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GEMs Primer
The Emerging Markets Debt Primer, 2024
Edition
Primer

Overview of the EM debt asset class 29 July 2024

This Primer discusses the market for Emerging Market (EM) debt, the evolution of the GEM Fixed Income Strategy &
asset class since the 1990s, the growth of local debt markets, the macro fundamentals Economics
that drive sovereign performance, debt sustainability considerations, the compensation Global
provided by spreads, defaults and restructurings, and derivative markets.
Lucas Martin, CFA
Sovereign Debt FI Strategist
EM debt universe is expanding BofAS
[email protected]
Emerging markets tradable debt stock grew almost 1900%, or 14% per year, from $2tn
Jane Brauer
in 2000 to about US$42tn by the end of 2023. Local debt and corporate debt explain Sovereign Debt FI Strategist
most of that growth. BofAS
[email protected]

Returns, Sharpe ratios and correlations David Beker >>

Bz Econ/FI & LatAm EQ Strategy
Over the past 10 years, emerging markets external debt has provided an annualized 3% Merrill Lynch (Brazil)
[email protected]
return and 9% annualized volatility, resulting in a Sharpe ratio higher than Treasuries.
Returns were weakly correlated with Treasuries and more highly correlated with US HY,
US IG, EM local debt and EM equities. 10y Local Market annualized returns were -0.2%.

Debt sustainability considerations

Sovereign spreads are closely linked to investor’s perception about a country’s
probability of default. We outline considerations on debt dynamics (with accompanying
formulas), debt structure, and gross financing needs.
Unauthorized redistribution of this report is prohibited. This report is intended for [email protected]

Spreads compensate for default and risk premium

Sovereign external debt investors require compensation for both default and non-default
risks. Based on 40 years of history, the historical probability of default over 5 years is
around 2% or lower for investment grade sovereigns, 3% for BB-rated sovereigns, 16%
for B-rated sovereigns, and much higher for CCC-rated.

Compensating for these historical default rates would only require 5y spreads of around
30bp (BBB), 50bp (BB) and 265bp (B). Since sovereign spreads typically exceed the
spread needed to compensate for default risk, this suggests that a large proportion of
the spread can be attributed to risk premiums for uncertainty, volatility, liquidity, and
correlations with risky assets, among others.

Defaults and restructurings

Since there is no bankruptcy court for sovereigns, countries that cannot afford their
debts must lower their debt burdens with restructurings. We review the recent history of
defaults and restructurings, considerations for successful debt exchanges, development
of collective action clauses, litigation by holdout investors, and lessons from 2020.

Trading ideas and investment strategies discussed herein may give rise to significant risk and are
not suitable for all investors. Investors should have experience in relevant markets and the financial
resources to absorb any losses arising from applying these ideas or strategies.
>> Employed by a non-US affiliate of BofAS and is not registered/qualified as a research analyst
under the FINRA rules.
Refer to "Other Important Disclosures" for information on certain BofA Securities entities that take
responsibility for the information herein in particular jurisdictions.
BofA Securities does and seeks to do business with issuers covered in its research
reports. As a result, investors should be aware that the firm may have a conflict of
interest that could affect the objectivity of this report. Investors should consider this
report as only a single factor in making their investment decision.
Refer to important disclosures on page 52 to 54. 12720129

Timestamp: 29 July 2024 06:00AM EDT

Contents
Emerging Markets Debt: Introduction 3
The EM Debt Universe 4
External Debt Markets 5
Local Debt Markets 12
The foreign investor base 14
Emerging markets debt performance 15
Emerging market fundamentals that contribute to returns 19
Sovereign Debt Sustainability 20
Consideration 1: Debt Dynamics 20
Consideration 2: Debt structure 22
Consideration 3: Gross Financing Needs 23
Example: Comparing Debt Sustainability 24
What do EM spreads compensate for? 25
Probability of default and risk premium 25
Weak link between asset class spreads and defaults 26
Historical sovereign default rates 29
Sovereign Restructurings 31
Distressed Debt International Litigation 32
Successful Debt Exchanges 36
Unsuccessful Exchange, Argentina 2001 39
Repeat defaulters 41
Lessons from Argentina and Ecuador 2020 restructurings 42
Argentina’s 2020 restructuring: Low conditionality 44
Ecuador’s 2020 restructuring: Market-friendly approach 45
2024 Restructurings 46
China’s role in sovereign defaults & restructurings 48
China has become single largest creditor to EMs 48
China geopolitical influence and lack of transparency 48
China increasingly involved in debt restructurings 49
Derivatives 50
Conclusion 51

2 GEMs Primer | 29 July 2024

Emerging Markets Debt: Introduction
In this Primer, we discuss the market for emerging market (EM) debt, the evolution of
the asset class, the growth of local debt markets, the macro fundamentals that drive
sovereign performance, debt sustainability considerations, the compensation provided
by spreads, and sovereign defaults and restructurings. The asset class is distinct from
most of the developed market international investing because the largest and most
liquid foreign currency bonds are primarily sovereign bonds, but there is no bankruptcy
court for sovereign external debt and countries can institute capital controls which
affect all local debt.

Emerging markets (EMs) comprise nations whose economies are viewed as developing,
or emerging, from underdevelopment. These nations usually include almost all of Africa,
Central and Eastern Europe, Latin America, Russia, the Middle East, and Asia (excluding
Japan). There is no single definition of Emerging Markets. Some define it as countries
that do not have G10 currencies, though that might classify some AAA rated countries as
EM. EM status is not defined solely by region, nor low credit rating, as many emerging
markets are now investment grade.

Since the early 2000s emerging economies, which had previously depended primarily on
external debt denominated in foreign currency, started focusing on opening their local
debt markets to foreign investors, as well. Many of these countries are heavily
dependent on commodity exports, whereas others have extensive service and
manufacturing sectors.

Emerging markets debt includes sovereign bonds and loans issued by governments, as
well as fixed income securities issued by public and private companies domiciled in
emerging market countries. The assets could be denominated in any currency. Many of
these countries defaulted on commercial bank loans in the 1980s and began the 1990s
by converting the defaulted loans to restructured sovereign foreign currency bonds,
known as Brady bonds (named after the US Treasury Secretary that proposed them).
While the early to middle 1990s might be thought of as the era when defaulted foreign
currency loans were restructured into global bonds, the late 1990s onward will be
thought of as the era when defaulted bonds were restructured into new bonds and local
markets opened up to foreign investors.

Exhibit 1: Domestic Debt reached $37tn while External Debt was $5tn in 2023
Growth in Domestic versus External tradable debt (US$ tn)
40
EXTERNAL DOMESTIC
35
30
25
20
15
10
5
0
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023

Source: BofA Global Research, BIS.

BofA GLOBAL RESEARCH

GEMs Primer | 29 July 2024 3

The EM Debt Universe
Emerging markets tradable debt stock grew almost 1900%, or 14% per year, from 2000
to about US$42tn 24 years later. The growth in total debt has been primarily driven by
higher issuance of domestic sovereign debt and external corporate bonds, mainly from
China. This is partly due to increased foreign inflows into domestic debt markets.

Tradable versus Non-Tradable Debt

Tradable debt here excludes non-tradable debt such as International Monetary Fund
(IMF) loans, but tradable debt is not necessarily liquid debt. Only a subset of tradable
debt is liquid and qualifies for inclusion in benchmark indices, which we describe below,
because the latter has an additional requirement of access for foreigners, liquidity for
valuation purposes, and other constraining criteria.

Domestic versus External Debt

Domestic debt is issued locally and is governed by the local laws of the issuing country.
Domestic debt is usually denominated in local currency and may also be called local debt
or local debt markets (LDM).

External debt (EXD) is issued externally and is governed by the laws of a foreign country.
It is usually denominated in foreign currency, primarily US dollars and Euros, and may be
called foreign currency debt (FC). Occasionally, countries will issue external bonds
governed by foreign law but denominated in local currency.

Exhibit 2: Types of Emerging Market Debt accessible to foreign investors

Main types of debt by category
External Debt (EXD) Local Debt (LDM)
Foreign Currency Sovereign Bonds Local Currency Sovereign Bonds
EM government bonds issued primarily in USD EM government bonds issued in local currency
Foreign Currency Corporate Bonds Local Currency Corporate Bonds
EM corporate bonds issued primarily in USD EM corporate bonds issued in local currency
EM Sovereign Credit Default Swaps (CDS) Interest Rate Derivatives
CDS protection against the default of EM debt Swaps, futures
EM FX
Spot, forwards
Source: BofA Global Research
BofA GLOBAL RESEARCH

Foreign investors initially focused only on external debt instead of domestic debt. The
outstanding face value of external emerging market index-eligible bonds is close to
$2.7tn, of which US$1.4tn is corporate debt and US$1.3tn is sovereign debt. This means
that around a 59% of the tradable debt (about US$5tn) is index eligible. Most of the
growth in external debt has been through the issuance of corporate bonds or sovereign
global and Eurobonds, terms that are often used interchangeably.1 External corporate
debt has been growing faster than external sovereign debt.

Domestic debt has become an increasing share of all debt, now around US$37tn, or 89%
of the total emerging markets tradable debt universe. The lower liquidity, frequent
investment restrictions, varied market practices, and higher convertibility risk make
trading in domestic bonds more difficult for foreign investors than trading in external
bonds. However, the potential for significant investment gains due to the decline in local
interest rates from highly inflationary and high yielding periods, coupled with currency
appreciation, was a driver for significant growth in assets invested in local markets
beginning in the mid-2000s.

Debt Stock by Region

Latin America originally dominated the external tradable debt universe, but with increased
issuance in other regions, the breakdown of outstanding external debt has become fairly

1
A Eurobond is a bond that is issued and sold to international investors and is not subject to registration.
A global bond is a bond that is registered in the jurisdictions of the major financial centers.

4 GEMs Primer | 29 July 2024

evenly distributed. Asia now represents 45% of external debt outstanding, with Latin America
at 23%, the growing Middle East and Africa at 19% and Emerging Europe at 13%.

In local debt, Asia dominates with 81% of the tradable domestic debt, primarily driven by
the debt of China and India. China alone has 60% of the domestic debt. Asia is followed
by Latin America with 12% of the domestic debt. Within Asian markets, local debt is
93% of all debt in Asia, and within Latin America, local debt is 81% of the total debt.

External Debt Markets

Both the stock of external debt outstanding per country and the number of issuing
countries have grown since the early 1990s when countries began to issue foreign
currency bonds (Exhibit 3).

Size of market
External debt markets are now dominated by corporate bonds, but sovereign debt still
dominates local markets. External debt issuance has been running at around US$400bn
annually, compared with US$30bn during the early 1990s. Now around 35% is sovereign
and 65% corporate, provincial, or quasi sovereign. Corporate issuance has been
increasing in general as corporate borrowers now enjoy wide access to the international
capital markets.

Diversification of Issuers
The increase in the number of countries from which sovereign and corporate bonds have
been issued has been beneficial to investors seeking diversification and whose
investment performance is benchmarked against an index. The larger number of issuers
has reduced the concentration of the largest countries in any of the major emerging
market indices.

Major market indices of external debt include outstanding external sovereign debt with
sufficient liquidity to provide daily pricing. External bonds have few trading restrictions,
and historically have been of great interest to the broadest range of foreign investors.

The number of emerging market countries which issue external debt has increased from
4 in 1991 to close to 80 by 2024. Initially, the external debt stock was the result of large
countries with foreign commercial bank loans converting those loans to bonds. As those
countries continued to tap external debt markets, over time, smaller countries also
began to issue. The countries with the largest debt stocks in sovereign and corporates
are in Exhibit 4.

Benchmark EM Sovereign and Corporate Indices

EM sovereign and corporate bonds totaling $2.7tn are eligible for inclusion in emerging
market indices. This is larger than the entire US$2.1tn market capitalization of the ICE
BofA Global High Yield Index.

Sovereigns are about 48%, corporates 52% of EM external debt indices

The 3 most frequently used family of benchmark indices are the JPMorgan EMBI Global
(EMBIG) index of sovereign and quasi sovereigns, the Bloomberg Barclays EM Aggregate
Index (EMUSTRUU) of USD sovereigns and corporates and the ICE BofA Emerging
Markets External Sovereign Index (EMGB) of EUR and USD bonds. Each of those indices
have a USD sovereign market value near $1-2trillion as of 2024.

While there’s no unique definition, most investors consider a company to be a “quasi

sovereign” if the government owns more than 50% of its equity. Often, such quasis are
of such strategic government importance that investors expect them to have an implicit
government guarantee, if needed. Quasi sectors are mainly in oil & gas, but also in
metals & mining, utilities and finance.

The JPM index includes USD sovereign and quasi sovereigns that are 100% owned by
the government, such as Pemex. The ICE BofA index includes only sovereign issuers, not

GEMs Primer | 29 July 2024 5

quasi sovereign, and from countries that do not issue a G-10 currency. The ICE BofA
index also includes EUR-denominated debt. The five largest countries comprise about
30% of the indices today compared to 98% of the index at inception in 1993.

Corporate debt growth

The emerging market corporate bond market is one of the fastest growing asset classes
globally, at $1.4tn in 2024 from just $74bn in 2000. In each corporate index family,
about 2/3 of the market capitalization is comprised of investment grade bonds.

Over the last three decades, Eastern European, African, Middle Eastern, and Asian markets
have gained market share. Asia dominates the market capitalization, mainly from China’s
large issuance of quasi sovereign bonds after 2010. This has left Latin America with only
25% of the market capitalization of external debt qualifying for index inclusion, compared to
98% at inception of the indices. Asia issuance declined substantially since 2022.

The most frequently used indices that include corporates are the USD JPMorgan CEMBI
($2.5tn face value), the Bloomberg Barclays EM Aggregate Index that includes USD, EUR,
and GBP-denominated sovereign, quasi-sovereign, and corporate debt from EM issuers
($2.5tn LG20TRUU of which $2.2tn is in USD) and the ICE BofA Emerging Markets EM
corporate index ($1.4tn, EMCB).

Use of modified indices to increase diversification

To reduce concentration risk, most investors use modified indices that limit the size of
the largest countries instead of weighting countries solely by their market value.

Capping country weights reduces the risk that an idiosyncratic shock by a single distressed
country could cause excessive deterioration in portfolio performance. Capping corrects for
the risk that distressed countries often increase issuance (because they are financing large
fiscal deficits) and thus increase uncapped portfolio weight prior to default.

The Argentina default of 2001 was an important driver of the shift towards capped
indices, as it represented a very large part of the unconstrained index at the time.

Exhibit 3: Growth of sovereign and corporate, USD-and EUR-denominated bonds, included in

many benchmark global indices ($bn)
EMGB and EMCB face value of indices by year end
1,800
Sovereigns (EMGB Index) Corporates (EMCB Index)

1,500

1,200

900

600

300

0
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022
Source: BofA Global Research, Bloomberg, ICE Data indices, LLC.
BofA GLOBAL RESEARCH

6 GEMs Primer | 29 July 2024

 Exhibit 4: Top 10 countries: China is the largest corporate issuer Exhibit 5: Top 10 countries: Saudi Arabia is the largest sovereign
Top 10 countries: corporate debt index face value (EMCB Index) issuer (recently overtaking Mexico)
Top 10 countries: sovereign debt index face value (EMGB Index)

Corporate Sovereign
Saudi Arabia
China $101bn
$272bn Mexico
46 other $93bn
countries
$429bn
Türkiye
$77bn

Mexico 63 other
Indonesia
$136bn countries
$76bn
$627bn

Indonesia Romania
$42bn Korea $73bn
$118bn Argentina
Chile $57bn $67bn
India $59bn Brazil $99bn UAE $62bn
Saudi Arabia $71bn Israel $44bn
UAE $91bn Chile $41bn Philippines
Hong Kong $74bn
$41bn
Source: BofA Global Research, Bloomberg, ICE Data indices, LLC. Source: BofA Global Research, Bloomberg, ICE Data indices, LLC.
BofA GLOBAL RESEARCH BofA GLOBAL RESEARCH

Emerging market countries are home to companies such as Vale, the largest iron ore
company; Codelco, the largest copper company; Bimbo, the largest baker; and JBS, the
largest meat packer, to name a few. The Mexican telecommunications company, America
Movil, is one of the largest in the world. The Industrial and Commercial Bank of China is
the largest bank in the world. Mexico’s Pemex has issued some of the most actively
traded bonds in the world, including corporate bonds from developed markets.

Previously, rating agencies would not rate an emerging market corporate higher than the
rating of its sovereign (this was termed a “sovereign ceiling”), expecting that in a crisis,
a government could appropriate the foreign exchange of the corporate or prevent it
from converting local currency into foreign currency. But that criterion has been relaxed.
Although credit analysts once viewed corporate bond valuations primarily in comparison
to its sovereign, increasingly, analysts consider a company’s global peer group when
determining value, in addition to geographic location.

