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Book review: A CDS route to weighing up sovereign debt defaults

Jochen Andritzky’s book demonstrates the importance of analysing CDS prices alongside bond prices in assessing the likelihood of sovereign default and expected recovery values. Felix Salmon examines the evidence.

Jochen Andritzky, Sovereign Default Risk Valuation

One of the more popular pastimes among journalists and analysts when countries start threatening default is to start talking about the default probability, which is implied by the bond price. Another popular pastime in such cases is to express astonishment at the basis between the spread on that country’s credit default swaps and the spread on its bonds. Both pastimes, it turns out, are based largely on ignorance of how the market in bonds and CDS actually works.

A new book by a young IMF economist, Jochen Andritzky, Sovereign Default Risk Valuation, brings its readers up to speed – and then some – on exactly what can and can’t be deduced by looking at bond prices and CDS spreads.

The first few chapters can be skipped without missing much: they give an overview of sovereign defaults and restructurings with a strong bias towards the official sector, as you might expect from an IMF economist. Andritzky hasn’t spent much time in the market and doesn’t seem to understand how the buy side thinks or why holdout and vulture investors play such a crucial role in the bond market.

Andritzky does, however, understand that Argentina – contra many fears at the time of its debt restructuring – does not seem to have set a dangerous precedent for other countries that find themselves forced to reprofile their foreign bonds. A series of small Caribbean countries such as Dominica and Belize has defaulted in the wake of the Argentine experience, and all of them have engaged in soft, market-friendly restructurings. Andritzky clearly sees these countries, and not Argentina, as setting the new norm. “Soft restructurings are already the predominant way (and will be applied even more frequently) to ease and resolve upcoming debt problems,” he writes.

The key insight here is that the world of sovereign debt has changed radically since Ecuador startled many by first defaulting on its bonds in 1999. At that point the market in emerging sovereign debt was still known as the Brady market, after the Brady plan that converted defaulted bank loans into Euroclearable bonds. Brady bonds were deliberately made as hard to restructure as possible, and required 100% of bondholders to approve any change to their payment terms. The idea was that the Brady plan would be a once-and-for-all restructuring, and that no sovereign would default on its bonds – up until that point, bonds (as opposed to loans) had been sacrosanct, mainly because they accounted for a tiny proportion of overall indebtedness. Of course, the Brady plan made bonds a huge part of sovereign indebtedness overnight, and the first Brady country that ran into a crisis – Ecuador – promptly defaulted on its sovereign bonds.

When Ecuador successfully restructured its bonds, bondholders ended up receiving roughly 70 cents on the dollar for their defaulted obligations. Since then, bond restructurings have become relatively commonplace, and every sovereign defaulter bar Argentina has exceeded that mark. And yet, when analysts look at bond prices to determine default probabilities, they still assume a recovery rate of 25 cents on the dollar – lower even than Argentina imposed on its creditors – on the outdated grounds that countries will only restructure their bonds if and when they’re utterly bankrupt.

Enter Andritzky. He has been looking at the CDS market, where spreads behave very differently to the bond market in distressed situations. There’s a very good reason for that: while investors buying bonds are interested in recovery value as a fraction of the amount they’re paying for the debt, or its market value, investors selling protection in the CDS market are interested in recovery value as a fraction of the face value of that debt. When the market price is close to face value, the spreads on the two instruments will be very similar. But when bonds are trading at 50 cents on the dollar, the spreads on CDS are naturally going to widen much more than the spreads on the underlying bonds. (For much the same reason, when bonds go up in price, as they have done of late, the basis turns negative. Again, this is entirely natural, and not a sign of inefficient markets.)

Andritzky’s insight is that by comparing the relative behaviours of the bond and the CDS markets, one can distinguish between two different variables – the probability of default, on the one hand, and the expected recovery value, on the other. If all you know is the price of a bond, you can’t know whether it’s pricing in a low probability of a hard restructuring or a high probability of a soft restructuring. Assuming a hard restructuring, with a recovery value of 25 cents on the dollar, begs the question, and gives a skewed value of how likely the market actually thinks that a default is.

By looking at both bond prices and CDS prices, however – and Andritzky has actually done this, with Brazilian prices during the 2002 crisis – one can isolate not only a much more realistic default probability but also the actual expected recovery value. In the case of Brazil, it turns out, that recovery value was closer to 40 cents than 25 cents, and in future it’s likely to be higher still.

Right now, all eyes are on Ecuador. There are two big unknowns there: first, will incoming president Rafael Correa default on his bonds; and secondly, if he does so, will he do so in a market-friendly way, or will he take a leaf out of Argentina’s book instead and try to soak bondholders as much as possible. Using Andritzky’s formulae, anybody who wants to express a position on either of those two questions is finally able to do so directly.

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