Pricing Contract Terms In A Crisis: Venezuelan Bonds In 2016
Bocconi University – Department of Finance; European University Institute – Robert Schuman Centre for Advanced Studies (RSCAS)
Bocconi University – Department of Finance; Bocconi University – BAFFI Center on International Markets, Money, and Regulation
G. Mitu Gulati
Duke University School of Law
University of Zurich – Department of Banking and Finance
June 9, 2016
As of this writing in June 2016, the markets are predicting Venezuela to be on the brink of default. On June 1, 2016, the 6 month CDS contract traded at about 7000bps which translates into a likelihood of default of over 90%. Our interest in the Venezuelan crisis is that its outstanding sovereign bonds have a unique set of contractual features that, in combination with its near-default status, have created a natural experiment. This experiment has the potential to shed light on one of the long standing questions that sits at the intersection of the fields of law and finance, the question of the degree to which financial markets price contract terms. We find evidence to suggest that at least within the confines of a near-default scenario, the markets are highly sensitive to even small differences in contract language.
Pricing Contract Terms In A Crisis: Venezuelan Bonds In 2016 – Introduction
The question is the degree to which financial markets price contract terms. Under a robust conception of the efficient markets theory, one would expect all relevant public information to get incorporated into the price of a financial security. And that would certainly include information as to the contract terms of a bond that are key to determining the investor’s payout when the debtor defaults. But empirical testing of the question of how efficient the sovereign debt markets really are visa-vis contract terms has proved difficult for a variety of reasons, the primary one being that data is rarely available that allows a clean comparison of bonds of the same issuer that are similar in all other characteristics except for a particular contract term (where that contract term has a meaningful likelihood of impacting the investor’s payout).
One prominent instance that created a natural experiment that allowed testing of the above proposition was the Greek default in 2012. In that restructuring, Greece paid different types of bonds different payouts as a function of their legal terms; most prominently their governing law and guarantee status. And researchers have found evidence that the markets did anticipate the prediction that the foreign law governed Greek bonds and Greek guarantee bonds had a higher potential payout than the generic local law sovereign bonds.
Governing law and guarantee status though are highly salient contract terms. They are features that are obvious to investors from the very front page of the prospectus or offering circular. For example, every investor presumably knows whether he holds a local-law government bond or a foreign law one. One just has to look at the length of the sales documents; the former is often no more than a page or two whereas the latter can go into the hundreds of pages of fine print. But what about small differences in the fine print? Are the markets aware of these smaller differences in the legalese and are they able to price securities accordingly?
In the sovereign debt literature, there has been much debate about this question in the context of one contract term in particular: the collective action clause or CAC. The reason for the interest in the pricing of this term, which started roughly in 1995 after the so-called “Tequila crisis” in Mexico, is that the inclusion of this particular type of contract term has been advocated on multiple occasions by a number of policy makers and researchers as a way to improve the international financial architecture. At the time, the standard contract term governing modifications for foreign sovereign bonds under New York law required unanimous approval of the creditors for any changes to be made to the payment terms of the bond (e.g., principal, interest, maturity, currency). That unanimity requirement, in turn, meant that any attempt at debt restructuring was subject to a significant risk of holdouts. And that risk of the holdouts grabbing a disproportionate share of the pie made all creditors reluctant to enter an exchange. A shift to a lower vote threshold, such as 75% of the creditors, where a super majority could do a cram-down of dissenting creditors–similar to what most domestic bankruptcy systems allow–was more sensible, the advocates of the CACs argued. Some of them explained that the unanimity provision in New York law bonds was the product of mindless copying from New York law corporate law bond documents. The counter argument, made by opponents of the CAC reform proposals, was that the unanimity requirement was the product of rational contracting; and was a way for debtors to commit to creditors not to engage in strategic default.
To cut a long story short, the theoretical debate remains as yet unresolved. As a practical matter though, the advocates of CACs won. Starting in April 2003, almost every single New York law governed sovereign bond has moved away from unanimity provisions towards a vote requirement of less than that (usually 75%). What interests us here is one of the primary rationales that was given for resolving the debate. And that was that regardless of the merits of the theoretical arguments over whether the unanimity provision was an inefficient historical artifact or a rational attempt to use contracts to constrain moral hazard, markets didn’t pay attention to small wording differences in contract terms. Further, the argument went, if markets weren’t going to price the difference between a unanimity requirement for the modification of key terms and a 75% CAC, then the issuer had every incentive to include the CAC in its bond contracts.
The basis for the foregoing argument was a series of papers that found that bonds with CACs and bonds without CACs did not seem to be priced very differently. There were questions that could be raised about these initial studies though in that they were usually comparing bonds issued under English law (that tended to have CACs) versus bonds under New York law (that tended to have unanimity provisions). But English and New York law vary in many ways and the contracts written under them also tend to vary in ways well beyond a single provision. Further, the countries who issued in one jurisdiction tended to be different from the ones issuing in the other; adding to the apples versus oranges character of the first generation of CAC pricing studies. Finally, there tend to be a plethora of non-legal factors impacting bond prices–liquidity, geo-political importance of the sovereign, likelihood of a bailout from the IMF, quality of local political institutions and so on. The argument can always be made therefore that the impact of contract terms on price is too difficult to discern using the rough tools available to an econometrician because there are too many factors to control for and not enough data.
The current Venezuelan crisis though has potentially given us a natural experiment to test the foregoing question, albeit in a limited setting. For reasons explained below, Venezuela turns out to have three sets of bonds with different modification provisions–and these are all under New York law and largely identical in all other respects other than their CACs. Further, Venezuela is in deep crisis; as of this writing, its probability of default within the next six months is north of 90%. This is important because this is the scenario where, in theory, legal terms should be most important to market participants. And finally, given the politics of its current government and the general oil glut there is a very low expectation of a bailout from the IMF, any other Official Sector institution, or some rich nation such as China that desperately needs oil. Put simply, we have a country with multiple bonds under the same law (New York) that have small differences in their contract terms that should matter a great deal to the likely payouts that the holders of these bonds will receive in the event of a default.
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