AT THE END of February, Mexico, the most important bond issuer in Latin America, stunned the market with a new $1 billion bond that included collective action clauses (CACs). At a stroke, the sovereign had answered the most pressing question facing the emerging-market debt asset class: could it create a mechanism for sovereign workouts or not?
The bond was oversubscribed and Mexico made it clear that from now on CACs will appear in every bond it issues. CACs now seem certain to be included in forthcoming bonds from Uruguay, and will probably appear in Korea’s next issue. In the case of Latin America, the hope is that these clauses will clear the way for capital to start flowing into the region again.
It’s the culmination of a long debate. As one treasury official said at the annual meeting of the Inter-American Development Bank in Milan last month: “I love talking about this stuff, and even I’m sick of talking about this stuff.” Huge amounts of time and energy have been expended by the IMF, the G7, the US Treasury and the private-sector trade associations. And while everybody agreed that the key aim was to try to restore private-sector capital flows to the region, it was clear that seemingly endless talk and no action was having the opposite effect.
“This discussion has dragged on too long in the minds of officials,” says Agustín Carstens, Mexico’s undersecretary of finance. “We had to find an expedient way to put the issue to rest.”
People wanted to know: would the IMF force a move to an international sovereign bankruptcy procedure, would the market dig in its heels and make sure nothing actually happened, or would there be some kind of market-sanctioned middle way whereby clauses facilitating debt restructuring would be inserted into bond documentation? In the end, it was the latter course, for CACs, that won the day.
Collective action clauses, which had long been pushed by the G7, empower a super-majority of bondholders (usually 75%) to change the payment terms of a bond. Over the past couple of years, the US Treasury has also become a vocal proponent of CACs, along with long-time supporters in the UK and Canada.
Most of the private sector was originally opposed to CACs, mainly because they deprive individual bondholders of the right to sue if most of their fellow creditors go along with a restructuring. Issuers were also wary of including CACs in their bond documentation. It’s generally a bad idea, when selling bonds, to spend a lot of time explaining exactly what’s going to happen in the event that you default. And since the primary effect of CACs is to make bonds easier to restructure, at the margin they are likely to make a default more likely, as well.
But at the end of January the private sector had come around to accepting CACs, and a group of seven trade associations released a set of model clauses that they said would “strengthen crisis prevention and resolution in emerging markets”. The trade associations made it clear, however, that they would only be in favour of the introduction of CACs so long as the IMF’s preferred statutory solution to sovereign debt restructuring was taken off the table.
The private sector’s clauses, developed over many months, put the threshold for changing payment terms at 85% of bondholders, and also allowed holders of 10% of bonds to veto any changes. The percentages were taken not of a quorum, as under UK law, but of all outstanding bondholders, and bonds controlled by the sovereign itself were explicitly stripped of voting rights.
The documents also included new covenants regarding engagement (laying out how a crisis-hit issuer would interact with a bondholders’ committee) and transparency (ensuring that bondholders were always kept apprised of the issuer’s true financial state of affairs).
Within a month of the release of the model clauses, CACs had arrived – not just on paper but in reality, through Mexico’s 2015 global bond.
“Mexico realized that the market and investor thinking had evolved to the point that CACs could be incorporated into their bonds without impacting the cost of borrowing,” says Cynthia Powell, syndicate head at co-lead JPMorgan. “The private-sector proposal underscored the growing level of support for CACs.”
Mexico’s Carstens explains that his decision to issue the bond was largely driven by the market. “We needed to go when we felt that the market was ready for this,” he says.
It was a major U-turn. Mexico had long been an opponent of CACs: at the IMF annual meetings in October last year, finance minister Francisco Gil Diaz said he had no intention of using them. And other market participants continued to hear exactly the same kind of language from the Mexican finance ministry only a month or two before the new bonds were launched.
Alonso García, Mexico’s general director of public credit, tries to explain the reversal. “What changed was merely the fact that there was a very open and active discussion on CACs,” he says. “The benefit of that discussion was that the perception changed. At the end of the discussion, everybody agreed that CACs could be appropriate for both issuers and buyers of bonds – and at no extra premium.”