Credit quality of Emerging Market countries

Emerging markets have improved in credit quality as an asset class. This is now a
diverse asset class ranging from investment-grade credits to defaulted debt. The asset
class was created from weak economies struggling to improve after the 1980s. Since
then, many countries have pursued macroeconomic policies that allow them to better
weather external shocks and reduce their sensitivity to changes in capital flows; and
their credit quality has improved as a result. During some periods, emerging market
economies have even been the growth drivers of the global economy.

Despite the difficulties surrounding the 1997 Asian debt crisis and 1998 Russian default,
there have been many more positive than negative ratings actions since then. Thus, the
percentage of investment-grade bonds in the major benchmark indices has risen from
under 10% in the mid-1990s to close to 60-70% 25 years later. Credit quality also rose

GEMs Primer | 29 July 2024 7

by three notches from BB-/Ba3 to BBB-/Baa3, when considering the rating of the index
weighted by market capitalization (Exhibit 6 and Exhibit 7).

The large increase in the size of the EM sovereign investment grade universe brought
new buyers. Just as the credit quality of the overall sovereign index increased, so did the
quality and diversity of the investment grade universe (Exhibits 8-10). In 2003, Mexico
was over 70% of the IG subindex with a BBB- rating and there were almost no A-rated
or better issuers. Today there are many highly rated issuers.

Moreover, the IG subindex currently has a bimodal distribution, with bonds clustered
around BBB as well as AA/A+, whereas 10 year ago most of the bonds were clustered
around BBB and BBB-. This bimodal distribution can be explained by two factors. First,
there has been significant issuance from highly rated Gulf countries, such as Saudi
Arabia, UAE, and Qatar (issuance picked up after the 2014 oil shock). Second, several
countries that were rated BBB in 2013 have since then lost their investment grade
rating, becoming “fallen angels”, such as Brazil, Türkiye, and South Africa.

Exhibit 6: EM sovereign bond credit quality improved - 0% were Exhibit 7: Average credit quality of the market was BB when EM
investment grade in in 1991, hit 70% in 2013, now 50% in 2024 sovereign market opened with a small number of Brady bonds.
Distribution of market value in US$ denominated sovereign bonds Average rating deteriorated to B during the 1994 Peso crisis and is
now back to BBB-
100% Average credit quality of US$ denominated sovereign bonds

80% BBB
60%

40%

20% BB

0%
1991 1996 2001 2006 2011 2016 2021 B
A-AA BBB BB B C
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
2017
2019
2021
2023
Source: BofA Global Research, Bloomberg, ICE Data indices, LLC (DGOV Index).
BofA GLOBAL RESEARCH
Source: BofA Global Research, Bloomberg, ICE Data indices, LLC (DGOV Index).
BofA GLOBAL RESEARCH

8 GEMs Primer | 29 July 2024

Exhibit 8: The distribution of IG rated sovereign bonds has changed dramatically over the past 20
years. In 2004, most of the IG market value was in BBB- bonds. Currently, IG bonds have a bimodal
distribution, with a mix of highly rated bonds (AA, AA-, A+) and BBB bonds. Since many countries
have become “fallen angels” over the years, there are few BBB- bonds remaining.
IG countries’ market value in $bn as of June 2004, 2014, and 2024, per rating bucket

210

180

150

120

90

60

30

0
BBB

BBB
AA+
AA
AA-
A+
A
A-
BBB+

BBB-

BBB
AA+
AA
AA-
A+
A
A-
BBB+

BBB-

AA+
AA
AA-
A+
A
A-
BBB+

BBB-
2004 2014 2024
Source: BofA Global Research, Bloomberg, ICE Data indices, LLC. Note: Credit rating is based on average of Moody’s, S&P, and Fitch.
BofA GLOBAL RESEARCH

Exhibit 9: Over past 10 years, mix of IG issuers has changed due to inclusion of new highly rated
issuers and loss of “fallen angels” that were downgraded to HY
New or upgraded to IG sovereign issuers and fallen angel sovereign issuers since 2014
New IG Issuers Since 2014 Fallen Angel Issuers Since 2014
China (A+, $24bn) Azerbaijan (BB+, $1bn)
Hong Kong (AA, $14bn) Bahrain (B+, $22bn)
Hungary (BBB, $32bn)* Brazil (BB, $39bn)
Kuwait (A+, $5bn) Bahamas (B+, $2bn)
Kazakhstan (BBB, $7bn) Morocco (BB+, $8bn)
Saudi Arabia (A+, $101bn) Namibia (B+, $1bn)
Russia (BBB-, $31bn)**
Türkiye (B+, $77bn)
Trinidad & Tobago (BB+, $2bn)
South Africa (BB-, $20bn)
Source: BofA Global Research, Bloomberg, ICE Data indices, LLC. Note: Credit rating is based on average of Moody’s, S&P, and Fitch.
Note *: previously a HY issuer that became IG. Note**: as of Mar’22.
BofA GLOBAL RESEARCH

GEMs Primer | 29 July 2024 9

 Exhibit 10: In 2024 AA-As rated countries represents 48% of the EM IG sovereign spectrum
IG countries’ market value in $bn as of June 2024, per rating bucket (largest on top, Others at the bottom)

240 Indon, Mexico,

210 Phlippines, Others

180 KSA,
China
150
Others
120
Colom,
90 HK, Others
Korea,
60 UAE Poland,
Qatar
30 Chile Malaysia
Uruguay
0
AA+ AA AA- A+ A A- BBB+ BBB BBB-
Source: BofA Global Research, Bloomberg, ICE Data indices, LLC. Note: Credit rating is based on average of Moody’s, S&P, and Fitch.
KSA = Kingdom of Saudi Arabia
BofA GLOBAL RESEARCH

Exhibit 11: In 2014 (10 years earlier) AA-As rated countries represented just 16% of the EM IG
spectrum
IG countries’ market value in $bn as of June 2014, per rating bucket (largest on top, Others at the bottom)

150 Türkiye, Indon, Philip,

135 Uruguay, Others
120 Russia, Brazil,
105 Panama, Others
90
Mexico,
75 Lithuania, Peru
60 Poland,
45 UAE, Malysia,
30 Qatar Trin & Tob
15 HK, Israel
Korea
0
AA+ AA AA- A+ A A- BBB+ BBB BBB-
Source: BofA Global Research, Bloomberg, ICE Data indices, LLC. Note: Credit rating is based on average of Moody’s, S&P, and Fitch.
BofA GLOBAL RESEARCH

Exhibit 12: In 2004 (20 years earlier) AA-As rated countries represented 31% of the EM IG spectrum
IG countries’ market value in $bn as of June 2004, per rating bucket (largest on top, Others at the bottom)

40 Mexico, Trin & Tob

35
30
25
Korea,
20 Others
S. Africa,
15
Hungary, Malaysia, Tunisia,
10
Qatar Others Thailand
5
0
AA+ AA AA- A+ A A- BBB+ BBB BBB-
Source: BofA Global Research, Bloomberg, ICE Data indices, LLC. Note: Credit rating is based on average of Moody’s, S&P, and Fitch.
BofA GLOBAL RESEARCH

10 GEMs Primer | 29 July 2024

Sukuks: Islamic finance
An important development in EM debt has been the rise of sukuks, which are financial
instruments that are compliant with Islamic law, particularly the prohibition on interest.
There are currently around $139bn in EM sukuks outstanding, of which $67bn are
sovereign sukuks and $72bn are corporate sukuks.
Sukuks replicate the financial flows associated with bonds. Instead of receiving a coupon
payment, sukuk investors receive a “periodic distribution amount” and instead of receiving
a principal payment, sukuk investors receive a “dissolution distribution amount.”
The underlying contractual arrangements of sukuks are complex and involve the creation
of a special purpose vehicle (SPV) that issues certificates to investors and uses the cash
proceeds to purchase assets (generally from the government). 100% of sukuk sovereigns
are governed by English Law.
Sukuks represent about 30% of the external debt funding for their core markets (GCC,
Malaysia, Indonesia, Türkiye, and Pakistan). Spreads can be slightly lower than similar
non-sukuk bonds, but demand remains robust, especially in Islamic finance circles.
The majority of sukuks are investment grade. Not surprisingly, defaults are low (only
about 0.2% of all issued sukuk have defaulted, according to Fitch). But as a result, the
recovery rate of these instruments is largely untested.
Exhibit 13: Largest sukuk issuer is KSA (Saudi Arabia), followed by UAE Exhibit 14: Largest corporate sukuk issuer is KSA (Saudi Arabia),
Face value of total outstanding sukuks bonds, by country, in $mn followed by UAE
Face value of corporate outstanding sukuks bonds, by country, in $mn
Türkiye,
8,350 Türkiye,
UAE, 850
35,210
Bahrain, UAE,
8,450 27,310
Saudi Arabia, Egypt, Saudi Arabia,
51,555 1,500 32,055
Hong Kong,
Qatar, 1,000
3,000 Indonesia, 17,500 Bahrain,
Pakistan, Korea, 1,800 2,450
Oman, Malaysia, Korea,
1,000 Qatar, Malaysia, 1,800
Philippines, 1,000 5,750 7,550 Maldives, 500 3,000 Oman,
2,500 4,250
Source: BofA Global Research, Bloomberg, ICE Data indices, LLC
BofA GLOBAL RESEARCH Source: BofA Global Research, Bloomberg, ICE Data indices, LLC
BofA GLOBAL RESEARCH

Exhibit 15: Among sovereigns alone, largest sukuk issuer is KSA Exhibit 16: Sukuk bonds issuance reached a peak in 2023 at $38bn
(Saudi Arabia), followed by Indonesia Yearly issuance of sukuks in $mn through June 2024
Face value of sovereign outstanding sukuks bonds, by country, in $mn
40,000 Sovereign
Türkiye, 35,000 Corporate
UAE, 7,900
7,500 Bahrain, 30,000
6,000 Egypt, 25,000
1,500 20,000
Saudi Arabia, 15,000
Hong Kong,
19,500
1,000 10,000
5,000
Pakistan, 1,000 Indonesia, -
Philippines, 1,000 17,500
Malaysia, Maldives,
Oman, 3,250 500
3,300
Source: BofA Global Research, Bloomberg, ICE Data indices, LLC
Source: BofA Global Research, Bloomberg, ICE Data indices, LLC
BofA GLOBAL RESEARCH
BofA GLOBAL RESEARCH

GEMs Primer | 29 July 2024 11

Local Debt Markets
In the 1980s, country fundamentals across emerging markets were weak with twin fiscal
and current account deficits, high inflation, large external debt stocks, currency crises,
and in some cases institutional uncertainty. At that point, financing needs were normally
covered by external debt, denominated in a G10 currency, and governed by New York,
London, or Tokyo laws.

Fundamentals started to improve in the 1990s as countries implemented

macroeconomic stabilization programs, adopted a more responsible fiscal stance, and
moved away from fixed exchange rate regimes toward floating ones. In several cases,
monetary policy started to be managed using inflation targeting regimes.

The pro-market reforms led to a gradual improvement in economic fundamentals. Inflation

declined and currencies became more stable. Under this new backdrop, investors gained
confidence in buying debt denominated in local currency issued by countries and
corporations in the emerging markets. Most local debt was bought by local investors,
primarily local financial institutions and pension funds, but foreign investors have become
an increasing share of holders of local debt. Foreigners at some point in the last few years
held close to 40% of local government fixed rate bonds in several countries.

Investing in local emerging markets debt is similar to investing in any international

foreign currency denominated bond; returns have two main sources: local yields and local
currency returns. Because holders also incur currency risk, convertibility risk and other
capital controls risks, local market bond yields are normally higher than those for
external debt. In addition, local yields of emerging market countries have traditionally
been more volatile than those of developed markets, consistent with higher volatility in
inflation. That said, in the last two decades we saw a significant decline in local yields
responding to better fundamentals, higher credibility, and/or to lower global yields.

But emerging markets, along with developed markets, also saw rising inflation during
2021-2022 and in some cases, such as Brazil and Chile, emerging market central banks
were more proactive than those in developed markets to raise rates to tackle inflation,
which was, for the most part, successful in bringing down inflation.

Capital controls
Capital control is a policy device that a government uses to regulate the foreign currency flows
into and out of the country, usually used to restrict volatile movements of capital due to
investor speculation. Controls on inflows typically seek to avoid the macroeconomic
implications of large and volatile capital inflows, such as currency appreciation, loss of
competitiveness, and credit booms. Controls on outflows are used to limit the downward
pressure on their currencies and foreign reserves, a significant risk to a local bond investment.

The implementation of capital controls is a key risk for foreign investors holding, or
planning to hold, local debt. Most emerging market countries have some form of capital
controls that can be increased as needed. Even countries with free convertibility of their
currencies could institute capital controls in the future if deemed necessary. Capital
controls normally can take the form of transaction taxes, transfer taxes, withholding
taxes, reserve requirements, unremunerated reserve requirements, multiple exchange
rate systems, and/or limitations in terms of the amount of assets to be held, caps on
volume permitted, controls on the international sale or purchase of various financial
assets, and sometimes even limits on the amount of money a private citizen is allowed
to take out of the country. As the IMF discussed,2 the most common experiences in
using capital controls are capital controls to limit short-term inflows, capital outflow
controls during financial crises, and extensive exchange controls during financial crises.

2
International Monetary Fund, “Capital Controls: Country Experiences with Their Use and Liberalization”.
Occasional paper 190 (2000).

12 GEMs Primer | 29 July 2024

Convertibility risk
Convertibility, or transfer, risk is the risk that a government will restrict the conversion
of local currency into foreign currency or restrict the transfer of foreign currency out of
the country. In other words, it is the risk that an investor will not be able to repatriate
the cash flows of the investment, normally due to exchange restrictions imposed by a
government. Drastic measures may occur during crises. Several such examples are:

• Korea, 1997: Daily currency move was limited to 5% and the FX market would shut
down after that level was reached.
• Russia, 1998: Banks froze dollar withdrawals, and the central bank terminated the
fixing of the currency in the Moscow International Currency Exchange auctions.
• Argentina, 2001 and 2019: Authorities limited domestic residents’ access to
dollars and required exporters to sell dollar proceeds promptly after collection.
• Venezuela, 2003: Limited ability of locals and foreign companies to convert
bolivars into US dollars.
• Brazil, 2008-2013: The government adopted an IOF tax on foreign inflows for
specific financial transactions, but the tax moved back to zero in 2013.

Investing in local debt markets

As discussed above, investors can gain exposure to local currency returns by buying a
local currency instrument in a particular market. To do so, an investor would have to
send funds to the country, convert it into local currency, and then buy a local debt
instrument. While this process appears simple, there are several nuances that need to be
managed.

Countries have different regulations, laws, and limits for foreign investment, typically
including the need to set up a local account, hire a local custodian, report activity to the
local regulator, and pay taxes if applicable. Also, each country has its own requirements:
some countries limit the amount and or the type of bonds that foreign investors can
hold, others impose taxes on capital inflows, have minimum holding periods, or intervene
heavily in the foreign exchange market, and so on. In some cases, local trading
conventions differ from the international ones, adding an additional layer of caution
when trading a local debt instrument.

Holders of domestic debt

Although foreign investors have significantly increased their percentage ownership of
assets in emerging local debt markets, and in a few markets, they hold 30-40% of the
sovereign fixed rate bonds, local investors are still the main holders of local debt.

Banks are a key player among local investors, but so are other local institutional
investors (pension funds, mutual funds, and insurance companies). When risk aversion
picks up globally, foreign investors tend to sell domestic EM bonds and repatriate their
capital. Historically, local institutional investors with a longer investing horizon have
been able to step in to buy bonds, cushioning the price and yield movements.

GEMs Primer | 29 July 2024 13

 Exhibit 17: Foreigners hold close to 40% of Peru’s domestic bonds but only 1% of India’s domestic
bonds
Foreign holdings share of local governments bonds as of 2Q 2024.

50%

40%

30%

20%

10%

0%
PE CZ MY ZA RO KR CO HU MX ID TR PL TH BR IL CN RU UA IN
Source: BofA Global Research, Haver, local governments’ websites.
BofA GLOBAL RESEARCH

Types of local bonds

Local bond types issued by EM countries are no different in nature than those issued by
developed markets. While calculating conventions may differ, foreign investors normally
have access to several debt instruments denominated in local currency. The most
common instruments are fixed-rate bonds (coupon bonds), fixed-rate notes or bills (zero-
coupon bonds sold at discount), inflation-linked bonds, floating bonds (linked to the
reference interest rate or to a market rate close to the reference interest rate), and in
some cases foreign exchange linked bonds (linked to a hard currency but payable in local
currency) or fixed rate local bonds with debt service payable in USD at the then-
prevailing foreign exchange rate.

