Cost of sovereign CDS contracts higher than necessary, says IMF working paper

By Reshmi Basu

New York, July 5 - The likely high recovery values after restructuring suggests that the cost to buyers of credit default swaps contracts on sovereign names may be higher than necessary, given that recent debt restructurings that constitute credit events are more frequent than out-and-out defaults, according to an International Monetary Fund working paper by Manmohan Singh and Jochen Andritzky.

Recovery values in sovereign debt have not been the subject of extensive research, given the changing nature of debt crises, said the authors.

In the working paper, the authors tried to measure the recovery value by examining recent episodes of distress. The frequency of restructurings far surpasses actual defaults in the high-yield market and in emerging markets, wrote the authors in their paper, which represents their views, not the IMF's.

The CDS contract can only be exercised if it is associated with a credit event such as a change in interest rate, change in principal amount, delay of interest or principal payment date, change in ranking of priority and change in currency.

In the case of emerging markets and after a credit event, the "protection buyer can exercise the option to deliver an acceptable bond in a permitted currency to the protection seller."

The authors noted that a voluntary debt exchange may preclude such rights.

In a two-step calculation, the authors derive CDS spreads by calculating a theoretical recovery value for cheapest-to-deliver bonds.

For the paper, the authors view CDS spreads as the marginal cost of debt, while the EMBI+ sub-index for a country represents the average cost of traded debt.

"During distress, it is the marginal cost that is often more relevant; and although CDS spreads are a derivative of the cash bond market, their volatility and absolute levels may lead to sell off in the underlying bonds," the authors write.

It is a misconception to assume that the recovery value from a restructuring or during a debt exchange collapses to 20% or 25% of face value, the authors write.

For instance, in Uruguay, the price of its lowest bond was in the 40 cents range. In the Dominican Republic, the cheapest-to-deliver bond neared the 70 cents range. During Brazil's 2002 crisis, the bonds did not go below 35 cents to the dollar.

The authors concluded that recent credit events on emerging market sovereign bonds have often been the result of a restructuring than an outright default.

"Although significant economic terms may be altered as part of the restructuring, bond prices do not collapse, since there is no interruption of payments, and there is no impasse between the debtor and the creditors," wrote the authors.

The statistical analysis shows that recent episodes of distress, which have turned into debt exchanges, have not resulted in bond prices falling to 20 or 25 cents on the dollar.

"Emerging market CDS contracts would do well to account for such restructurings, which become more common as both the debtor and the creditor work towards a negotiated settlement rather than an outright default."

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