In previous posts in the past, we've highlighted the fantastic commentary from Third Avenue's Focused Credit Fund. The fund commentary for the most recent quarter is again out, and I'd thought I'd highlight the discussion on sovereign risk. You can read the entire commentary here: Third Avenue 3Q 2011 Shareholder Reports. Enjoy!
Sovereigns, Corporate and BankruptcyOur investors have been asking us about sovereign debt ever since the question of European solvency emerged in 2010. The prospect of truly high-yield debt, paying in some cases north of 20%, emerging from the European Union instead of the more traditional confines of the emerging markets, has some bond buyers salivating and others just plain scared. Government debt is supposed to be the safe stuff, after all. A compelling case can be made for that, unless things go wrong. At the moment, the potential for things to go wrong for sovereigns is very high. They have bonds coming due and need access to the capital markets in order to refinance them.Sovereigns have three things going for them, from an investor’s point of view:• They can print their own money, so a sovereign borrower that issues debt in its own currency can avoid default. However, investors risk serious currency devaluation. For example, the Brazil 10-year bond issued in U.S. dollars yields 3.5%, while the equivalent maturity bond issued in the local currency (the Brazilian real) yields 8.5%. This difference in required return reflects investors’ uncertainty or concerns about the possible devaluation of the real. In addition, if a significant amount of a country's debt is issued in a foreign currency or the country has given up control of its own money supply (as with the Eurozone countries) they can find themselves at the mercy of the capital markets and face an increased risk of default.• A government can raise taxes on their citizens and corporations or raise other fees, in order to cover its obligations, though political considerations can temper this impulse.• There are international agencies, banks and financial arrangements that can come to the aid of a failing sovereign borrower, while most corporate borrowers have to stand or fall on their own.Corporate borrowers cannot print money and they cannot raise prices and just expect to keep their customers. A country in worse financial shape can use its central bank to kick the can down the road. Corporations also cannot appeal to the International Monetary Fund or the World Bank for a rescue. With very few exceptions, an overly indebted corporation that is unable to meet its obligations will be allowed to fail, no matter how important its managers and shareholders think it is.While that might make it sound like sovereign debt has a certain safety to it that corporate debt does not, this is largely illusory from the point of view of a debt holder. When you own sovereign debt, you have very little leverage with your borrowers. Because a sovereign’s debt is backed by the full faith and credit of the sovereign entity, once faith is gone liquidity evaporates and a sovereign’s ability to borrow ceases. The liquidity crisis can create a solvency crisis. Conversely, if a corporation experiences a liquidity crisis it does not necessarily create a solvency crisis, as its assets may be used as collateral to raise capital at some point in the capital structure. If all else fails, you have the court system to seize assets.From a creditor’s perspective, the weaknesses of holding sovereign debt are directly attributable to the lack of protections afforded by a bankruptcy code.• A sovereign entity can delay restructuring its debt indefinitely.• A country’s land, assets or people cannot be repossesed by lenders.• A country cannot be wound down or reorganized into something else.• A country’s leaders are beholden to constituencies other than bond holders.• Ultimately, a country’s leaders cannot be forced by creditors to make decisions that they do not want to make.While we have been discussing this in terms of a country’s debt, sovereigns are really a broader category that includes municipal debt and debt issued by Native American tribes to fund casinos operating under the Indian Gaming Regulatory Act. Municipal debt can be broken down into two categories – general obligation bonds and revenue bonds. General obligation bonds act like sovereign debt, as they are backed by the full faith and credit of the state or municipality issuing them. Revenue bonds, on the other hand, are more like corporate debt, as they are backed by assets or a revenue stream (such as a bridge or toll road) and rates can be raised or, theoretically, assets seized in order to pay bondholders.In recent history, we have seen countries choose default and receive scant economic punishment for doing so. Russia defaulted in the late 1990s and saw its cost of borrowing skyrocket. But a few years later, conditions normalized. In 2001, Argentina, which had linked its currency to the