The foreign investor base

The profile of the emerging markets’ sovereign investor base has become more diverse
due to the growth of emerging markets debt and excess historical returns. Ownership
was once concentrated in the hands of a few creditor banks and dealers, but now is
distributed more widely through actively traded global and local bonds.

First EM investors were commercial banks and high-net-worth individuals

In the 1980s, emerging market debt was mostly in the form of U.S. dollar-denominated
loans to emerging market governments from foreign commercial banks. Intermarket
dealers traded participations in those loans.

Originally, the principal nonbank investors were high-net-worth individuals from

emerging markets countries. They were the first to realize that these countries had
begun to “turn the corner,” and in the late 1980s began to repatriate their funds by
buying distressed assets. This, in turn, triggered a steady recovery in asset values, which
was further supported by the subsequent issuance of Brady bonds.

Rise in credit quality of the asset class led to changes in the investor base
In 1996 Poland became the first emerging market sovereign to achieve an investment
grade rating, but not the last, as currently almost 50% of emerging market sovereigns
are investment grade (Exhibit 6 and Exhibit 7). This opened the door for demand from
high-grade investors for investment grade emerging market bonds. Higher returns have
played a key role as well, attracting more investors.

Low global yields boosted interest in emerging markets

After the 2008 financial crisis, developed market interest rates remained low, increasing
the demand for higher-yielding emerging markets assets. The high returns on emerging

14 GEMs Primer | 29 July 2024

market bonds increasingly attracted institutional investors. A broader range of insurance
companies and pension funds, in search of higher yields and diversification, now invest
in emerging markets. With relatively low financing costs and many newly formed hedge
funds offering the potential of levered returns, the demand for assets grew.

Broad investor base, including “crossover” investors

The investor base is currently broad, with a large percentage being dedicated emerging
market managers of mutual funds, Exchange Traded Funds (ETFs), pension funds,
insurance companies and growing sovereign wealth funds. Other participants are hedge
funds, including those with macro, credit, or distressed strategies.

Finally, there are “crossover” investors from developed high grade or high yield bond
markets who view emerging markets as an additional asset class to include in their
portfolios. Notably, emerging markets are an increasing portion of the global bond funds,
partly due to the opening of many local markets to foreigners.

Emerging markets debt performance

High yields, high returns, and high Sharpe ratios have made emerging markets debt an
appealing asset class. Exhibit 18 shows the Emerging Markets sovereign spread vs the
US High Yield spread.

Exhibit 18: Spreads of EM Sovereigns have been historically lower than those of US HY, but considering the
improvement in the credit quality over time, the relative EM spread is historically quite high
Emerging Markets and U.S. High-Yield Spreads (bp): January 2000 to June 2024

2250 Emerging Markets Sovereign US High Yield

2000
1750
1500
1250
1000
750
500
250
0
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024
Source: BofA Global Research, Bloomberg, ICE Data indices, LLC., EMGB and H0A0 indices
BofA GLOBAL RESEARCH
Historical returns
Emerging markets external debt has produced one of the highest returns among major
asset classes for a long time. Exhibit 19 shows the performance of the J.P. Morgan EMBI
Global Diversified Composite Index (JPEIDIVR) since inception in December 1993.

For almost three decades, returns for the asset class have exceeded other major fixed
income markets, with a cumulative return of over 900%, far above the average
cumulative returns of around 700% for U.S. high-yield bonds or around 300% for U.S.
Treasuries over the same period. Over that period, emerging markets debt has provided
a 7.5% annualized return compared with 6.7% for the U.S. high-yield market. In
comparison, cumulative returns of emerging market equities posted a 340% return, less
than the approximately 2000% of U.S. equities.

GEMs Primer | 29 July 2024 15

 Exhibit 19: Total return has been approx 50% higher for EM External Debt than for US High Yield
Total Return of J.P. Morgan EMBI Global Diversified Composite Index (JPEIDIVR Index), ICE BofA US Cash Pay
High Yield Index and ICE BofA US Treasury Index, for a $100 Original Investment since 1993 – June 2024

1200 Rates hikes

EM External Debt Covid-19 worldwide
US High Yield and oil
Greece, crisis
1000
Taper Fed and
US Treasuries
tantrum China
800
Global credit
Argentina crisis
600 default Brazil risk
Asia crisis election
400 Russia crisis
Mex Peso
crisis
200

Mex upgraded to BBB-

0
1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023
Note: EM External Debt: JPEIDIVR Index, US High Yield: J0A0 Index, US Treasuries: G0Q0 Index.
Source: BofA Global Research, Bloomberg, J.P. Morgan EMBI Global Diversified Composite Index, ICE Data indices, LLC.
BofA GLOBAL RESEARCH

EM sovereigns tend to issue long maturity foreign currency bonds, mainly 10-30 year,
while EM corporates, especially lower quality corporates, issue shorter bonds. Sovereign
bonds thus have an average life of around 12 years, compared to an average life of 6
years for corporates. As a result, sovereign bonds have higher sensitivity to interest
rates. Due to the long-term downward trend in US interest rates, the higher interest rate
sensitivity had benefited holders of sovereign bonds for years, as they had outperformed
EM corporates and Global High Yield. However, when U.S. interest rates rise, as they
have in 2021-2022, the higher interest rate sensitivity became a disadvantage.

A small part of the historical return of EM external sovereign debt is due to the lower
Treasury yields. From inception of the indices in the early 1990s to 2022, U.S. Treasury
rates declined by 200 basis points, or an average of 7 basis points per year. This
accounts for about 1% of the historical annual return.3 The remainder of the return can
be attributed to the coupon income, price appreciation due to spread tightening, and the
accretion of bond prices to par upon maturity.

By 2021, Treasury yields had fallen greatly, reaching historical lows while emerging
markets spreads simultaneously compressed significantly to historically tight levels. It
would be difficult for annualized returns to be as high in the future as they were in the
last 25 years. Indeed, in 2022 sharply higher Treasury yields and wider spreads resulted
in a loss of 18% total return for EM external sovereign debt.

Volatility and Sharpe ratios

Over the past 10 years, emerging markets external debt provided about a 3% annualized
return, and it exhibited a 9% annualized volatility (see Exhibit 20 and Exhibit 21).

Higher return assets typically exhibit higher volatility. A risk-adjusted return measure, the
Sharpe ratio, can be used to compare volatility-adjusted returns. The Sharpe ratio is the
ratio of excess returns (returns minus the risk-free rate) divided by the volatility.

From 2014-2023, the annualized returns of emerging markets external debt (3.2%) have
exceeded the returns of U.S. Treasuries (1.3%). Emerging markets external debt has also
3
A spread tightening of 10 basis points would increase the index value by 0.8%.

16 GEMs Primer | 29 July 2024

exhibited a higher Sharpe ratio (0.34 vs. 0.27), meaning that higher returns more than
compensated for higher volatility. The Sharpe ratio of emerging markets external debt
also exceeded that of global government bonds or emerging markets equity.

On the other hand, emerging market external debt returns slightly above that of US
investment grade corporates but below US high-yield corporates over the past 10 years.
As mentioned previously, the higher duration of the asset class was a hinderance when
global rates rose sharply in 2022.

Exhibit 20: EM External Debt shows a higher return and less volatility than EM Local Debt and EM
Equities
10-Year Annualized Total Return vs Volatility, 2014-2023

15
S&P Equity
12
Annualized Return %

9 Europe Equities
6 Municipals US High Yield
US Corp EM External Debt EM Equities
US Treasury
3
EM External IG EM External HY
Mortgages
0
Global Govt EM Local Debt
-3
0 5 10 15 20
Annualized Volatility %
Note: For S&P Equity the index is SPTR; Mortgages: M0A0 Index, Municipals: U0A0 Index, US High Yield: H0A0 Index, US Corp: C0A0 Index,
Europe Equities: E100 Index, US Treasury: G0Q0 Index, EM External Debt: JPEIDIVR Index, EM External Debt IG: DGIG Index, EM External Debt
HY: DGHY Index, EM Equities: GDUEEGF Index, Global Govt: W0G1 Index, EM Local Debt: GBIEMCOR Index.
Source: BofA Global Research, Bloomberg, ICE Data indices, LLC.
BofA GLOBAL RESEARCH

Exhibit 21: 10-Year Total Return for EM External Debt outpaces EM Equities and EM Local Debt
10-Year Total Return, Volatility, and Sharpe Ratio (Annualized), 2014-2023
Annualized Return Volatility Sharpe Ratio*
S&P Equity 12.03 15.2 0.79
US High Yield 4.51 7.9 0.57
Europe Equities 6.99 16.1 0.43
Municipals 3.12 5.1 0.61
US Corp 2.98 6.6 0.45
EM External Debt 3.22 9.4 0.34
EM External IG 2.74 8.0 0.34
EM External HY 3.12 12.6 0.25
EM Equities 3.05 17.3 0.18
Mortgages 1.38 4.6 0.30
US Treasury 1.34 4.9 0.27
EM Local Debt -0.17 11.2 -0.02
Global Govt -0.39 6.7 -0.06
Note: The Sharpe ratio numerator is the excess return vs Treasury bills (T-bill return =+1.25% in that period) over the return volatility.
Annualized returns are calculated from 2014-2023 considering divs/cpns reinvested in the index. For S&P Equity the index is SPTR;
Mortgages: M0A0 Index, Municipals: U0A0 Index, US High Yield: H0A0 Index, US Corp: C0A0 Index, Europe Equities: E100 Index, US
Treasury: G0Q0 Index, EM External Debt: JPEIDIVR Index, EM External Debt IG: DGIG Index, EM External Debt HY: DGHY Index, EM Equities:
GDUEEGF Index, Global Govt: W0G1 Index, EM Local Debt: GBIEMCOR Index.
Source: BofA Global Research, Bloomberg, ICE Data indices, LLC
BofA GLOBAL RESEARCH

GEMs Primer | 29 July 2024 17

Correlation with other asset classes
Emerging markets external debt returns are weakly correlated with the returns of U.S.
Treasury bonds (0.34, see Exhibit 22). The correlations of returns are higher with US
high yield corporates (0.84), US investment grade corporates (0.84), EM local debt (0.80)
and EM Equities (0.74). Low correlations can give emerging markets an important
diversification role in a global portfolio.

EM local debt is highly correlated with EM equity and with EM external debt because
both local debt and local equity returns have a currency component and local and
external debt is increasingly managed together by a similar investor base.

Liquidity
Many investment-grade and high-yield bond portfolios include some emerging markets
debt, and thus high-yield managers represent an important source of “crossover”
investors (as opposed to “dedicated” EM investors). Crossover investors buy emerging
market debt because these bonds may be included in their global credit or bond
benchmark indices. In addition, valuations can be better at times than in developed
market debt and liquidity can be better.

Compared to EM Corporates and US high yield indices, average EM sovereign issues are
twice as large, making sovereign pricing more transparent and bid-ask spreads narrower.
Thus, emerging markets sovereign debt plays a key role in high-yield portfolios by
offering greater liquidity when needed.

Some emerging market corporate bonds are as liquid as most US corporate bonds. Over
363 corporate issues in the ICE Emerging Market Corporate indices have outstanding
face value of least US$1bn, in addition to 627 sovereign issues in the sovereign index.
This is also above to the 483 bonds in the ICE BofA Global High Yield Index that are of at
least US$1bn.

Average trading volume of emerging markets debt recorded by the Emerging Markets
Traders Association is usually about US$15bn per day, of which $11bn is local debt.
These volumes can decline by 20-40% following market crises or periods of low risk
appetite. Corporate bonds have smaller issue sizes and trade about 30% less frequently
than sovereigns, despite the larger stock of corporate bonds compared to external
sovereign bonds.

18 GEMs Primer | 29 July 2024

Emerging market fundamentals that contribute to returns
EM debt investors monitor economic indicators to allocate their investments across
countries and such reallocations can affect relative spreads. Many of the indicators are
important for analyzing debt sustainability (a concept described in the next section).

Important economic indicators include: real gross domestic product (GDP) growth,
consumer price index (CPI) inflation, current account/GDP, fiscal balance/GDP, public
debt/GDP, net external position/GDP, foreign exchange (FX) reserves/short-term external
debt, current account balance/GDP, net foreign direct investment/GDP, private
credit/GDP, bank loans/deposits, non-performing loans as a percent of bank portfolios,
and external debt/exports of goods and services.

Political and institutional stability is always considered, as well. Many investors

increasingly look at Environmental, Social, and Governance (ESG) indicators to
complement their economic analysis.

Exhibit 22: There is a high correlation between EM Debt and US High Yield, US Corporates and EM Local Debt returns
Inter-market correlations of returns 2014-2023
EM EXD EM EM US High US Global S&P Europe EM EM Local
Debt IG HY Yield Corp US Treasury Govt Municipals Mortgages Equity Equities Equities Debt
EM EXD Debt 1.00 0.88 0.93 0.84 0.84 0.34 0.59 0.71 0.52 0.68 0.69 0.74 0.80
EM Debt IG 1.00 0.67 0.72 0.92 0.68 0.78 0.84 0.76 0.57 0.55 0.61 0.67
EM Debt HY 1.00 0.80 0.65 0.07 0.40 0.52 0.31 0.65 0.71 0.73 0.80
US High Yield 1.00 0.74 0.15 0.43 0.55 0.40 0.80 0.75 0.72 0.66
US Corp 1.00 0.69 0.77 0.84 0.76 0.57 0.54 0.60 0.61
US Treasury 1.00 0.82 0.74 0.86 0.08 0.07 0.11 0.20
Global Govt 1.00 0.77 0.81 0.32 0.35 0.44 0.55
Municipals 1.00 0.83 0.39 0.41 0.42 0.47
Mortgages 1.00 0.35 0.32 0.35 0.34
S&P Equity 1.00 0.84 0.71 0.55
Europe Equities 1.00 0.75 0.67
EM Equities 1.00 0.82
EM Local Debt 1.00
Note: For S&P Equity the index is SPTR; Mortgages: M0A0 Index, Municipals: U0A0 Index, US High Yield: H0A0 Index, US Corp: C0A0 Index, Europe Equities: E100 Index, US Treasury: G0Q0 Index, EM External Debt:
JPEIDIVR Index, EM External Debt IG: DGIG Index, EM External Debt HY: DGHY Index, EM Equities: GDUEEGF Index, Global Govt: W0G1 Index, EM Local Debt: GBIEMCOR Index.
Source: BofA Global Research, Bloomberg, ICE Data indices, LLC.
BofA GLOBAL RESEARCH

GEMs Primer | 29 July 2024 19

Sovereign Debt Sustainability
Sovereign spreads are closely linked to investor’s perception about a country’s
probability of default and the sustainability of its debt. We focus on three considerations
regarding debt sustainability: (1) Debt dynamics, (2) Debt structure, and (3) Gross
financing needs.

Consideration 1: Debt Dynamics

All else being equal, countries with high and increasing debt ratios should expect to pay
higher spreads to issue bonds. The first step to understanding debt sustainability is
calculating how a country’s debt-to-GDP ratio will change over time. Investors monitor
the debt-to-GDP ratio, instead of the nominal stock of debt, because a country’s
capacity to service its debt is proportional to the size of its economy (tax revenue is
proportional to nominal GDP).

Fiscal policy and automatic debt dynamics

Contributions to changes in the debt-to-GDP ratio can be grouped into two categories:
(1) fiscal policy and (2) automatic debt dynamics.

• Fiscal policy: Change in debt ratio due to the current year’s fiscal primary balance
(revenues minus non-interest expenses).

• Automatic debt dynamics: Change in the debt ratio due to macroeconomic

variables (growth, interest rates, inflation, currency fluctuation) and the country’s
pre-existing debt-to-GDP ratio.

While governments have some discretion over fiscal policy, fiscal policy is not set in a
vacuum and deficits can be strongly affected by the same variables that contribute to
automatic debt dynamics.

For example, fiscal policy can be especially sensitive to growth. Tax revenues tend to
improve when the economy is growing and many emerging market governments receive
significant revenues from commodity exports, such as oil and metals.

On the other hand, several expenses are mandated by laws or constitutional rights,
limiting the government’s discretion to reduce spending during downturns. Moreover,
government sometimes opt to increase spending during recessions to smooth out the
business cycle.

As a result, deficits as a proportion of GDP usually increase during economic

contractions due to a simultaneous decline in revenue as a proportion of GDP and
increase in spending as a proportion of GDP.

Debt-stabilizing primary balance

The debt-stabilizing primary balance is an important concept because it can tell an
investor how close or far away a country is to stabilizing its debt ratio. The debt-
stabilizing primary balance is the fiscal primary balance that the government needs to
maintain so that its debt-to-GDP ratio remains unchanged from one year to the next. If a
country’s fiscal primary balance is lower (higher) than the debt-stabilizing primary
balance, then debt-to-GDP will rise (fall) from one year to the next.

