Sovereign GDP-Linked Bonds – Making it Happen - December 9 (London)
GDP-Linked Bonds – Latest Updates
The Seminar Overview: On Friday, December 9, Allen & Overy hosted a Seminar entitled “Sovereign GDP-Linked Bonds – Making it Happen” for members of EMTA, ICMA and the IIF in New York. The Seminar explored the case for governments issuing GDP-linked bonds as a way to make their balance sheets safer, provide additional fiscal space during future down-turns, reduce the likelihood of solvency crises and thereby enhance global financial stability.
The Seminar, which was suitable for investors in both EM debt and equity securities, provided an opportunity for market participants to analyze and comment on the economic and legal structure for a GDP-linked bond set out in the London Term Sheet (see links below). The Term Sheet has been developed by an ad hoc legal and financial sector working group based in London with research support from the Bank of England, which has published a paper on this topic. The ad hoc working group, which was assembled by the Bank of England, began work on the Term Sheet in early 2015. EMTA has been represented on the working group by Christian Kopf and Dean Menegas of Spinnaker Capital, and Starla Griffin of Slaney Advisors, who was formerly an EMTA staff member. While at EMTA, Starla carried out an extensive survey of EMTA members’ views on GDP-linked instruments and feedback from that survey has been incorporated in the design of the London Term Sheet.
The Seminar featured presentations from members of the ad hoc working group, as well as a roundtable discussion with key market participants.
James Benford from the Bank of England provided the economic rationale and context for looking at GDP-linked bonds at this time, namely the heavy debt burdens of many advanced economies, coupled with slow global growth. Benford made the case that such bonds would both broaden fiscal space and stabilize debt payments, and therefore be beneficial to both advanced economies – particularly in the Eurozone – and some EMs. Christian Kopf then discussed commercial aspects in the design of the GDP-linked bond in the London Term Sheet, and Yannis Manuelides, a partner at Allen & Overy and also member of the ad hoc working group, discussed legal considerations in the design.
There was then a lively panel discussion moderated by Ali Abbas, Deputy Head of the Debt Policy Division in the Strategy, Policy and Review Department of the IMF. Abbas also discussed the IMF’s interest in GDP-linked bonds, and other forms of state-contingent debt. He was joined on the panel by Nick Rohatyn, CEO of the Rohatyn Group (and one of the founders of EMTA), Claire Husson-Citanna, portfolio manager at Wellington; Drausio Giocomelli, Head of EM strategy at Deutsche Bank, Mark Walker, Managing Director and head of sovereign advisory at Millstein & Co, and Albert Papa, Head of North American rates at Swiss Re.
The London Term Sheet. To review, the London Term Sheet attempts to define a set of economic and legal terms for a potential GDP-linked bond to help facilitate discussions within both the private and official sectors about the utility of these instruments. It differs from the GDP-linked warrants familiar to the EM marketplace in several ways. Specifically, the GDP-linked bond:
is denominated in domestic currency;
has a payment structure modeled on an Inflation-linked bond with coupon and principal repayments indexed to the level of nominal GDP at current prices, over a specified time; and
provides for a semi-annual coupon payment and bullet repayment of principal at maturity date.
The Term Sheet also includes a number of provisions to address concerns about data integrity (including providing investors with a number of put events if GDP data is not published or is compromised), and provides a unique legal structure that aims to ring-fence the GDP-linked bonds in the event of a default on an issuer’s fixed-rate bonds.
As designed, the GDP-linked bond principal amount increases or decreases in line with increases or decreases in nominal GDP. Interest payments, which are pegged to the principal, also increase or decrease over the defined payment periods. Investors gain to benefit by receiving higher coupon payments in times of growth and a higher principal repayment amount if cumulative nominal GDP has been positive over the life of the bond. Sovereign issuers benefit by gaining greater fiscal space in the face of economic downturns or shocks as their payment obligations under the GDP-linked bond would automatically decline. As a result, issuing such instruments as part of an overall debt management strategy could lessen the default risk on an issuer’s fixed rate bonds.