Whether or not Mexico paid a premium for including CACs in its new bond is contentious. Mexico, along with its lead managers, is adamant that it didn’t. Rival bankers and most investors generally say that Mexico paid a premium of between 10 and 20 basis points (see above).
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Gil Diaz: at the IMF meeting |
Why Mexico issued now But just because the country could issue bonds with CACs there was no particular reason to think that it would do so – especially since it had completed its funding needs for the year, and in fact was expressly forbidden from doing any net debt issuance. (Mexico got around that problem by using the proceeds of the new bond for liability management, buying back Italian lira Brady bonds.)
So the big question in the market is why – why did Mexico do this deal, and why did it choose this time to do it?
Market speculation is rife that the real reason for Mexico’s sudden conversion to the cause of CACs was that it had some kind of quid pro quo with the US Treasury, which had made no secret of the fact that it wanted a major emerging-market issuer to break the ice and go first with CACs. There was some speculation that the US had more or less guaranteed the deal for the Mexicans, that it would reimburse any premium that Mexico was forced to pay.
If there was such a deal we wouldn’t know about it. “You don’t want to signal that you’re willing to pay a premium,” says Chris Canavan, head of Latin American debt capital markets at Goldman Sachs. “It would be a bad idea to signal to bond investors that you’re willing to do something that some investors feel is harmful because you’re trying to please a different constituency.”
Maybe there was some kind of understanding on trade, immigration or some other such issue. But the most likely deal is also the simplest: a general understanding that if Mexico issued a bond with CACs, the US Treasury would kill the IMF’s plan for a statutory sovereign debt restructuring mechanism, or SDRM.
Mexico is certainly steadfastly opposed to SDRM (although, of course, it was also steadfastly opposed to CACs until a couple of months ago). Finance secretary Carstens admits that there is some connection between the two. “We wanted to show that collective action clauses were possible and we felt that they are a far superior strategy to SDRM,” he says.
SDRM is top of the agenda for the IMF’s spring meetings this month. The IMF’s governing body, the International Monetary and Financial Council, will consider the Fund’s detailed proposal for SDRM, and the US is the single most powerful voice on the IMFC. Now that CACs are up and running, and there’s a lot of momentum behind a parallel Code of Conduct that countries would sign up to explaining what they would do in crisis situations, the expectation is that the IMFC will shove SDRM on to the back burner.
In Milan, US Treasury officials were dropping large hints that they would do just that. “The Treasury is most focused on market-friendly, voluntary ways to address issues,” said one. “What we’re seeing with Mexico’s recent issue is the perfect example of that. There is an increasing consensus developing on how to do this contractually. In the light of that, we think this is the most fruitful path to pursue. Energy should be focused on CACs, and not spent a whole lot longer focusing on other routes.”
Michael Chamberlin, executive director of Emta, says: “SDRM must be dead if the market is willing to accept CACs.”
Mexico realized that it was in its own interest to be first with CACs, and so it issued as soon as bonds with CACs became an inevitability – essentially, when the private-sector proposals were released. As one senior adviser to Mexico puts it: “They decided that if they were going to lie in this bed, they might as well make it.”
Once the private sector had given its approval to CACs, there followed much speculation that Korea will issue a bond with them quite quickly. It also rapidly became clear that Uruguay’s upcoming bond swap, which involves exchanging most of the outstanding debt for new bonds with longer maturities in an attempt to stave off default, will also employ CACs.
Many big investors like the idea of Uruguay – or, for that matter, any other country – having CACs in most of its bonds if it ever does default, since that is likely to reduce the amount of time it takes for a comprehensive restructuring to be worked out. A good example is the city of Buenos Aires, which, unlike the province of Buenos Aires or the country of Argentina, only issued bonds with CACs. Though Argentina looks set to remain in default on its external debt for the foreseeable future, Buenos Aires managed to persuade a supermajority of its bondholders to accept new payment terms on their bonds, and has now cured its default.