Note that the debt-stabilizing primary balance may be a surplus or a deficit, depending
on the country’s macroeconomic variables. The debt-stabilizing primary balance will
typically be a surplus if real interest rates exceed real growth rates. The debt-stabilizing
primary balance will typically be a deficit if real interest rates are lower than real growth
rates.

The basic intuition on whether a primary deficit or surplus is needed to keep the debt
ratio stable is that when the real growth rate is higher than the real interest rate, the
government can afford a primary fiscal deficit because the economy (the denominator in

20 GEMs Primer | 29 July 2024

the debt ratio) is growing faster than the stock of debt (which grows by the interest rate
charged by investors). On the other hand, when the real growth rate is lower than the
real interest rate, the government needs to maintain a primary fiscal surplus because the
economy is growing slower than the stock of debt.

Political constraints can limit the feasibility of fiscal adjustments within a short period
of time. If a country is far away from its debt-stabilizing primary balance and fiscal
policy can only be adjusted gradually, then the country’s debt ratio may continue to rise
for several years.

How economic variables affect a country’s debt-to-GDP ratio

The year-over-year change in a country’s debt-to-GDP ratio is affected by the following
variables:

• Fiscal primary balance (revenues minus non-interest expenses): A fiscal primary

deficit will increase the country’s debt-to-GDP ratio and a primary fiscal surplus will
reduce the country’s debt-to-GDP ratio.

• Growth: Higher real growth will lower the country’s debt-to-GDP ratio, since it will
increase the denominator of the debt-to-GDP ratio.

• Debt-to-GDP ratio: Higher pre-existing debt-to-GDP ratio will increase the debt-to-
GDP ratio by increasing the interest payments due on the pre-existing stock of debt.

• Interest rates: Higher effective interest rates will increase the debt-to-GDP ratio
by increasing interest payments.

• Inflation: Higher inflation will decrease the debt-to-GDP ratio by reducing the real
cost of interest service and increasing the nominal size of GDP (however, note that
higher inflation is not a panacea because inflation can increase the interest rate
demanded by investors on new debt and can also lead to currency depreciation).

• Exchange rate: A depreciation of the domestic currency will increase the debt-to-
GDP ratio by increasing the local currency value of the foreign currency debt.

• Proportion of foreign currency debt: A higher proportion of debt denominated in

foreign currency increases the sensitivity of the debt-to-GDP ratio to exchange rate
fluctuations.

Calculating the change in debt-to-GDP ratio

The intuition behind the formula for calculating the change in the debt ratio is the
following: the debt-to-GDP ratio increases (decreases) by the primary deficit (surplus)
plus the contribution of the automatic debt dynamics due to growth, the pre-existing
debt stock, inflation, interest rates, and currency depreciation.

The change in a country’s debt-to-GDP ratio can be calculated with the formula shown
in:

Exhibit 23: Formula to calculate the change in a country’s debt ratio

Change in debt ratio is determined by the primary balance plus the contribution from automatic debt
dynamics (growth, inflation, interest rates, and currency fluctuation).

Source: BofA Global Research.

BofA GLOBAL RESEARCH

GEMs Primer | 29 July 2024 21

In the formula in Exhibit 23, 𝐷𝐷𝑡𝑡 is the current year’s debt-to-GDP ratio, 𝐷𝐷𝑡𝑡−1 is the prior
year’s debt-to-GDP ratio, 𝑝𝑝𝑝𝑝 is the fiscal primary balance (revenues minus non-interest
expenses), 𝑔𝑔 is the real GDP growth rate, 𝑖𝑖 is the nominal effective interest rate
(weighted average of domestic and foreign nominal interest rates), 𝑖𝑖 𝑓𝑓 is the nominal
interest rate on foreign currency debt, 𝜋𝜋 is the inflation rate (more precisely, the growth
rate of GDP deflator), 𝛼𝛼 is the proportion of debt denominated in foreign currency in
year t-1, and 𝑒𝑒 is the nominal exchange rate depreciation (percentage increase in local
currency value of one U.S. dollar). Unless noted otherwise, the variables refer to their
values in year t.

Calculating the debt-stabilizing primary balance

The debt-stabilizing primary balance (𝑝𝑝𝑝𝑝∗ ) can be calculated by setting the change in the
debt-to-GDP ratio (𝐷𝐷𝑡𝑡 − 𝐷𝐷𝑡𝑡−1 ) equal to zero and then re-arranging the equation to solve
for the primary balance, as shown in Exhibit 24. Note that the debt-stabilizing primary
balance is reached when the government’s primary fiscal balance exactly offsets the
contributions from automatic debt dynamics.

Exhibit 24: Formula to calculate a country’s debt-stabilizing primary balance (pb*)

The debt-stabilizing primary balance is the budget deficit/surplus that keeps the debt ratio unchanged YoY,
calculated by setting the change in the debt ratio equal to zero and re-arranging the equation

Source: BofA Global Research.

BofA GLOBAL RESEARCH

Consideration 2: Debt structure

In addition to a country’s debt-to-GDP ratio, characteristics of a country’s debt structure
may also expose the country to higher or lower vulnerability to macroeconomic shocks.

Currency Denomination
A country with a large proportion of its debt denominated in foreign currency is more
vulnerable to an increase in the debt-to-GDP ratio due to a depreciation of domestic
currency. Sharp currency depreciations usually accompany emerging market crises and
can make the country’s foreign currency debt unaffordable.

Fixed vs. Floating Rates

A country’s effective interest rate is more sensitive to fluctuations in interest rates if
the country has a high proportion of floating rate debt. Fixed rate debt protects the
country from spikes in interest rates (historically, emerging market central banks have
hiked interest rates during crises to protect against a currency depreciation). On the
other hand, fixed rate debt reduces the transmission of declining interest rates.

Maturity Profile
Debt with a short maturity profile is more vulnerable to a decline in refinancing rates
because a short maturity profile means that a larger proportion of debt must be repaid
each year. When debt comes due, countries must find investors willing to rollover the
maturing debt. If there is insufficient demand to refinance maturing debt, countries
must pay maturing debt out of their savings, or they might be forced to default (see next
section for an additional discussion).

To reduce refinancing risk, many countries perform liability management operations

where they buy back shorter-term debt maturity (this is typically financed by
simultaneously issuing long-term debt).

22 GEMs Primer | 29 July 2024

Ownership
If debt is primarily owned by a captive group of investors, then it may be less vulnerable
to a decline in refinancing rates during a crisis. Generally, domestic institutional
investors are more captive than foreign investors. Domestic investors often need to own
government securities to meet regulatory requirements and domestic investors often
have a home bias. Long-term investors, such as pension funds or insurance companies,
are typically stickier sources of demand for government bonds than short-term investors
like hedge funds.

Governing Law
It is generally easier for a country to restructure its debt if the debt is governed by
domestic law since local courts might be more sympathetic to the government’s
arguments and domestic laws could be changed (even retro-actively). It is harder to
restructure debt governed by foreign law, such as New York or English law as investors
have the possibility of filing lawsuits in those foreign jurisdictions.

Consideration 3: Gross Financing Needs

Gross Financing Needs (GFNs) = Primary Deficit + Debt Service
Gross financing needs (GFNs) refers to the debt that a country needs to issue each year
to cover its fiscal primary deficit and to cover its debt service (interest expense plus
principal amortizations).

Gross financing needs are typically expressed as a percentage of GDP and are often
distinguished between domestic currency needs and foreign currency needs. Note that if
the country has a fiscal primary surplus, then the gross financing needs are reduced by
the surplus.

Gross financing needs are subject to two important risks:

• Interest rate risk: Risk that investors demand higher interest rates to purchase
new debt. Higher interest rates could make a debt stock that was previously
affordable with lower interest rates no longer affordable.

• Rollover risks: Risk that investors fail to purchase new debt to refinance maturing
debt. If refinancing rates drop significantly, a country is said to have lost market
access.

Percentage of bonds able to be refinanced declines when investors fear default

Investors often reduce their purchases of sovereign debt when they believe that a
sovereign can no longer afford to pay the coupons and principal on its debt. When the
rate of refinancing declines and a country loses access to debt markets, countries must
cover debt service by drawing down on assets, such as savings or international reserves,
by printing money which can push up inflation, or by seeking a loan from the
International Monetary Fund (IMF), which is considered the lender of last resort.

Loss of market access is often accompanied by capital flight by both residents and non-
residents, leading to currency depreciation and depletion of international reserves.
Countries may impose capital controls to preserve their international reserves, but the
controls may not be sufficient (investors may find ways to circumvent the controls).

Depletion of assets can trigger default

If investor confidence is not restored, the depletion of assets due to loss of market
access can force a country to stop paying its debts, leading to a moratorium and an
eventual debt restructuring. For this reason, external debt investors monitor closely the
country’s stock of international reserves and exchange rate developments. On the other
hand, if a country seeks an IMF program, it may be asked by the IMF to restructure its
bonds if it its debt is judged to be “unsustainable.”

GEMs Primer | 29 July 2024 23

High GFNs increase vulnerability to investor sentiment
Countries with high gross financing needs are therefore more vulnerable to changes in
investor sentiment that could lead to higher interest rates or lower refinancing rates.
Lack of appetite for debt issuance can force a country to enact fiscal austerity to reduce
its fiscal deficit (reducing financing needs) or may lead to a debt crisis if it cannot find
liquidity, like an IMF loan, to refinance maturing debt.

Domestic ownership of debt can mitigate risks of high GFNs

It may be easier for countries with a deeper pool of domestic institutional investors to
sustain higher gross financing needs. Otherwise, countries must rely on foreign investors
to fill their financing gaps. Foreign investors are usually more sensitive to changes in
global liquidity conditions, which can be independent of domestic developments, and
foreign investors may reduce rollover rates during periods of global uncertainty.

Example: Comparing Debt Sustainability

In Exhibit 25, we compare the debt-stabilizing primary balances of 3 hypothetical
countries (Country A, Country B, and Country C), calculated with the formula presented in
Exhibit 24. To simplify the comparison, all countries have the same growth rate, inflation
rate, and have no foreign currency debt.

Exhibit 25: Country C shows how higher interest rates can make debt unaffordable
Example of debt sustainability comparison
Country A Country B Country C
Debt/GDP Ratio, t-1 80% 40% 80%
Effective Interest Rate, Nominal 7.0% 9.0% 9.0%
Growth Rate, Real 3.0% 3.0% 3.0%
Inflation Rate 2.0% 2.0% 2.0%
Share of Foreign Currency Debt 0.0% 0.0% 0.0%
Debt-Stabilizing Primary Balance (pb*), % of GDP 1.5% 1.5% 3.0%
Source: BofA Global Research.
BofA GLOBAL RESEARCH

Countries A & B: Different debt ratios, same debt-stabilizing primary balances

Note that both Country A and Country B have the same debt-stabilizing primary balance
of 1.5% of GDP. Country A has twice the debt ratio (80%) as Country B (40%). However,
Country A’s interest rate is 2pp lower (7% for Country A and 9% for Country B). As a
result, Country A needs to run a 1.5% primary surplus to keep its debt ratio unchanged at
80%. Due to its more costly interest rates, Country B needs to run the same 1.5%
primary surplus to keep its debt ratio unchanged at the lower rate of 40%.

Country A probably more vulnerable to shocks than Country B

Although both Country A and Country B need to keep their fiscal balances at the same
level to stabilize their debt ratios, Country A is probably more vulnerable to a debt crisis
than Country B due to Country A’s higher debt ratio.

A high debt ratio usually implies high gross financing needs, subjecting Country A to
higher interest rate risks and rollover risks. Policymakers cannot control the interest
rates demanded by investors to refinance debt nor can they control the demand for new
debt issuance. A spike in interest rates could make Country A’s debt service less
affordable, as illustrated with Country C.

A country could mitigate its high debt ratio by reducing its gross financing needs. For
example, it could have long-maturity debt (reducing debt amortizations) or it could run a
budget surplus. A country could also use its regulatory powers to compel domestic
investors to purchase more domestic debt than they otherwise would (this is known as
“financial repression”).

24 GEMs Primer | 29 July 2024

Country C shows how higher interest rates can make debt unaffordable
Country C illustrates the risks that higher interest rates could make debt that was
previously affordable into unaffordable debt. Country C combines Country A’s 80% debt
ratio with Country B’s 9% interest rate. Country C’s debt-stabilizing primary balance is
3% of GDP, twice as large as the 1.5% debt-stabilizing primary balances of Countries A
and B.

It is therefore much harder for Country C to stabilize its already high debt ratio than it is
for Countries A or B. The pace at which a country’s effective interest rates could
increase depends on the country’s debt structure (fixed vs. floating rates and maturity
profile) and gross financing needs.

What do EM spreads compensate for?

Probability of default and risk premium
Sovereign external debt investors require compensation for both default and non-default
risks. Despite the focus that sovereign investors place on debt sustainability, it is likely
that a large proportion of the sovereign spread can be attributed to risk premiums that
compensate for uncertainty, price volatility, liquidity, and correlations with risky assets,
among others.

The risks that sovereign external debt investors face include:

• Default: Risk that interest and principal payments are not made on full and on time.
After defaults, sovereigns typically restructure and extend maturities, reduce coupon
rates, or reduce principal amounts. These modifications often result in significant
losses for bondholders. The historical rate of default over 5 years for foreign-
currency, foreign law bonds are low for investment grade countries (around 2%), but
higher for high-yield countries (3% for BB-rated countries and 16% for B-rated
countries).

• Uncertainty: To evaluate a country’s creditworthiness, investors must make

assumptions about fiscal policy and macroeconomic variables in the long-term.
These variables are very uncertain, particularly in countries where polices can
change dramatically after elections. In addition, although credit ratings signal
potential risk, rating agencies may be slow to adjust ratings, particularly when
fundamentals are deteriorating quickly.

• Price volatility risk: Spreads widen during periods of risk aversion as investors re-
price bonds lower to protect themselves against larger-than-typical price
adjustments. Higher volatility regimes can persist, and it is difficult for investors to
predict how long the higher volatility will last.

• Liquidity risk: Risk of higher transaction costs (wider bid-offer spreads) during
periods of uncertainty and risk aversion.

• Correlations with selloffs in other risky assets: EM assets tend to perform

poorly when global risk aversion increases. When global liquidity conditions are
loose and risky assets are favored by investors, EM spreads tend to compress slowly
while investors search for yield and accept lower risk premiums. But when global
conditions deteriorate, EM spreads can widen quickly, especially for lower-rated
countries.

GEMs Primer | 29 July 2024 25

 Exhibit 26: Sovereign defaults on foreign currency, foreign law bonds are rare and occur when
asset class spreads are both widening and tightening (red=notable large defaults
Sovereign defaults on foreign currency and JPM EMBI Global Diversified Spreads
1500
JPM EMBI Global Diversified Spreads (bp)
1300

1100

900

700

500

300

100
1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024
Source: BofA Global Research, Bloomberg, Moody’s, JP Morgan (JPEIDISP Index). Note: *Denotes default that is primarily on domestic law
bonds and included in the chart for context. **Default due to unwillingness to pay, rather than inability to pay. ***Technical default related
to court decision. ^Default due to sanctions.
BofA GLOBAL RESEARCH

Weak link between asset class spreads and defaults

Higher default rates have not been consistently linked to wider spreads for the asset
class since 2000. Default frequency has not always increased during periods of higher
EM spreads and defaults have still occurred when EM spreads were compressing.
Nevertheless, the COVID-19 pandemic, Russia-Ukraine war, and higher funding costs
have led to a clustering of defaults since 2020.

Sovereign defaults by large countries on foreign currency bonds issued under foreign law
are nevertheless historically rare. On the other hand, defaults by small economies,
particularly island nations, have been more common. But losses from defaults by these
small countries are typically immaterial for diversified foreign investors, given the small
weights of such countries in typical portfolios.

Over the past 20 years, defaults on foreign currency, foreign law bonds by very large
issuers were limited to just four countries: Argentina (2001, 2014, 2020), Venezuela
(2017), Lebanon (2020), and Russia (2022). Though prominent, defaults by Russia (1998)
and Greece (2012) were primarily against domestic law bonds. Remarkably, the 2008
global financial crisis did not unleash a wave of defaults. That year, Ecuador selectively
defaulted on its foreign bonds, but this default resulted from an unwillingness rather
than inability to pay.

Sanctions or judicial decisions have caused two well-known defaults, despite the
countries having had both the ability and willingness to pay. The 2014 Argentina default
was driven by a court ruling that prohibited bond payments unless Argentina paid
holdouts (investors who did not participate in the 2005 or 2010 restructurings and
instead sued to enforce their rights), while the 2022 Russian default was due to
sanctions that prevented payments to bondholders.