Issues Discussed. The main topics of interest were
(i) the fact that the GDP-linked bond is denominated in domestic currency;
(ii) the legal status of the GDP-linked bond vis-à vis a sovereign’s conventional bonds, specifically the fact that the London Term Sheet does not provide a cross-default to the conventional bonds and envisages aggregating GDP-linked bonds as a separate class under the CACs (if governed by foreign law); and
(iii) whether the instrument should include some kind of principal protection, such as a floor.
Domestic currency: As explained in the Overview document (see link below), the design of the GDP-linked bond described in the London Term Sheet has been guided by the principle of aligning the sovereign’s payment obligations (both coupon and principal) with its ability to pay, in order to reduce or avoid the need for costly sovereign defaults and debt restructurings. A sovereign’s ability to service its debt depends to a large extent on the evolution of nominal tax receipts in domestic currency. In turn, changes in nominal tax receipts in domestic currency are strongly correlated with changes in the country’s nominal gross domestic product (GDP). This is why it makes most sense for sovereigns to issue GDP-linked bonds in domestic currency. However, it is envisaged that the currency of the issuing sovereign should be Euroclearable, and hard-currency settlement within Euroclear is also an option.
Status: There was a great deal of concern raised about whether the GDP-linked bond would be in some way ‘senior’ to a sovereign’s conventional bonds. Mr Manuelides explained in great detail that, in fact, the GDP-linked bond ranks equally (pari passu) with a sovereign’s other “borrowed money” and is in no way senior to conventional bonds. However, the point was made that the GDP-linked bonds should be viewed as a separate class of instruments, much as Treasury Bills are viewed differently from a sovereign’s Eurobonds. This is further supported by the fact that the GDP-linked bond is denominated in local currency, and its pay-out profile differs from the fixed-rate bonds.
Specifically, the terms of the GDP-linked bond provide for automatic and pre-defined debt relief in times of crisis. In this way, the sovereign’s debt sustainability position is enhanced, which should further help to avoid a default on the GDP-linked bonds (and possibly the conventional bonds). Defaults have costly effects on the wider economy and uncertain outcomes for bondholders. Long-term investors in the GDP-linked bonds have an economic incentive to refinance maturing bonds even during a severe downturn as they gain to benefit from a swifter economic recovery. For these reasons, the London Term Sheet does not contain a cross-default to the conventional bonds, and it proposes that GDP-linked bonds be aggregated as a separate class of bonds in the unlikely event of a default on both the conventional bonds and the GDP-linked bonds.
Furthermore, the issue of aggregation under the CACs is only relevant for foreign law bonds, as the ICMA model CACs are in foreign law bonds, not domestic law bonds. This choice of foreign law has been offered because the ad hoc working group recognized that investors may want this extra level of legal protection in order to ensure their rights are protected, particularly in the area of data integrity, which is controlled by the sovereign. Therefore, the GDP-linked bonds contain the ICMA model CAC, but call for aggregation only with other GDP-linked bonds.
Principal Protection. There was a great deal of support for including some kind of principal protection in the GDP-linked bond. The draft reviewed at the Seminar had a fully symmetrical payment mechanism, which would mean that principal could be redeemed at less than par if economic growth was negative across the life of the bond. Many investors were not happy with this outcome. The new version of the Term Sheet (see link below) includes an option for including a floor.
Follow-up. Following the Seminar, EMTA and IIF members were asked to provide additional input on the London Term Sheet. The ICMA consultation has also continued. As a result of the input received, a new version of the London Term Sheet is now available, along with a revised Overview document. The Payment Structure document remains the same. In addition, the following link covers key commercial and legal features of the GDP-linked bond detailed in The London Term Sheet, feedback received on these features from key investor bodies (including ICMA, IIF and EMTA) and how that feedback has been taken into consideration; issues that warrant further attention are also included: Click Here.
Meanwhile, on the official sector side, the IMF is preparing a paper on GDP-linked bonds that will be available for the IMF’s April Meetings. The G20, under the German Presidency, is also expected to request further work on the topic, and therefore input from the private sector on the London Term Sheet is extremely important.
Please feel free to provide any comments or feedback on the London Term Sheet to Aviva Werner
awerner@emta.org or Starla Griffin at starla.griffin@slaneyadvisors.com.