If and when Uruguay implements CACs, they are almost certain to be very similar to those proposed by the private-sector trade associations. Mexico, on the other hand, as advised by its lawyers at Cleary, Gottlieb, Steen&Hamilton, saw very little need for many of the private sector’s proposals, and realized that it had a one-off opportunity to write its own bond documentation unburdened by precedent.
It’s not the first time Mexico has behaved in this way: it took the lead in issuing first Aztec and then Brady bonds, and again got to structure them according to its own needs and desires.
Strong-arm tactics Mexico’s CACs were a lot weaker than what the private sector was asking for. For one thing, they didn’t have any engagement, initiation or transparency clauses. Mexico also diluted the private sector’s proposed definition of a government-controlled entity for the purposes of whether or not a bondholder could vote for a restructuring. Bondholders, worried about the Argentine precedent where the government strong-armed the local pension funds into doing what it asked, wanted to exclude government-regulated institutions. But Mexico didn’t want to tell its pension funds that they could buy its bonds yet not vote them in a restructuring, so out went that clause.
Most important, Mexico lowered the proposed threshold for changing the payment terms of the bond to 75% from 85%, and increased the amount of bonds needed to block a restructuring to 25% from 10%.
Some big bondholders like the idea of a lower threshold, since they are always going to be in the majority, and don’t want to see aggressive hold-outs delaying the day when the bonds can start paying coupons again. In fact, says Mexico’s Carstens, “if you run into trouble, for the majority of bondholders it would work to their advantage to have the lower threshold”.
Nevertheless, the private sector in general, and dedicated emerging-market bondholders in particular, were opposed to a 75% threshold: they considered that it made default too easy, and constituted too much of a sacrifice in return for giving up the right to sue for repayment in full.
Mexico could get away with a 75% threshold in its bonds because it is an investment-grade issuer, and sells mainly to large crossover accounts that have not been part of the debate and that neither know nor care much about CACs. These are the type of investors that will sell their bonds long before any default, so the details of the restructuring process don’t really affect them. And they can generally easily be persuaded that they already own a lot of bonds with CACs – those issued in London – and that if it doesn’t matter there, it shouldn’t matter in New York.
A senior emerging markets banker draws the analogy with Lucent Technologies, in the US. When Lucent was a high-flying investment-grade technology company, it could issue on terms largely of its own choosing. Now that it’s going through restructurings, its creditors can require the company to insert many different covenants into its bonds.
So it goes with Mexico: the country’s ability to exclude any parts of the private-sector proposals that it took exception to is something of a point of pride. It shows it is a strong issuer, and doesn’t need to make concessions to the buy side in order to be able to sell its bonds.
That said, however, if Mexico were to come with significantly weakened CACs after some other country issued bonds with strong CACs, the differences would have been more glaring and the bonds might have been a harder sell.
“It’s a lot easier if the investment-grade issuer goes first and establishes a benchmark,” says Mark Walker, partner in charge of the Mexico account at Cleary Gottlieb. “If a benchmark had been set by a weaker credit, it would have been much harder for Mexico to move away from that.”
Conversely, the same calculus works in Uruguay’s favour. Now that Mexico has set a precedent with a 75% threshold and no covenants, creditors are likely to be more well disposed to the country if it ups the threshold and includes various clauses ensuring that it will pay all bondholders’ legal fees and the like. Before Mexico, that might have been simply expected, since those clauses were in the model CACs put out by the private sector; now, such a move might be seen in a more favourable light.
Canada has already issued bonds with CACs. Once Mexico and Uruguay both go down the same road, then issuers at all levels of creditworthiness will have blazed the trail, and such clauses will probably become normal and expected.
It will take many years for sovereign bonds with CACs to become a majority of the total outstanding. But if and when a country runs into trouble – much as Uruguay is doing now – that country might be first to do a megaswap into bonds with CACs, and then, should a full-scale restructuring become necessary, restructure each of the new bonds relatively easily.
Bondholders will probably be much happier with that than they were with the old-style exit-consent-laden restructuring of the type seen in Ecuador.