In February 2022, immediately following Russia’s invasion of Ukraine, the US Office of

Foreign Assets Control (OFAC) sanctioned primary and secondary market trading of
Russia bonds, thus preventing Russia from borrowing in the capital markets.
Specifically, it prohibited US persons from buying Russia sovereign bonds, as well as

26 GEMs Primer | 29 July 2024

many Russian corporate bonds, and specifying that US persons can only sell to
documented foreign persons. This action severely limited the trading, value and liquidity
of Russian bonds. In addition, Russia was blocked from making the debt service
payments through the USD Swift banking system and clearing houses were not allowed
to process Russia payments, thus triggering a default on the (investment grade)
sovereign bonds that remains in place in July 2023 with no indication that it will be
lifted.

Several sovereign defaults occurred in 2020 in the context of the COVID-19 pandemic,
including Lebanon, Ecuador, and Argentina. Those economies entered the pandemic with
pre-existing vulnerabilities that were exacerbated by the crisis. The combination of
tighter financial conditions and the Russia-Ukraine war led to a second wave of defaults
in 2022, including Russia, Ukraine, Belarus, Sri Lanka, and Ghana.

The previous time that there was a clustering of defaults was during the mid-1980s.
However, during that time external debt was primarily contracted via bank loans rather
than bonds. The 1980s are less comparable to today due to structural shifts in emerging
markets. These shifts include flexible exchange rates and inflation targeting,
accumulation of foreign reserves, and reduced reliance on foreign currency financing.

Wider asset class spreads: Higher risk premiums can accelerate crises
During periods of higher risk aversion, the spreads of all countries typically widen. The
spread widening is typically proportional to the perceived strength of the country’s
fundamentals (countries with weaker fundamentals widen more).

For countries with stronger fundamentals, it is probable that wider spreads primarily
reflect larger risk premiums, rather than a higher probability of default. Investors can
usually expect risk premiums to recede once the period of heightened risk aversion ends
and volatility subsides.

For countries with weaker fundamentals, higher spreads due to global risk aversion could
hasten the onset of a crisis. Higher interest rates increase interest expense and can lead
to a self-fulfilling bad equilibrium. Persistently higher interest rates increase the risk of
default, which increases the interest rate demanded by investors or reduces the
availability of financing, which in turn increases the risk of default, and so on. Without a
circuit-breaker, this cycle can lead to a debt crisis.

Historical probabilities of default by rating

Exhibit 27 shows the historical rate of default on foreign currency debt by rating
published by rating agencies. The historical cumulative probability of default over 5
years is around 2% or less for countries rated BBB or higher.

In contrast, the probability of default for high-yield countries increases significantly as

credit quality declines, reaching 3.4% for BB-rated countries, 16.2% for B-rated
countries, and much higher for CCC-rated countries. The recent wave of sovereign
defaults has naturally increased the historical default rates (the default rate for B-rated
sovereigns has increased from 14.9% to 16.2% with the latest annual update
incorporating 2023 data).

One important caveat for historical probabilities of sovereign default is that the
statistics are based on a small sample of sovereigns, few of which have defaulted. In
contrast, the sample size for corporates is much larger.

Compensation for default risk

Exhibit 28 shows the 5-year spreads required to compensate for the historical
probability of default given a country’s rating. For investment-grade countries, 5-year
spreads of about 20-30bp would be required to compensate for the historical probability
of default. The required compensation is higher for high-yield countries: about 50bp for

GEMs Primer | 29 July 2024 27

BB-rated and 265bp for B-rated sovereigns (note that higher default rates have
increased the compensation needed for B-rated sovereigns by around 20bp).

For high-yield sovereigns, downgrades imply large increases in the spread required to
compensate for the incremental risk of historical default. For example, a downgrade
from BB to B+ would increase the required spread from about 50bp to 160bp, equivalent
to a 110bp increase.

Exhibit 27: Historical probability of default on foreign currency debt is Exhibit 28: Spread of only about 25bp needed to compensate for
only 2% for BBB-rated countries, but rises significantly for high-yield historical probability of default of BBB-rated countries
countries 5y spreads to compensate for historical probability of default by rating
Historical cumulative probability of default over 5y by rating
427
25 24.8
400

5y Spreads (bps) to Compensate for

Historical 5y Probability of Default (%)

Historical Probability of Default

20
300 265
16.2
15
200
159
10
91
5.9 100
52
3.4 31 35
5
2.1 2.3 10.1 19 23 27
1.3 1.5 1.8
-
A- BBB+ BBB BBB- BB+ BB BB- B+ B B-
-
A- BBB+ BBB BBB- BB+ BB BB- B+ B B-
Source: BofA Global Research. Note: Required spread calculated with simplified formula: Spread =
Source: BofA Global Research, Moody’s, S&P, Fitch. Note: Probabilities of default are averaged by [-(1-RR)/T]*[ln(1-PD)], where RR=Recovery Rate (in percent) and PD=Probability of Default (in
rating bucket (A/BBB/BB/B), as published by Moody’s (1983-2023), Fitch (1995-2023), and S&P percent). Calculation uses 25% Recovery Rate.
(1975-2023). For intermediate rating notches, a linear trend is used to interpolate ratings above BofA GLOBAL RESEARCH
BBB and a polynomial trend is used to interpolate ratings below BBB.
BofA GLOBAL RESEARCH

Exhibit 29 compares the sovereign CDS spread (as of July 2024) against the spread
required to compensate for the historical probability of default. The difference between
the CDS spread and the spread required to compensate for the historical risk of default
likely reflects risk premiums for non-default risks. The gap could also reflect investor
views that a country’s rating does not reflect its true creditworthiness or that future
rates of default may be different from historical rates of default.

The risk premium is typically smaller for investment grade countries and larger for
lower-rated countries. The risk premium is probably higher for lower-rated countries
because the cost of incorrectly overestimating the country’s creditworthiness, in terms
of potential spread widening, can be much higher for low-rated countries than for highly
rated countries.

28 GEMs Primer | 29 July 2024

 Exhibit 29: Difference between CDS spread and spread required to compensate for historical
probability of default likely reflects risk premium for non-default risks (CDS spreads as of July
2023)
Comparison of CDS spreads and spreads required to compensate for historical risk of default by rating

450
400
350
300 TR
5y Spread (bps)

250
ZA
200 CO
PA
150
MX BR
100 PE
MY
50 PH ID
CL
-
A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B-
Spread to Compensate for Historical Probability of Default CDS Spread
Source: BofA Global Research, Bloomberg, Moody’s, S&P, Fitch. Note: Calculation uses 25% post-default recovery rate. CN=China,
CL=Chile, SA=Saudi Arabia, MY=Malaysia, PE=Peru, PA=Panama, PH=Philippines, ID=Indonesia, MX=Mexico, RU=Russia, CO=Colombia,
ZA=South Africa, BR=Brazil, TR=Türkiye.
BofA GLOBAL RESEARCH

Historical sovereign default rates

The average annual sovereign default rate, measured in face value terms as a proportion
of total external sovereign debt, has been 2% over the last 23 years. As a proportion of
high-yield debt alone, the average annual sovereign default rate has been 4%.

These average annual default rates include the high sovereign default rates of 2001,
2020, and 2022, but very low sovereign default rates in almost all other years. 2020 set
a recent record for EM sovereign defaults/restructurings in terms of face value
($107bn), number of issuers, percent of issuers, and percent of outstanding face value.
2022 also had a very high level of defaults, with 7 countries defaulting on a total face
value of $89bn.

EM corporate bond defaults have been on a different cycle. 2008 was a year of both
high EM and high developed market corporate defaults, but not a year of high sovereign
defaults. However, the year with the most EM corporate defaults by number of issuers
was 2022 with 72 issuers defaulting ($91bn).

GEMs Primer | 29 July 2024 29

 Exhibit 30: 72 corporates and 7 sovereigns defaulted in 2022, almost Exhibit 31: The face value of defaulted debt was $91bn for corporates
doubling the very high level of defaults in 2020 and $89bn for sovereigns in 2022
Defaults: Number of issuers by year Face value of defaulted debt ($bn)

90 200 Sovereign
Sovereign
80 180 Corporate
Corporate 160
70
60 140
120
50
100
40
80
30 60
20 40
10 20
0 0

Source: BofA Global Research, Bloomberg, ICE Data indices, LLC. Source: BofA Global Research, Bloomberg, ICE Data indices, LLC.
BofA GLOBAL RESEARCH BofA GLOBAL RESEARCH

Adding sovereigns and corporates, 2022 had 79 issuers defaulting on $180bn of debt,
making it an absolute record for EM debt as a whole.

Exhibit 32: As a percentage of IG and HY sovereigns, sovereign debt Exhibit 33: As a percentage of HY sovereigns alone, sovereign debt that
that defaulted in 2022 was close to 7% of the total EMGB index face defaulted in 2022 was around 17% of the total IG00 index face value
value (IG + HY sovereigns) (only HY sovereigns)
EM sovereign default rates as % of all EM EXD outstanding sovereign debt, EM sovereign default rates as % of only EM high yield outstanding sovereign
including investment grade and high yield debt

16% 30%
26%
14%
25% 22%
12% Sovereign Defaulted Debt
10% Sovereign Defaulted Debt
20% 17%
10% 23y average 2%
23y average
8% 3.5y default 2% 7% 15%
6% 5%
10% 8%
4% 6%
2% 5%
2% 1% 1%
0% 0% 0% 0% 1% 1% 1% 2% 1% 0%
0% 0%

Source: BofA Global Research, Bloomberg, ICE Data indices, LLC. Source: BofA Global Research, Bloomberg, ICE Data indices, LLC.
BofA GLOBAL RESEARCH BofA GLOBAL RESEARCH

30 GEMs Primer | 29 July 2024

Sovereign Restructurings
See our EM Sovereign Default Primer for additional insights on defaults.

Defaults are typically resolved through negotiations with creditors

When countries no longer have the ability or willingness to pay their debts, they may
default on their obligations and/or declare a payment moratorium. To resolve the
default, countries will usually negotiate a debt restructuring with their creditors, typically
by engaging with a representative creditor committee. Typically, the targets of the debt
restructuring are informed by recommendations made by the International Monetary
Fund (IMF). Negotiations could last just a few months or could drag on for years in
protracted cases.

When necessary, the country may also seek debt relief from its bilateral/official
creditors. The Paris Club is the traditional forum for discussing debt relief with bilateral
lenders (there are 22 permanent members of the Paris Club, mostly comprising Western
nations and their allies). More recently, the Common Framework has been created to
coordinate the actions of the Paris Club with non-Paris Club lenders, such as China.

The goal of a restructuring is to reduce debt service

The goal of a debt restructuring is to provide the country with some debt service relief,
particularly in the short-term. This should give the country time to reduce
macroeconomic imbalances that led to the default and eventually allow the country to
issue new debt and refinance amortizations.

Debt relief can be provided by lowering the coupon rates, extending maturities, reducing
the face value of existing debt, or some combination of the three measures. A successful
debt exchange involves sovereigns exchanging the vast majority of their old bonds for
new bonds with lower debt service.

If the debt exchange sufficiently lowers the country’s debt burden, then spreads could
tighten post-restructuring to reflect a lower probability of default on the new lower cash
flows, supporting post-restructuring bond prices (the post-restructuring interest rate is
referred to as the “exit yield”).

Debt exchanges can happen before or after a default occurs. An orderly pre-default
exchange would be in the interest of investors, the issuing country, and third parties
such as the IMF. There have been successful pre-default voluntary exchanges in
emerging markets, such as Uruguay (2002). It has also become more common for
countries to request payment deferrals through consent solicitations to avoid outright
defaults (Ecuador 2020, Ukraine 2022).

On the other hand, outright and protracted defaults can result in a deepening of the
financial and economic crisis, reducing the country’s payment capacity.

Lawsuits from “holdout” investors were a significant challenge in the past

Litigation by “holdout” investors was a difficult issue in the past because protracted
litigation prevented countries from moving on from the default. Holdouts are funds that
buy distressed debt at a low price, decline to participate in a debt exchange, and then
litigate to collect fully on the contractual payments. However, the introduction of
collective action clauses (CACs) has greatly reduced this risk, as seen in the 2020
restructurings.

In the remainder of this section, we discuss the role of third-party support, New York law
documentation, and collective action clauses. We follow with details of some exchanges
that took place in the past as guides for future exchanges, both inside and outside of
emerging markets debt.

GEMs Primer | 29 July 2024 31

Role of the IMF and other institutions
The International Monetary Fund (IMF) and the World Bank were established by the
Western nations after World War II as the “permanent machinery” to anchor the Bretton
Woods international monetary system.

When developing countries began experiencing debt problems in the late 1960s, the
Paris Club was formed to restructure debt from export credit agencies. A decade later,
the London Club was formed to deal with workouts of foreign commercial bank debt.
Because external debt migrated from loans to bonds in the 1990s, restructuring
defaulted debt required a new process.

The IMF and the US Treasury have played significant roles in proposing a permanent
mechanism to deal with defaulted debt, though restructurings continue to be addressed
in an ad-hoc way. While the IMF has generally focused on emerging markets during
recent decades, the IMF also played a key role in providing funding for developed
economies, such as during the European debt crisis in the 2010s.

The IMF, along with other multilateral development banks (MDBs), typically provide loans
to countries that are facing a liquidity crisis, as long as the debt is considered by the IMF
to be “sustainable” and the country agrees to fulfill IMF program targets (this is known
as “conditionality”). But if the debt is judged to be “unsustainable”, then the IMF is likely
to request a debt restructuring as a condition for its lending support.

IMF programs typically include targets for fiscal deficits, inflation, reserve accumulation,
and structural reforms to increase the country’s competitiveness. Countries are also
typically asked to devalue their exchange rates if the IMF believes the domestic currency
is overvalued.

IMF loans must be repaid in full and on time. There has never been IMF debt
forgiveness, except in the case of some Highly Indebted Poor Countries (HIPC), an
initiative launched in 1996 by the IMF and World Bank, with the aim of ensuring that no
poor country faces a debt burden that it cannot manage. Thirty-two countries, mostly in
Africa, benefited with full debt relief. More recently, the IMF created the flexible credit
line (FCL) with less conditionality but for countries with stronger fundamentals.

Although IMF debt is not typically forgiven, maturing payments can sometimes be
refinanced with new loans under new programs. A new program has the effect of
extending the maturity of the original loan, at the expense of agreeing to new
conditionality. Similarly, debt owed to multilateral development banks (MDBs), such as
the World Bank and the Interamerican Development Bank (IDB), are considered to be
senior debt not subject to debt restructurings.

Distressed Debt International Litigation

There is no bankruptcy court for sovereign defaults, like exists for corporate defaults.
Therefore, the outcome of most of sovereign defaults is either the resumption of
payments or, in most cases, a distressed debt exchange under which existing bonds are
modified or exchanged for new bonds.

No bankruptcy court for sovereigns

In a corporate context, a bankruptcy court can “cramdown” a restructuring of liabilities,
but no equivalent mechanism exists for sovereign debt. The absence of a formal
bankruptcy process makes sovereign debt restructurings very challenging to coordinate
among different classes of creditors. There have been recurrent debates on how to
reform the sovereign debt restructuring process to limit the risk that litigation could
disrupt or delay a debt restructuring.

In the past, progress in debt restructurings was impeded by interference from “holdout”
investors. Holdout investors do not participate in the debt exchange agreed upon by
most creditors and keep their original bond contract. Holdout investors then file lawsuits

32 GEMs Primer | 29 July 2024

to demand full payment based on the original contractual agreement. In exchange for
dropping their suits, holdouts sometimes negotiate a preferential settlement for
themselves.

Typically, holdout investors are specialist distressed debt funds that acquire large
holdings and have the means to engage attorneys to sue the sovereign and then to
attach assets (i.e. request that the assets be seized by a court order and delivered to
them). Lawsuits can take years to resolve, so this strategy requires a long time horizon.

Sovereign immunity
The Foreign Sovereign Immunities Act of 1976 is the primary law that governs bringing
a lawsuit in the United States against a foreign sovereign country. In general, sovereign
countries enjoy immunity, but there are exceptions and countries often waive immunity
in their bond documentation. Several common law countries have adopted similar
legislation to the US on sovereign immunity.

Obtaining a court judgement that orders that a defaulting country honor its contractual
bond obligations is no guarantee that the country will in fact pay. In contrast to
corporate defaults (where a bankruptcy court can award ownership of a firm’s assets to
its creditors), it is very difficult for creditors to find and attach the foreign assets of a
sovereign. A country may have plentiful domestic assets, but it is unlikely that that a
domestic court would consent to attachment.