U.S. dollar and had, thus, given up the ability to print money to cover its debts, chose default over an austerity and divestiture programs pushed by the International Monetary Fund. Argentina’s bondholders lost 70% on average. It has been said that buying Argentina’s bonds is like getting remarried (the triumph of hope over experience). Only in Argentina’s case, it is like remarrying the same person three times and expecting a different outcome. Unlike private companies, countries do not dissolve just because they default. They live to borrow another day.One of the unifying characteristics of all of these sovereign bonds is that the interests of debt holders are often not paramount in the event of insolvency. Governments are accountable to (or fear) their people first and foremost. Politicians are sometimes even rewarded for not making unpopular concessions to bondholders. As mayor of Cleveland in the 1970s, Dennis Kucinich allowed his city to default, rather than agreeing to sell its public utility. That decision made him wildly popular with his constituents and is the main reason he is a congressman thirty years later. It may not be right from the creditor’s perspective, but it is reality.The Focused Credit Fund owns one municipal bond issue, backed by the revenue of 9,000 parking spaces around Yankee Stadium and one bond tied to a Native American owned casino.The advantages of holding corporate debt become clear when a company faces the threat of a potential restructuring:• Managers have strong incentive to pay lenders because they stand to lose their jobs and equity if they do not.• Corporations can sell some of their assets or divest businesses in order to pay obligations.• Corporations can be wound down and their assets sold to pay creditors.• Corporations can be reorganized into new businesses, with the new equity going to its creditors.• Corporations in financial trouble can be purchased by a more financially secure company.• There are clear laws, procedures and precendents that govern the U.S. corporate bankruptcy process, whereas anything goes in a sovereign default.• The U.S. bankruptcy code sets forth a clear priority for claims that assures that debt holders are treated fairly in order of their rank and seniority in the capital structure.• There is a limited time of exclusivity for the debtor in bankruptcy before debtholders can gain control.The corporate borrowers that we are discussing here are either governed by U.S. bankruptcy law or something similar. In countries with unfriendly or uncertain bankruptcy laws, and in the area of sovereign debt, the interests of creditors are not as protected. The absolute priority for claims provides a structure that borrowers and lenders can use to work through solvency and liquidity issues. For example, a corporation can offer to exchange existing debt for more senior paper in order to extend maturities and reduce short-term debt obligations. Since there is no similar absolute priority of claims with sovereign debt (witness the recent debt ceiling debate about which U.S. creditors would be paid first in the event of default), this type of exchange is difficult, if not impossible.When a sovereign issuer faces a solvency crisis, the willingness of the government to pay its creditors becomes the key issue. A corporation almost always wants to pay, in order for management to save itself. It will sell prize assets to do so. A country will not. Could you imagine the U.S. government selling Yellowstone National Park to China and then letting a foreign government run it for profit? The decision by Greece’s government to divest some of its assets in order to pay bondholders is at the root of much civil unrest there. Around the world, we have seen leaders elected on a platform of not allowing foreign bondholders to take from the people. Lenders to corporations are not so often treated as pariah outsiders. When a company is in the zone of insolvency, its Board of Directors becomes accountable to its lenders and can be compelled by a court to act in their creditors’ interests.Setting outright invasions aside, there is no merger and acquisition market for countries. In the corporate world, resource conversions can serve both debt and equity holders well. Germany cannot buy Italy and make it more German. A corporate restructuring or resource conversion has the potential to deliver equity-like returns for creditors, because assets that the corporation might have bought at a discount can later be sold at a premium. Sovereigns cannot offer such returns, because they cannot be restructured.Ultimately, the buyer of sovereign debt is making the leap of faith that the borrower will repay, even when times are tough and even if it is not politically expedient to do so. The owner of corporate debt has to trust their borrower as well, but that trust can be enforced through the lender’s legal claims on the borrower’s assets. We feel safer in that more tangible world of debt investing.