However, Brazil has carried out debt exchanges that are pure liability management exercises, such as its $2.9 billion exchange in October 1999 of un-collateralized par and discount bonds for a new 30-year global bond led by Chase Securities and JP Morgan. Brazil received some $4.1 billion in offers. The deal reduced Brazil’s debt by about $900 million and released $520 million in collateral in US Treasury zero-coupon bonds.

And Brazil is always thinking of future opportunities to manage its debt stock more efficiently. Last year it launched a new $5.16 billion, 40-year global bond to retire $5.22 billion in debt. The Brazilians, advised by Chase Securities, Goldman Sachs and Morgan Stanley, included a unique new feature to the bond by giving investors the option to cash in their bonds anytime between the fifteenth and fortieth anniversaries. This gave Brazil the opportunity to call the bond or invite bondholders to cash their bonds in if the sovereign thought it could service new debt more cheaply.

However, it was Brazil’s most recent debt exchange, a $2.15 billion ‘par-for-par’ exchange offer in March of this year that illustrated the sovereign’s growing sophistication as a liability manager. Brazil wanted to attract banks holding Brady bonds that previously had no incentive to participate in debt exchanges because accounting and tax regulations meant that if they marked the security to market they would incur a charge.

To entice banks into exchanging their Bradys, Brazil offered them a cash premium to make up any difference in the value of the collateralized Brady bonds and the new global bonds. This deal enabled Brazil to retire $2.5 billion in Brady bonds. It was such a success that Mexico did a copy-cat deal a week later exchanging $3.3 billion in old bonds.

Brazil’s 50-month $1 billion global bond in May lead managed by Deutsche Bank and JP Morgan was more in line with the sovereign’s preferred approach of structuring deals that raise fresh capital and incorporate debt management features. Gleizer says Brazil would like to have issued at the long end of the curve but it made more sense to issue between the ’04 and ’06 pillars at the shorter end of the curve and incorporate a one-time extendable option for bondholders to swap out of May’s 50-month bond into a reopening of Brazil’s 2020 on January 15, 2002.

Investors are terrified of a repeat of Ecuador’s imposed exchange last year, which wiped 40% off the country’s $6.46 billion bonded debt. Trouble in Argentina, which owes $128 billion and is the second-largest economy in South America, would have a far greater impact on the markets than tiny Ecuador.

Lee Buchheit, partner at Cleary, Gottlieb, Steen&Hamilton, Ecuador’s counsel on the exchange says, “It was the first time that a restructuring on Brady default had been done and no one was sure of what the outcome would be.” Ecuador met with investors to try and resolve the issue, but Buchheit says that “it was a take it or leave it situation in the end.”

Ecuador won the approval of 97% of its bondholders for the exchange, setting a precedent for Brady debt restructurings. Mike Corbat, head of emerging market debt capital markets at Salomon Smith Barney, which advised Ecuador, says, “Ecuador put forward the best offer it could based on its constraints. ”

Surprisingly, the hedge and vulture funds that forced the country into default did not put up much of a fight over the exchange’s terms. Elliott Associates, a New York vulture fund, fought for better terms but did not take legal action to try and extract back payments on the debt. Buchheit says this was probably because the fund was still awaiting the outcome of a court case against Peru.

Mark Cymrot, a lawyer at Washington-based Baker&Hostetler, which represented Peru in its defense against the fund, says Elliott Associates bought Peruvian bank debt at 45%-50% of its face value and instead of agreeing to take Brady bonds, it “insisted on full payment, tried to disrupt the whole deal by getting a detachment order, fought it for four years but did not get paid.”

Elliott Associates took its case to the Second Circuit Court of Appeals in New York, won a ruling in its favor, and then blocked Brady bond payments to Peruvian creditors in seven jurisdictions. The vulture fund dogged Peru until it paid out $58 million in unpaid interest at the end of 2000. “The ruling came at a time when Peru was in the midst of political turmoil and [former president] Fujimori was on the way out, so it was just easier to pay and be done with it,” says Cymrot.

Hedge funds and vulture funds are a threat when there is a lot of uncertainty and speculation surrounding an exchange, say bankers. The recent volatility in Argentine bonds is partly caused by hedge funds, building up large short positions or selling Argentine paper they do not own on the hope that it will fall in price.

It is a nerve-wracking game. Bondholders need to be compensated for taking on more risk. “Investors holding short-term, high-yielding debt need an incentive to extend their exposure,” explains Jean-Dominique Bütikofer, a fund manager at Julius Baer. But Argentina cannot afford to overpay. The government also has to convince markets that it will use the time it has bought wisely and implement reforms to restore growth. “If Argentina’s debt exchange is going to be a success it needs to big, transparent and accompanied by action from the government,” says one banker.

Even if the exchange is a success, it would offer only temporary relief if Argentina’s economy fails to bounce back. Cavallo – or his successor – may yet be forced to impose an involuntary restructuring if he fails to rekindle confidence, growth and the tax revenues the country needs to continue meeting its commitments. If he succeeds, he will cover himself in glory and the path to the presidency could lie wide open. LF