There is a more favorable legal climate for attaching assets in Continental European law
than in Britain and the United States (though the vast majority of existing external
sovereign bonds are governed by either New York or English law). In Continental Europe,
successful litigators have attached the assets of the central bank of the sovereign
whose claims they were holding.4 In addition, central banks that are incorporated
separately for commercial purposes do not have immunity; only the sovereign does.

Another avenue open to holdout investors involves wire transfers. In the US, an
attachment order can only reach a wire transfer either before it is initiated or after
payment is made complete. However, Europe does not have an equivalent law. A holdout
investor could potentially intercept payments from a sovereign on restructured debt to
bondholders in Europe.5

Changing the provisions of a bond

Many bond documents include provisions that allow bondholders to vote to change the
terms of that particular bond through a vote (weighted by the face value of holdings).
These votes can allow a majority or super-majority of bondholders to agree on a bond
restructuring.

New York law documentation pre-2003

Prior to 2003, standard New York law contracts required the unanimous consent of all
creditors to change “key financial terms” (such as payment dates and amounts).
Typically, all other terms could be amended with the support of one-half or two-thirds of
the outstanding bondholders. Some New York law bonds also require that 25% of the
bondholders agree before litigation can be initiated. After 2003, collective action clauses
were introduced that made it easier to change bond terms (more below).

English law documentation

Standard English law contracts allow a super-majority of bondholders (typically 75% of
those present in a quorum-qualifying meeting) to amend all bond terms, including the
bond’s payment dates and amounts. Many English law bonds also have provisions that
make it difficult for an individual bondholder to initiate litigation.

4
Cardinal vs Yemen and Leucadia vs Nicaragua.
5
Elliot vs Peru.

GEMs Primer | 29 July 2024 33

New York law remains overall the most common governing law for outstanding paying
sovereign bonds but with a small lead of 53%. However, English law is gaining ground,
given the higher issuance lately by sovereigns in EMEA and Asia, which issue more often
under English law. See our report on Governing Law.

Exhibit 34: Most currently paying external EM sovereign bonds are governed by NY law (53%)
EM external sovereign debt currently outstanding, by issuance year ($mn), in EMGD index

300,000 New York English

250,000

200,000

150,000

100,000

50,000

Source: BofA Global Research, Bloomberg, ICE Data indices, LLC. Note: Index includes non-defaulted USD & EUR sovereign debt
BofA GLOBAL RESEARCH

Exit consents
Exit consents are created when bondholders accept new bonds in the bond exchange,
but in the process provide their consent to amend the non-payment terms of the old
bond. Exit consents can destroy value by impairing the liquidity and litigation prospects
as they change such features as cross-default, listing, and acceleration clauses. Typically,
these changes can be undertaken without a unanimous vote from bondholders6.

Collective Action Clauses

A Collective Action Clause (CAC) defines how many bondholders are needed to agree on
a change in the repayment terms of a bond. If that threshold is met, the amendment
becomes applicable for all bondholders, even those that did not consent. As a result,
CACs make it very difficult for holdouts to succeed, because once their bonds are
modified, they no longer can litigate to collect on the original terms.
CACs were introduced to deal with holdout creditors. CACs have long been present in
bonds sold under UK law. Under New York law, these clauses were first introduced by
Mexico in 2003 and have since become standard. The Greece restructuring further
increased the adoption of Collection Action Clauses for both developed and emerging
sovereign issuers.
With CACs, financial and non-financial bond terms can be amended without unanimous
consent. The typical provision allows 75-85% of the bondholders to amend a bond’s
financial terms, as long as no more than 10% of the bondholders object. Financial terms
could include payment dates and amounts. The remaining non-financial terms might be
amended only with the support of 66% of the bondholders.
Initially, collective action clauses applied to each bond series individually. However, these
single series CACs (sometimes called “first generation” or regular CACs) were thought to
be insufficient to prevent holdouts from obstructing the restructuring process in one or
more particular bond series.
Starting in 2014, most sovereign bonds were issued with additional aggregated CACs
(sometimes called “second generation” or enhanced CACs), which allow bondholder
votes on a restructuring proposal to be pooled across multiple bond series. For example,

6 Certain provisions that relate to the ability of creditors to sue to collect on their bonds cannot be
amended at all.

34 GEMs Primer | 29 July 2024

they may require a 66⅔ percent threshold for each individual series plus an 85 percent
threshold in aggregate for several series, vs. an individual 75 percent threshold under
series-by-series CACs.

With aggregated CACs, it is still possible that creditors, individually or as a group, obtain
a blocking position with respect to a particular series. However, it is more difficult to
obtain a blocking share with aggregated CACs compared to single series CACs.

Because these CACs have evolved over time to offer greater issuer protection from
holdout creditors, prices of specific distressed sovereign bonds tend to be higher when
the voting thresholds are lower. Investors might price in favorable treatment due to their
CAC thresholds, as was observed in the 2020 restructurings of Argentina and Ecuador.

Exhibit 35: Enhanced CACs features were initially incorporated in sovereign foreign law debt in 2014
Outstanding stock by issue year ($bn)

350 No CACs Regular CACs Enhanced CACs

300
250
200
150
100
50
0
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
Source: International Monetary Fund, “Do Enhanced Collective Action Clauses Affect Sovereign Borrowing Costs?” By Kay Chung and
Michael G. Papaioannou. Working paper 20/162 (2020).
BofA GLOBAL RESEARCH

Exhibit 36: Prices after defaults varied between $10 and $60 in the main cases
Price action for 2 years following default (Day 0 = Default Date) for USD foreign law debt

85 $ Leban30 Srilan30 Argent28 Ecua40

80 Ghana34 Ven27 Zambia27
75 Zambia
70 2020
Sri Lanka
65
2022
60 Ghana 2022
55
50 Argentina 2020
45
40
35 Ven
30 2017
25
20 Ecuador 2020
15
10
5 Lebanon 2020
0
0 40 80 120 160 200 240 280 320 360 400 440 480 520
Business Days After Default (252 business days in a year)
Source: BofA Global Research, Bloomberg
BofA GLOBAL RESEARCH

GEMs Primer | 29 July 2024 35

 Exhibit 37: Returns after defaults were mainly positive, with a few exceptions
Returns following default (Day 0 = Default Date) for USD foreign law debt, Date shows default year

200 % Ecuador 2020

180 Argentina 2020
160
Zambia 2020
140

120 Ghana 2022

100
Sri Lanka 2022 Ven 2017
80

60

40
Lebanon 2020

20 Leban30 Srilan30 Argent28 Ecua40

Ghana34 Ven27 Zambia27 100 level
0
0 20 40 60 80 100 120

120 Business Days After Default (252 business days in a year)

Source: BofA Global Research, Bloomberg
BofA GLOBAL RESEARCH

Successful Debt Exchanges

Since 2000, there were several successful debt exchanges, such as Uruguay 2003,
Dominican Republic 2005, and Ukraine 2015. We define successful exchanges as one in
which the exchange offer is made, at the latest, before the end of the debt service
payment grace period, there is high creditor participation, and one in which the issuer
does not default again during the following five years (for more recent restructurings,
time will tell if they qualify).
Many investors consider the Uruguay 2003 and Ukraine 2015 cases as models for ideal
restructurings. Authorities took a market-friendly approach, losses were modest, and
bond prices subsequently rallied. On the other hand, the Argentina 2005 case is seen as
a very contentious restructuring.

Consent solicitations enable issuers to buy time

In recent years, a few countries have executed consent solicitations to request
permission from bondholders to delay payments (Belize, Suriname, Ecuador, Ukraine).
These solicitations enabled them to buy time and avoid being technically in default.

In a consent solicitation, an issuer requests the consent of bondholders to amend

material terms in the bond. By pushing out near-term payments, it allows the bond to
remain current or performing. If bondholders agree, the amendments are made in
accordance with the terms of the bonds. Sometimes, a small consent payment is offered
to incentivize bondholders to participate. Consent solicitations may become a more
frequent step in some sovereign restructuring life cycles.

Successful distressed debt exchanges

We highlight some aspects of the US$4.9bn 2003 Uruguay exchange, because it was
relatively large at the time and included several important features that could be
considered in the future global debt restructuring discussions.

Successful exchanges have several commonalities. The most important is that every
communication, from the economic statistics to the political speeches, shows that the
sovereign is nearing default. The message can be communicated by, for example,

36 GEMs Primer | 29 July 2024

missing a coupon payment, offering an exchange during the grace period of a missed
payment, declaring a moratorium, or announcing that they expect to miss the next
payment.

With that as a backdrop, the second commonality is that bond prices need to collapse, as
investors realize that the only choices are restructuring or default. If bond prices remain
in the US$80-90 range, the issuer has not communicated that there will be no more
payments without a reduction in debt service.

There also needs to be some subtle coercion in the exchange offer, so that bondholders
that do not participate in the exchange are not paid in full while other bondholders
accept a haircut or write-off. This holdout issue has been addressed through collective
action clauses, by conditioning the exchange on some minimum participation threshold
with the perception that insufficient participation would result in a default, and through
so-called exit consents.

Recovery values
In the EM sovereign context, there are two values that are both referred to as “recovery
values”. One is the settlement price in a credit default swap (CDS) auction, which
indicates the price of the cheapest bond around 30 days after default. The other is the
eventual value of the original debt after a debt restructuring and exchange has taken
place.
Recovery values have been diverse, and each credit has its own features at the time of
default. Following the 8 large emerging market defaults since 2008, that had
outstanding CDS swap contracts, almost all prices were in the $20-40 range (Exhibit 38).
Moody’s also provides a list of foreign currency and local currency defaults and
distressed debt exchanges with recovery rates around 30 days after default, including
defaults, missed payments and distressed exchanges (Exhibit 39).

Exhibit 38: CDS auction prices average has been $35 since 2008 but just $30 since 2017
Credit default swap auction prices, typically taking place about 30 days after default
Date Country CDS Auction Price
Jan-09 Ecuador 31.375
Mar-12 Greece 21.500
Sep-14 Argentina 39.500
Oct-15 Ukraine 80.625
Dec-17 Venezuela 24.500
Apr-20 Lebanon 14.125
May-20 Ecuador 34.875
Jun-20 Argentina 31.500
Sep-22 Russia (due to sanctions) 56.125
Sep-22 Ukraine 17.875
Average 35.200
Source: BofA Global Research.
Note: First CDS auction was Ecuador in Dec 2008. Russia CDS action in 2022 was delayed by many weeks waiting for the US
Treasury to enable the bond market to function temporarily, in order to enable settlement in the CDS auction.
BofA GLOBAL RESEARCH

GEMs Primer | 29 July 2024 37

 Exhibit 39: In 2022 there were five defaults: Russia, Sri Lanka, Belarus, Ukraine and Ghana
Default or Distressed Exchange (DE) of foreign currency (FC) and local currency (LC) debt
Recovery Rates Total Foreign Currency
Default 30d after default * Defaulted or Local Currency
Date Country (% of PAR) Debt ($bn) Sequence of Default Events (DE=Distressed Exchange) Bonds
Aug-98 Russia 18 72.7 Missed payments, DE, Missed payments, DE,DE FC, LC
Sep-98 Ukraine na 1.3 DE, DE, DE, Missed payments, DE FC, LC
Jul-99 Pakistan 52 1.6 (Grace period missed payments), Missed payment, DE FC
Aug-99 Ecuador 44 6.6 Missed payments, DE FC, LC
Jan-00 Ukraine 69 1.1 Missed payments, DE before maturity FC
Mar-00 Ivory Coast 18 0.4 Missed payments FC
Nov-01 Argentina 27 82.3 Debt swap open to locals only, DE, Missed payment, Pesoization, DE, Re-open DE FC, LC
Jun-02 Moldova 60 0.1 (Grace period missed payments), DE, Missed payment, DE FC
May-03 Uruguay 66 5.7 DE FC
Sep-04 Grenada 65 0.1 Missed payments, DE FC, LC
May-05 Dominican Rep 95 1.6 (Grace period missed payments), DE FC
Dec-06 Belize 76 0.2 Missed payment, DE FC
Jul-08 Seychelles 30 0.3 Missed payments, DE FC, LC
Dec-08 Ecuador 28 3.2 Missed payment, DE FC
Sep-12 Belize 40 0.5 Missed payments, DE FC
Feb-13 Jamaica 89 9.1 DE FC, LC
Mar-13 Grenada 36 0.2 Missed payments FC, LC
Jul-14 Argentina 68 29.4 Missed payments FC
Oct-15 Ukraine 80 13.3 Missed payments, DE FC
Apr-16 Mozambique 88 0.7 DE FC
Feb-17 Mozambique 61 0.7 Missed payments, DE FC
Mar-17 Belize 65 0.5 DE FC
Nov-17 Venezuela 28 36.7 Missed payment, ongoing FC, ongoing
Jun-18 Barbados 55 3.4 Missed payment, DE FC, LC
Mar-20 Lebanon 17 24.1 Missed payment, DE, ongoing FC, ongoing
Apr-20 Ecuador 27 17.3 DE FC
Apr-20 Argentina 46 61.5 Missed payment, DE FC, LC
Jul-20 Suriname 64 0.7 Missed payments, DE, ongoing FC, ongoing
Aug-20 Belize 44 0.5 DE FC
Nov-20 Zambia 57 3.0 Missed payment, ongoing FC, ongoing
Sep-21 Belize 51 0.6 Missed payment, DE FC
Mar-22 Russia 28 36.6 Missed payment, ongoing FC, ongoing
Apr-22 Sri Lanka 31 12.6 Missed payment, ongoing FC, ongoing
Jul-22 Belarus 14 3.3 Missed payment, ongoing FC, ongoing
Aug-22 Ukraine 22 23.0 DE FC
Dec-22 Ghana 41 13.2 DE FC, ongoing
Dec-23 Ethiopia 2 1.0 Missed payment, ongoing FC, ongoing
Source: Moody’s Investors Service. Note: Prices (Moody’s calls them recovery rates) are % of the par value of the bond at the time of the initial default event, 30-day post-default for missed payments or around the
close of an exchange for distressed debt exchanges. When the trading price is not available, Moody’s calculates an equivalent measure estimating the recovery as the ratio of the present value of the cash flows of
the new debt instruments received through the distressed exchange versus the outstanding face value of those initially promised, discounted by an approximated market yield at the time of default. For Argentina,
the trading price-based recovery rate at the time of default in 2014 was 68%. The ultimate recovery as of the time of default resolution in 2016 was about 97% as the missed interest payments were repaid in full.,
For Barbados, the recovery rate was based on the trading price of its defaulted foreign-currency bonds only. Argentina defaulted on short-term debt in August 2019 and on long-term debt in February 2020. Only
included the recovery rate of the defaulted long-term debt in February 2020
BofA GLOBAL RESEARCH
Uruguay, 2003: Model for orderly exchange that avoided default
Uruguay was among the first large market-friendly distressed sovereign debt
restructurings, seen at the time as beneficial for both the issuer and investors. It serves
as a model for other countries. Over 95% of the $4.9bn eligible bonds were exchanged
for new securities that matured later, stretching out debt payments, and that paid lower
interest rates. However, to call it successful, one must appreciate how distressed the
situation was for Uruguay at that time.

Uruguay faced distress due to spillovers from Argentina’s crisis

Uruguay had an investment grade rating before Argentina defaulted on US$95bn of debt
in 2001. Uruguay was current on its debt service prior to its 2003 voluntary exchange.
But there was great concern that the spillover effects from the contraction in
neighboring Argentina would make it impossible for Uruguay to maintain its fiscal
accounts. Uruguay’s primary trading partner was Argentina and Argentines held a sizable
amount of the deposits in Uruguayan banks.

38 GEMs Primer | 29 July 2024

In June 2002, the Uruguayan government lifted the currency bands it had in place and
allowed the peso to trade freely. By August 2002, there was a run on the banks, the
government froze some deposits, and bonds had plummeted to US$30 from US$100 at
the end of 2001.

Uruguay’s banking system was heavily dollarized, and neither the banks nor the
government held enough liquid dollar assets to back those deposits. Thus, the bank run
in Uruguay was due to an increasing recognition by depositors that the central bank’s
foreign reserves totaled less than the amount of dollar deposits in the system.

External support helped restore confidence

Banks were not able to reopen until the U.S. pledged $1.5bn to bolster the financial
system (through a bridge loan from the U.S. Treasury’s Exchange Stabilization Fund). The
IMF pledged $2.8bn in assistance to Uruguay and asked Uruguay to propose a debt
exchange before failing to make a payment on its debt. The IMF provided Uruguay with
an initial $303mn payment on the loan pledge in March 2003, and the debt exchange
was offered a month later. The objective was to try to avoid the type of crisis that took
place in Argentina. External support to Uruguay restored confidence because the loans
were used to give a 100% guarantee on the dollar checking and savings deposits. The
exchange was successful because most investors realized the risks of not participating
were high.

