Investors burned by Sri Lanka’s $12.5 billion default are taking advantage of the years of restructuring that followed to try to force the island nation’s leaders to better manage the country.
Industry experts say the result is a first-of-its-kind governance bond that will reduce Sri Lanka’s debt costs if it improves transparency and financial management.
Bondholders overwhelmingly approved the debt restructuring program, which includes several types of new instruments to replace failed bonds.
For Sri Lanka and its creditors, the stakes are high.
“This crisis is first a governance crisis, which then turns into an economic crisis,” said Nishan de Mel, executive director of Verité Research, a Colombo-based think tank that first proposed the bond of governance.
“And if you don’t repair the foundations, you can build as much as you want, it will all collapse again.
ORIGINAL SIN
Sri Lanka plunged into a full-scale economic crisis in 2022, triggering its first sovereign debt default. The fallout from COVID-19 and soaring prices after Russia’s invasion of Ukraine have dried up its foreign currency reserves, causing widespread shortages of food, fuel and medicine.
But bondholders like Kaan Nazli, a portfolio manager at Neuberger Berman, said poor governance – in the form of unsustainable tax cuts introduced in 2019 – was the “original sin” that pushed Sri Lanka into edge of the abyss.
“This made it very vulnerable to these shocks and ultimately led to default,” said Mr. Nazli, who was part of the committee that negotiated the debt restructuring with government officials.
The crisis has exposed billions of dollars in insufficient public spending. President Gotabaya Rajapaksa resigned in 2022 and the Supreme Court later ruled that his conduct contributed to the economic crisis.
The new bond would reward Sri Lanka with a 75 basis point reduction in the interest rate if it proves that it is managing the country’s economy efficiently and transparently by achieving two objectives.
It must exceed the International Monetary Fund’s baseline revenue-to-GDP forecasts for 2026 and 2027, and it must publish a fiscal strategy for 2026 and 2027 with details on total public debt, as recently laid out in law. adopted.
Raising revenue – that is, taxing workers and businesses enough to finance budgets – is a recurring problem in emerging markets that investors see as linked to governance; countries that provide little to their citizens struggle to justify taxes.
Similarly, opaque fiscal conditions, including hidden state-guaranteed debts, have led other countries to default.
If Colombo fails to meet its targets, it will not be penalized, but its nominal interest rates will increase from 3.6% to 9.25% by 2032, without a reduction of 75 basis points, meaning that it will not benefit from an $80 million reduction in its interest payments.
Mr De Mel described the deal as a “win-win”, which is rare.
“What the bondholders understood is that if we can reduce governance risk through this instrument, the value of the bond increases, because Sri Lanka is immediately seen as more likely to repay.
INNOVATIVE BUT RISKY
People who worked on the deal hail it as a precedent-setting instrument that could be used elsewhere to reduce bond costs in exchange for transparency or better debt management.
Governance has been at the heart of investors’ concerns since the recent wave of sovereign state failures. Debt shakeups in Zambia and Ghana included provisions requiring regular government presentations on debt levels and fiscal management.
“ESG has become a more important theme in investment analysis,” Mr. Nazli said, referring to environmental, social and governance criteria.
“I have a feeling we will have different contingent instruments and at some point the market will look to standardize them and take additional considerations into the cash flow analysis.
Leland Goss, chief executive and general counsel of the International Capital Market Association, said that while the $80 million in savings the governance bond could bring to Sri Lanka was relatively small compared to the overall country’s debt, the structure could bring larger changes.
“If it works, people accept the restructuring and it is negotiated in the market, people will follow and monitor the situation and they will be held accountable by the media and the market, which is quite interesting,” said Mr. Goss.
But in the meantime, some investors have been reluctant about the complex nature of the overall restructuring. In addition to the governance bond, the restructuring creates six new instruments, including four macro-linked bonds and one bond linked to accrued interest.
Bond prices have lost as much as 3 cents since the start of the month, to 64.3-65.6 cents on the dollar, which investors attributed to the fact that some holders sold before the restructuring agreement is concluded in order to avoid having complex instruments on their books.
Investors say the popularity of governance-linked bonds could depend on how Sri Lanka performs.
“As with all firsts, pricing and trading will be difficult,” said Giulia Pellegrini, senior portfolio manager at Allianz Global Investors.
“There is a risk that if this goes wrong for whatever reason, people will be deterred from following suit,” she added. “But I think all it takes is to build a pipeline like this…those challenges are fading away.