Steps taken to address potential holdouts

One of the reasons for the successful debt exchange was that most investors realized
that the risks of not participating were high. The government took the following steps to
deal with holdouts:
1. It required at least 80% participation to complete the exchange.
2. If resources were insufficient, it would pay on the new bonds first.
3. New bonds would be liquid and be included in benchmark indices; old bonds
would not be.
4. Those exchanging international bonds were asked to approve exit consents that
reduced the old bonds’ liquidity and their holders’ ability to enforce debt-
service payments.
5. New bonds paid debt service into a trust, which would distribute the payments
to bondholders, reducing the attachment risk by holders of the old bonds.
Notification was made that the old bonds would be treated less favorably by
bank and pension fund regulators because of their future illiquidity.

S&P rating agency and the credit default swap market considered it a default
Standard & Poor’s classified the debt exchange as a default, despite its voluntary nature.
The rationale was that the new bonds, with both a longer maturity and lower coupon, were
worth less than the old bonds in net present value terms.

Interestingly, the credit default swap (CDS) contracts were triggered not by the
voluntary USD exchange, but rather by a collective action vote on Uruguay’s yen Brady
bonds. The holders of the yen bonds voted to amend the bond terms and extend the
maturity. Since the extension became effective for 100% of bondholders, this was a
forced restructuring for some percentage of these bond holders, and this yen
rescheduling triggered the CDS.

Unsuccessful Exchange, Argentina 2001

Argentina June 2001 exchange failed to retore stability, defaulted in six months
In the year preceding its December 2001 default, Argentina was in the midst of a deep
recession. The peso was fixed one-for-one with the US dollar by law and Argentina had
limited monetary policy tools to control inflation. As a result, it borrowed too heavily
from the global capital markets, with roughly 90% of Argentina’s sovereign debt
denominated in dollars. Banks were in a difficult position with most of their assets

GEMs Primer | 29 July 2024 39

denominated in pesos and liabilities (such as deposits) denominated in dollars.
Government bonds represented more than 20% of their assets.
In June 2001, the government conducted a “mega swap”, exchanging close to US$30bn
of local, external global and external Brady debt, which was about one-third of the
outstanding external debt, much of it coming due soon. It swapped that debt for four
liquid external bonds, most of which paid no cash coupon initially, but instead capitalized
at a 12% per annum rate for five years before paying a high 12% cash coupon on a
larger capitalized face amount. The swap was considered voluntary. Some investors,
mostly local, hailed the exchange as the solution to Argentina’s debt problem. Others
were less optimistic and feared that the country’s debt service would soar after 2006.
Argentine local banks and pension funds were active participants in that exchange. The
attractive feature for Argentina was that it significantly reduced debt service for close to
five years. However, investor confidence did not increase sufficiently, and Argentina’s
funding needs could not be sustained.
The situation deteriorated further by November 2001, and a second “voluntary”
exchange of Brady and Eurobond debt for local loans was offered. This exchange was
originally only open to local investors, but the participant restriction was eventually
relaxed. The exchange was viewed as coercive by S&P, who downgraded all eligible
bonds to a default rating of “D”.
Simultaneously, there was a run on the banks, forcing the government to set limits on bank
withdrawals. Within a month, the sovereign declared a moratorium on the payments of
US$95bn of external debt, which at the time was by far the largest sovereign default in
history. The government also broke the currency peg, converted deposits to pesos, and had
to bail out the banks, which were heavily dollarized. The government froze and then
“pesified” the dollar deposits, effectively wiping out all of the banking system’s existing
capital. But it then issued new bonds to the banks to offset those losses.

Argentina default: large and complex

The Argentine restructuring from the 2001 default was much more complex and unique
than any that had preceded it:
• The size and complexity of the debt stock was enormous – US$95bn total face value
of defaulted external debt obligations covered over 80 individual external bond
issues in eight legal jurisdictions and in multiple currencies.

• There were multiple parties with competing agendas coming to the negotiating
table. Many of the investors were original or early holders that wanted to reduce the
losses on their investments.

• There were large blocks of bonds held by distressed debt funds with teams of
litigators to seek top recovery value. An active market for defaulted bonds over the
following 10 years allowed such funds to accumulate sizeable holdings.

Exchange proposal came three years after default

In early 2005, around three years after the moratorium in 2001, Argentina proposed a
relatively balanced exchange to bondholders. But only about $63bn out of $95bn was
exchanged in 2005.

Rather than extend maturities of the existing bonds, Argentina offered investors the
choice of two new bonds (so-called “Discount” or “Par” bonds). Argentina recognized, at
the original coupon rate, accrued but unpaid interest through December 31, 2001, and
added that to the principal claim.

For each Argentine claim, investors received a principal bond, with the Discount option
requiring a 66.3% haircut or the Par option requiring no haircut, past-due interest in cash
accruing from December 2003 (at new lower coupon rates), and a GDP warrant giving

40 GEMs Primer | 29 July 2024

investors the right to receive additional payments based on GDP growth in the event
that the economy recovered.

In 2010, Argentina offered another exchange, less favorable to investors than the prior
one. This exchange added another $20bn in participation, for a total participation rate
since the default of 92%. But still left close to $6bn of unrestructured bonds
outstanding.

Litigation
Several lawsuits prevented Argentina from being able to issue in the international
markets without resolving its disputes with holdouts. The most vocal distressed hedge
funds won court judgments against Argentina that totaled more than $2.3bn from U.S.
court suits.
During the litigation, it was up to a U.S. judge to determine if Argentina had shown
enough fairness and effort in these multiple exchange offers to keep these funds from
exercising those judgments. Although the court ruled in favor of the distressed
bondholders in October 2012, Argentina refused to pay.
Eventually, Argentina’s refusal to comply with the ruling led to another default. Applying
the pari passu clause in the defaulted bonds, a federal judge ruled that if Argentina made
any more payments on the exchange bonds issued during the restructuring, then it had
to pay what it owed to the holdouts. In addition, the court instructed financial
intermediaries not to help Argentina pay the exchange bonds if it did not also pay the
holdouts.

After exhausting its appeals, Argentina chose to default on the June 30 payment of the
2005 and 2010 exchange bonds rather than negotiate a settlement with the holdouts.
CDS was triggered in July 2014. This default was only resolved in 2016, when President
Macri negotiated a settlement with the holdouts, which then allowed Argentina to
resume payments on the exchange bonds and regain access to capital markets. All told,
the 2001 default took over 15 years to fully resolve.

Repeat defaulters
Restructuring, even after a default, does not assure future timely payments, not even for
a year or two. Some countries have repeatedly defaulted, including Russia, Ecuador, Ivory
Coast, Ukraine, and Argentina.

Russia’s 1997 restructuring then 1998 default on Soviet era debt

In 1997, Russia restructured US$32bn of debt obligations from the Soviet era, which
Russia had agreed to honor long after the breakup of the Soviet Union. The debt did not
cross-default to Russian Federation external bonds. That exchange had no principal
collateral, no interest collateral, and no haircut. In addition, the defaulted loans were
repackaged into new loans rather than bonds.

That restructuring was not sufficient. In 1998, there was no consensus view on how
Russia would be able to solve its debt crisis, as reserves were collapsing. Russia
defaulted on local debt and the US$32bn of Soviet era restructured loans. Russia did not
default on any of its Russian-issued Eurobonds. The defaulted loans traded as low as $6
in 1998-1999. Russia restructured again in 2000, and by 2003 Moody’s rated Russia
investment grade.

Ecuador: Unfair treatment, no willingness to pay

Ecuador was the first country to default on Brady bonds and the first to give differential
treatment to its bondholders, both in 1999 and in 2008. Ecuador defaulted in 1999,
restructured in 2000, then selectively defaulted in 2008. In 2008, the government
claimed that the restructured 2012s and 2030s were illegally issued by a prior
administration. The government selectively defaulted on those bonds, but not on the
2015s Eurobond that had later been issued under the current government in 2005.

GEMs Primer | 29 July 2024 41

Ivory Coast default: Willing, but not able
Ivory Coast had more French Franc Bradys than USD Bradys. It defaulted in 2000 on
US$3.5bn for failure to make a complete payment. This was the only country that has
made a partial payment on time. The government had expected to pay the rest after the
grace period, but was not able to make the payment. Investors did not vote to accelerate
the bonds, likely because the size was small, as was their ability to pay. The bonds were
restructured in June 2010 and a political stalemate by December 2010 caused a
disruption in government functioning and another default on the bonds.

Lessons from Argentina and Ecuador 2020 restructurings

Argentina and Ecuador took very different approaches to their 2020 debt restructurings,
which happened in the context of the pandemic.

Argentina defaulted on its bonds, while Ecuador requested and obtained permission to
defer coupon payments while it negotiated a comprehensive restructuring (in both cases
however, CDS was triggered). Ecuador obtained a pre-agreement with a majority of its
creditors before publicly announcing its offer, whereas Argentina did not obtain a pre-
agreement with its creditor groups. Ecuador proceeded with its original offer, despite
objections of some creditors, whereas Argentina improved its original offer twice
because it did not obtain sufficient creditor support for its earlier offers. Finally, Ecuador
restructured under an IMF program, whereas Argentina restructured outside of an IMF
program.

Similar restructuring timelines despite different strategies

The timelines between the first missed payments and the closing dates of the bond
exchanges were similar for the two countries despite their different negotiation
strategies. The restructuring took 4.5 months for Argentina and 5.2 months for Ecuador
(Ecuador’s restructuring was delayed slightly by a lawsuit and further delayed by the IMF
negotiation). From a historical perspective, the two restructurings were exceptionally
fast and executed under challenging conditions due to the COVID-19 global pandemic.
Indeed, Ecuador reached a pre-agreement with major creditors in just about a month.

Similar instruments offered to bondholders

Bondholders were offered similar new instruments in both restructurings. For their
principal claims, Argentina and Ecuador bondholders were offered amortizing bonds with
coupons that stepped up over time. The first amortizations for the new bonds were in
3.8 or 5.4 years, respectively. For their claims of accrued or past due interest, both
countries offered bondholders amortizing bonds with a 1% fixed coupon in Argentina or
zero coupon in Ecuador. In Ecuador’s case, the accrued interest was also subject to a
haircut, which was larger than the principal haircut.

Accrued interest: Recognized but with inferior treatment in Ecuador

Both Argentina and Ecuador fully recognized claims arising from accrued and past due
interest at their original contractual rates. However, Ecuador’s treatment of interest was
notably inferior compared to its treatment of principal. The interest claim was subject to
a larger haircut than the principal claim (14% vs. 8.9%) and interest claims were paid
with the bond with the lowest net present value (30s zero-coupon).

Double-limb collective action clauses (CACs) used to restructure

Both Argentina and Ecuador used double-limb aggregation collective action clauses
(CACs) to restructure their bonds (except for Ecuador 24s, which had older CACs and
required a single series vote).

Argentina and Ecuador’s restructurings were the first significant tests of the
effectiveness of CACs and they were essential in reducing holdouts in these two
restructurings. Double-limb CACs require the exchange to receive a minimum level of
support from each bond series and minimum level of aggregated support across all
affected bond series. Single-limb aggregation CACs (which only require a minimum level

42 GEMs Primer | 29 July 2024

of aggregated support across all affected bond series) were available for some bonds,
but this method was ultimately not employed.

Holdout risks not a significant concern

Compared to historical restructurings, holdout investors were not a significant concern
in the 2020 restructurings implemented by Argentina and Ecuador. Ecuador obtained a
98% consent rate, which resulted in 100% of bonds being restructured (this was in part
due to a non-traditional approach to CACs, see below for details). Argentina obtained a
94% consent rate, which resulted in 99% of bonds being restructured. Argentina
subsequently announced that it would continue to pay the bonds that were not
restructured (mostly small issue EUR Par bonds, issued during the previous restructuring,
and which already featured low coupons).

Documentation and original maturity mattered more than coupon rate

The most important determinants of each bond’s relative recovery value were the bond
documentation and original maturity and not the original coupon rate. In both cases,
bonds with higher CAC thresholds in their documentation (Pars and Discounts in
Argentina, 24s in Ecuador) were treated more favourably. In addition, short-end bonds
also received preferential treatment. New bonds were allocated according to their
original indenture (in Argentina) and also grouped by original maturity in both countries.
In Ecuador, short-end bonds received unique allocations of new bonds, but all bonds
maturing after 2024 received the same allocation of new bonds for their principal
claims.

GEMs Primer | 29 July 2024 43

 Exhibit 40: 2020 bond restructurings by Argentina and Ecuador employed different negotiation strategies but offered bondholders new instruments that
were similar
Comparison of Argentina and Ecuador’s bond restructuring
Argentina Ecuador
Technical Default? Yes No
CDS Triggered? Yes (Failure to Pay) Yes (Restructuring Applied to All via CACs)
Creditor Pre-Agreement for First Offer? No Yes
Multiple Sequential Offers before Creditor Acceptance? Yes No
IMF Agreement? No Yes (Closing Contingent on IMF Staff Level Agreement)
Collective Action Clause (CAC) Applied Double-Limb Aggregation CAC Double-Limb Aggregation CAC (Except 24s)
Incentive to Consent Higher Consideration for Accrued Interest Consideration for Accrued Interest AND Significantly Lower Recovery if
CAC’s Triggered
Lawsuit from Creditors? No Yes, Suit Filed in US District Court for SDNY
Consent Rate 94% 98%
% of Bonds Modified 99% 100%
Negotiation Length 4.5 months 5.2 months
Preferential Treatment Discos, Pars, Short-End Short-End, 24s
Treatment of Holdouts Continued to Pay No Holdouts After CACs Applied
Principal Haircut 0-3% 8.9%
Accrued Interest Haircut None 14%
New Bonds Offered for Principal Claim Sinkers with Step-Up Coupons Sinkers with Step-Up Coupons
New Bonds Offered for Interest Claim Sinker with Fixed Coupon (1% in USD) Sinker with Zero Coupon
Allocation of New Bonds Grouped By Original Indenture or Grouped By Grouped By Original Maturity
Original Maturity
New Coupon Rates 0.125% to 5.0% 0.5% to 6.9%
First Amortization 2024 (in 3.8yrs) 2026 (in 5.4yrs)
Source: BofA Global Research.
BofA GLOBAL RESEARCH

Argentina’s 2020 restructuring: Low conditionality

Argentina’s economy faced recurrent financial shocks since 2018 ahead of its ultimate
debt restructuring in 2020. The crisis began in April 2018 when the peso depreciated
significantly after global investors became concerned about the riskiness of financing
EM countries with wide current account deficits, such as Argentina.

The Macri administration inherited a wide fiscal deficit from the prior government and
attempted to reduce its fiscal deficit in a gradual manner. Gradualism was possible
because capital inflows from foreigners were available to finance Argentina’s wide
current account deficit.

But when global risk aversion spiked, the financing strategy became untenable. The
government turned to the IMF to finance its deficit and capital outflows. The IMF loan,
which later upsized and re-profiled to front-load disbursements was one of the largest
loans ever given by the IMF in such a short time period. At first, the IMF believed that
Argentina was facing a liquidity crisis, so a debt restructuring was not required.

Another financial shock occurred after the primary elections in August 2019, which
investors interpreted as signalling a high probability that Alberto Fernandez would be
elected president. In response to the crisis, the Macri administration tightened capital
controls and re-profiled domestic law debt. Fernandez was elected in October 2019 in
the first round of the elections and was inaugurated in December 2019.

The Fernandez administration signalled its intention to restructure Argentina’s debt, but
initially continued to pay external debt coupons. The last coupon paid on external debt
was on 31 March. Coupon payments due in April were not paid and their grace period
expired in May, resulting in a default and triggering CDS.

The government launched an invitation to bondholders to exchange its bonds on 21 April

2020 and set the invitation to expire on 8 May. Eligible bonds totalled approximately
$65bn (of which $45bn, €17bn, and CHF 0.4bn). The first invitation was not successful
and so the government launched an improved second invitation on 5 July. This second
invitation did not succeed either. Finally, the government announced on 4 August that it

44 GEMs Primer | 29 July 2024

had reached an agreement with creditor groups to proceed with a third invitation that
further improved terms.

On 31 August 2020, the government announced that 94% of bondholders consented to

the restructuring. 99% of eligible bonds were restructured after applying collective
action clauses (CACs). The government decided to keep paying bonds that were not
restructured under their original terms.

Argentina’s 2020 debt exchange happened without an IMF agreement that could have
required structural reforms and a commitment by Argentina to greater fiscal discipline.
The debt exchange failed to restore investor confidence and Argentina’s bonds
continued to trade at distressed prices after the restructuring.

In March 2021, Argentina entered into a new IMF program to refinance repayments from
its 2018 program. In retrospect, this new IMF program did not restore investor
confidence or provide investors with the spending oversight that might have improved
sentiment, as signalled by bond prices that remained at distressed prices.

Ecuador’s 2020 restructuring: Market-friendly approach

Ecuador initiated a restructuring of $17.4bn of Eurobonds after its economy was hit by
an exceptionally strong combination of negative shocks: large COVID-19 outbreak, low
oil prices, sharp recession, and limited room to maneuver due to dollarization and tight
liquidity.

The government announced that it would restructure its debts under an accelerated
timeline while negotiating with the IMF on a new program to replace the Extended Fund
Facility (EFF) program that began in 2019.

The government requested in April 2020 that bondholders consent to a deferral of

coupon payments due in H1 until mid-August. The consent solicitation was supported by
the vast majority of bondholders (82-96%, depending on the series). As a result, Ecuador
averted a “hard default.”

To signal its good faith towards creditors, Ecuador paid in full the $325m principal
amortization due in March, prior to requesting the coupon deferrals. Nevertheless,
although Ecuador did not technically enter into a “hard default”, the use of collective
action clauses (CACs) to defer the coupon payments was considered an event of default
for the CDS contracts.

After about a month of negotiations with bondholders, on 7 July Ecuador announced an

agreement in principle with major creditors (the creditor group represented 53% of
holdings). Although two smaller creditor groups rejected the offer and made a
counterproposal, the government launched a consent solicitation on 20 July based on its
original proposal. The deadline for the solicitation was set to 31 July, just 11 days later.
The restructuring was contingent on a staff-level agreement on a new IMF program.

The consent solicitation’s design took a non-traditional approach to collective action

clauses, since bondholders that did not consent to the solicitation risked significantly
lower recovery values if the collective action clauses were triggered. Besides not
receiving a consideration for past-due interest, non-consenting bondholders would be
unable to tender for new bonds and would instead have their original bond modified. The
modified bond had a much lower net present value than the package of new bonds
offered to consenting bondholders.

This exchange mechanism created a “prisoner’s dilemma” for bondholders that were
dissatisfied with the offer or the government’s negotiating tactic, since voting against
the offer could only succeed if a large proportion of bondholders also voted against the
offer. In our view, the prisoner’s dilemma could have encouraged high participation in
the offer, but also triggered a more contentious relationship with some creditors.

GEMs Primer | 29 July 2024 45

On July 29, two investors filed suit in the US District Court for the Southern District of
New York against Ecuador alleging securities fraud. They asked that the court enjoin
Ecuador from proceeding with the transactions, extend the expiration date of the
solicitation, and enable tendering bondholders to withdraw their consents. On 31 July,
the court denied the request for the injunction and allowed the tender to proceed.

On 3 August 2020, the government announced that 98% of bondholders consented to

the restructuring. 100% of eligible bonds were restructured after applying collective
action clauses (CACs). Non-consenting bondholders had their original bonds modified
and received a lower recovery value than consenting bondholders, who were allowed to
tender their old bonds for new bonds.

2024 Restructurings
Several of the outstanding post-pandemic defaults are poised to be resolved in 2024,
including Zambia, Sri Lanka, Ghana, and Ukraine (Russia and Belarus remain sanctioned).

While the restructurings of Argentina and Ecuador were resolved relatively fast in 2020,
the other cases have had a much slower resolution. Many of the delays can be explained
by the challenges due to the rise of China as an important bilateral lender to EM
sovereigns.

Common Framework: Initiative to incorporate China into debt relief process

The Common Framework, a G20 initiative, was intended to redesign the sovereign debt
restructuring process to reflect the increasing relevance of non-Paris Club lenders like
China, India, Saudi Arabia etc.

The Common Framework lays out a sequential process for sovereign debt resolution,
starting with bilateral financing assurances, which unlock IMF loans and kickstart the
resolution process. This is followed by an IMF Debt Sustainability Analysis (DSA), which
provides creditors with the IMF’s view on the defaulting country’s debt servicing
capacity. This DSA exercise is intended to inform the total amount of debt service relief
needed to restore sustainability.

How the debt relief required by the IMF is distributed among the country’s different
creditors is subject to negotiations between the country and the creditors. But official
creditors expect that the bondholders will receive “comparable treatment.”
Comparability can be assessed with a variety of criteria, including net-present-value
haircuts.

The Common Framework was announced in late 2020, and since then, has faced some
growing pains. The main roadblocks have come primarily from the challenges of
obtaining financing assurances from Chinese lenders as well as ensuring that the
restructuring agreed with bondholders complied with comparability of treatment (CoT)
requirements. To speed up debt resolutions, the IMF has adopted some reforms with the
goals of reducing delays in approving lending programs.

Zambia
Zambia defaulted on its debt in October 2020, and was among the first to seek
restructuring under the Common Framework. The Common Framework – intended to
enlist Chinese participation in restructuring – thus, faced its first major stress-test in
Zambia, as it struggled to incorporate Chinese lending practices into the already-
established principles of the international financial architecture. This included
disagreements on the designation of Chinese Development Bank lending as official
rather than commercial, concerns around the transparency of the debt held by Chinese
creditors, etc. These concerns delayed the formation of the official creditor committee
(OCC), a crucial first step in the restructuring process.

46 GEMs Primer | 29 July 2024

China finally agreed to serve on the OCC in April 2022, which allowed the IMF to approve
a $1.3 bn program for Zambia in August 2022. The OCC eventually restructured $6.3 bn
in bilateral debt in June 2023, which enabled Zambia to agree to a deal with its private
creditors in October 2023, covering nearly $4 bn in bonded debt. However, this deal was
rejected by the IMF – which believed it did not meet debt sustainability parameters –
and the OCC, which invoked the ‘comparability of treatment’ clause.

Zambia revised its deal with bondholders in March 2024, seeking compatibility with both
the IMF’s parameters and the OCC’s assessment of comparability. In May 2024, Zambia
announced that over 90% of bondholders voted in favor of the new restructuring
agreement, enabling Zambia to issue two series of restructured notes in June 2024
(known as Bond A and Bond B).

The cash flows of Bond A are fixed, but the cash flows of Bond B can increase if an
“upside case” is triggered by an upgrade in Zambia’s debt-carrying capacity score (which
is determined by the IMF) or by greater-than-anticipated exports.

Sri Lanka
Sri Lanka defaulted on its debt in April 2022, following a sharp economic downturn and
deep political unrest. A new government approached the IMF and began negotiations to
restructure both its bilateral and private debt.

However, Sri Lanka needed to secure financing commitments from its bilateral creditors
as a prerequisite to accessing IMF funds. While the Paris Club and other official creditors
agreed to enter negotiations soon after the default, Sri Lanka struggled to receive
formal support from China, which held nearly 50% of its official debt.

Sri Lanka reached an agreement to restructure $4.2bn in loans with China’s Exim Bank in
October 2023 and $5.8bn in loans with bilateral creditors in June 2024. In July 2024, a
deal in principle was reached with bondholders that could restructure $12.5bn in
defaulted bonds. The agreement included plain vanilla bonds, “macro-linked” bonds
whose payments can re-set higher if certain nominal GDP targets are hit, and
governance-linked bonds whose coupons can fall if certain reforms are implemented.

Ghana
Ghana defaulted on its debt in December 2022, and requested a debt restructuring under
the Common Framework. In contrast to Zambia and Sri Lanka, China reacted swiftly to
this request, and took on co-chairmanship of the official creditor committee in May
2023. In January 2024, Ghana reached an agreement to restructure $5.4bn in loans with
its bilateral creditors, allowing it to pursue negotiations with international bondholders.

Ghana reached a restructuring agreement in principle with bondholders in June 2024.

The official creditor committee formally confirmed that this agreement complied with
the comparability of treatment clause in July 2024, allowing the government to initiate
steps towards the debt exchange.

Ukraine
In the context of the war, Ukraine requested that bondholders defer coupon payments
during a two-year period, with the intention of subsequently performing a
comprehensive debt restructuring. The deferral was agreed to by 75% of the affected
bondholders, allowing Ukraine to freeze payments until August 2024. In July 2024,
Ukraine reached an agreement in principle with bondholders for a comprehensive
restructuring.

GEMs Primer | 29 July 2024 47

China’s role in sovereign defaults &
restructurings
China has become single largest creditor to EMs
Since the early 2000s, China grew to become by far the largest single creditor to
emerging market countries. There are some estimates that Chinese global development
projects total close to $900bn. China’s Belt & Road initiative is about half that, with
$400bn of loans lent in less than 10 years to over 60 countries. China’s lending has been
more prominent in Asia and Africa7, though in Latin America it was a relevant creditor to
oil-exporters Venezuela and Ecuador. Typically, China lends through its state-owned
banks, especially EXIM Bank and China Development Bank.

China’s new lending to EMs seems to have been significantly scaled back recently and
several borrowers are facing debt distress.

China geopolitical influence and lack of transparency

China imposes unique conditions on debtor sovereigns, and there is concern that this
could give Beijing undue influence over their economic and foreign policies. Lack of
transparency in bond documentation and loan terms is a common criticism of China’s
lending practices (Exhibit 42).

Exhibit 41: Bilateral lending from China to EMs has risen sharply in the Exhibit 42: Lack of transparency about China’s lending to EMs is a
past 10 years, especially to African countries significant investor concern
Debt stock owed to China by year in $bn Use of confidentiality clauses in Chinese bilateral loan contracts

US$ 12
Chinese contracts with confidentiality clause
EM Europe Africa Middle East Number of Chinese contracts in the sample
400 Chinese contracts without confidentiality clause
Asia/Pacific Latin America
9

300

6
200

3
100

0
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
2020
0
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017

Source: Gelpern, A., Horn, S., Morris, S., Parks, B., & Trebesch, C. (2021). How China Lends: A Rare
Look into 100 Debt Contracts with Foreign Governments. Peterson Institute for International
Source: Horn, Sebastian, Carmen M. Reinhart, and Christoph Trebesch. 2019. “China’s Overseas Economics, Kiel Institute for the World Economy, Center for Global Development, and AidData at
Lending.” NBER Working Paper No. 26050. BofA Global Research. William & Mary.
BofA GLOBAL RESEARCH BofA GLOBAL RESEARCH

7
Boston University maintains a database of China’s loans to Africa (https://www.bu.edu/gdp/chinese-
loans-to-africa-database/).

48 GEMs Primer | 29 July 2024

China increasingly involved in debt restructurings
China has become increasingly involved in debt restructurings to distressed emerging
market borrowers. There have been at least 84 credit events and distressed debt
restructurings from 2000-2021 involving Chinese lenders, according to a 2022 paper by
Horn, Reinhart, and Trebesch (Hidden Defaults) (Exhibit 43).

Exhibit 43: China increasingly involved in sovereign debt restructurings Exhibit 44: China has historically provided debt relief through
Number of restructuring events by creditor reprofilings instead of face value reductions. Paris Club and private
creditors have increasingly accepted face value reductions.
40 Type of debt relief provided by creditor

China
8 92
(2000-2019)
30
Number of restructuring events

Paris Club
98
(1970-1999)
20
Paris Club
70 30
(2000-2019)

10
Private
26 74
(1970-1999)

Private
0 64 36
(2000-2019)
1970 1980 1990 2000 2010 2020
Debt restructurings with Chinese creditors 0% 25% 50% 75% 100%
Debt restructurings with Paris Club
Debt restructurings with private creditors Face Value Reduction Reprofiling
Source: Horn, Sebastian, Carmen M. Reinhart, and Christoph Trebesch. 2022. Hidden Defaults.
Source: Horn, Sebastian, Carmen M. Reinhart, and Christoph Trebesch. 2022. Hidden Defaults.
World Bank Policy Research Working Paper Series No. 9925. Asonuma, Tamon, and Christoph
World Bank Policy Research Working Paper Series No. 9925. Asonuma, Tamon, and Christoph
Trebesch. 2016. Sovereign Debt Restructurings: Preemptive or Post-Default? Journal of the
Trebesch. 2016. Sovereign Debt Restructurings: Preemptive or Post-Default? Journal of the
European Economic Association, 14(1), 175-214. Asonuma, Tamon, Dirk Niepelt and Romain
European Economic Association, 14(1), 175-214. Asonuma, Tamon, Dirk Niepelt and Romain
Ranciere. 2017. Sovereign Bond Prices, Haircuts and Maturity. IMF Working Paper No. 17/119.
Ranciere. 2017. Sovereign Bond Prices, Haircuts and Maturity. IMF Working Paper No. 17/119.
BofA GLOBAL RESEARCH
BofA GLOBAL RESEARCH

Those credit events include 30 debt payment suspensions under the G20’s Debt Service
Suspension Initiative (DSSI), a program announced in 2020 to address the impacts of the
pandemic. Notably, China has generally avoided principal haircuts and has provided
mostly reprofilings (Exhibit 44). Until the 2000s, the Paris Club and private creditors also
tended to avoid principal haircuts, but over time they have become more common. The
downside to China’s concentration on reprofilings is that without principal reductions,
distressed countries may fail to recover debt sustainability.
More recently, there have been breakthroughs in the countries that have requested debt
relief from China in the context of the Common Framework.

GEMs Primer | 29 July 2024 49

Derivatives
In addition to cash bonds, institutional investors also transact in derivative markets on
Eurobonds. Derivatives have given institutional investors leverage and enhanced
opportunities to hedge a corporate or sovereign position, express a directional view, or
take advantage of relative mispricings in the market.

Credit default swaps (CDS)

Emerging market sovereign credit default swaps are among the most liquid and actively
traded CDS in the world, with 12 of the top 13 highest trading volume reported by DTCC
being emerging market sovereigns (Exhibit 45). Emerging markets credit derivatives
evolved alongside the rapid growth of the global corporate credit derivatives markets.
CDS have grown to play a major role in emerging markets investing and hedging.

CDS exposure is similar to the exposure of a floating-rate note investment. Both bond
spreads and CDS spreads relate to credit default risk. A CDS offers investors an
alternative way of going long or short a particular credit. South Africa, China, Türkiye,
Brazil, Mexico and Indonesia are the most actively traded credits in the world. In
addition, there are CDS indices, such as CDX.EM. The index is a basket of 18 global
emerging market sovereign credits, with the largest weights assigned to Brazil, China,
South Africa, Türkiye, Mexico and Indonesia.

The new wave of restructurings also has a big effect on CDS and how it trades, because
the “jump to default” risk is relatively small on these new low coupon bonds, since their
prices will be permanently low and will take many years of step-up coupons and
fundamental improvements for it to ever trade close to par.

The new consent solicitations that let the sovereign buy time is another way that CDS is
being triggered. In Ecuador in 2020, the CDS was triggered by the restructuring event,
rather than a failure to pay.

Exhibit 45: South Africa, China and Türkiye are the most traded CDS among EM
CDS Credits with highest average daily notional trading volume in 2023 ($mn), including emerging
markets and developed markets sovereign credits
500 USDmn
Emerging Markets
450
Developed Markets
400
350
300
250
200
150
100
50
0

Source: BofA Global Research, DTCC 2023 CDS average daily traded notional ($mn).
BofA GLOBAL RESEARCH
Companies with foreign direct investments or with equities in emerging countries have
used the sovereign CDS market extensively to hedge the overall sovereign risk, or to
determine what return they should target when lending to various private projects or
valuing the purchase of a local asset.

50 GEMs Primer | 29 July 2024

Exchange Traded Funds (ETFs)
A number of ETFs have been created that mirror the overall market and replicate an
index similar to those used as common benchmarks. The market capitalization of the
largest emerging markets ETF, EMB, was about 30% as large as the largest High Yield
ETF, HYG, in 2015 but eight years later it has grown to almost the same market
capitalization of the High Yield ETF. As with other ETFs, it is also used as a vehicle for
taking a long or short market view, as well as for hedging.

Conclusion
The Brady restructurings of the 1990s transformed illiquid commercial bank loans into
liquid, globally traded bonds. The issuance of Brady bonds transformed emerging
markets debt into an asset class in its own right. As the asset class has evolved, defaults
have occurred on external bonds since 1999, and the restructurings of those defaulted
bonds have allowed sovereigns to reduce debt service going forward, which provides the
sovereign with an opportunity to rebuild its economy.

Emerging markets debt has evolved into a sophisticated market with global investors ranging
from pension funds and hedge funds to mutual funds and individual investors. It has grown
tremendously over the last three decades as it has opened its doors to international
investment, not only in international markets but in local debt markets as well.

Although emerging markets debt has had well-known market shocks, it has weathered
them as investors return to the market for its generous returns compared with other
asset classes.

Emerging market debt has taken its place as a viable asset class, with product choices as
extensive as those in some developed debt markets.

Special Disclosures
Some of the securities discussed herein should only be considered for inclusion in
accounts qualified for high risk investment.

GEMs Primer | 29 July 2024 51

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