Many governments face large and seemingly insurmountable levels of debt. Headline mainstays Greece, Ukraine and Puerto Rico have recently been the subjects of debate over the necessity or suitability of receiving debt relief. Other governments may soon find themselves under the same spotlight.
But government entities do sometimes default, and unfortunately there is no single metric to gauge when debt is becoming unsustainable. In our view, creditors are focusing too much on fiscal rectitude and too little on growth. At some point, they must face reality and stop kicking the can down the road.
Unraveling the Arguments Against Default
But you promised! As parents say to the kid whining about not getting that new iPhone after all: circumstances change. Yes, the contract underlying the debt securities is a legal obligation, but when the ability to pay is hampered by economic events, poor government policies or wars—as is so often the case today—creditors must face reality. The contract only protects lenders from lack of willingness to pay.
Also, it takes two parties to create debt. Creditors cannot hide behind contracts after lending to entities with poor fundamentals and unsustainable debt dynamics. Besides, if the contract really is inviolable, then why do credit research? Why do we need diversification in fixed-income portfolios?
If a country defaults, it will never again have access to the bond market. Except that, historically, that simply hasn’t been true. Ecuador restructured in 2008 with a debt-to-GDP ratio of less than 30%—clearly a willingness-to-pay issue. Even so, the market lent it new money five years later, though there had been no change in political leadership.
Keep in mind that most countries in the emerging-market-debt universe have defaulted at some point in the past 30 years. In the corporate bond market there are numerous examples of companies that have defaulted and borrowed again. (Trump? Ahem.)
The crucial issue is getting a deal done that reduces the debt burden to sustainable levels, while instituting structural and economic reforms to ensure a return to economic growth. We would rather lend to an entity that has sustainable debt dynamics and good macroeconomic policies than rely solely on a promise to pay while ignoring those very real factors.
Simply put, it seems more rational today to lend after debt is brought in line with economic realities and the entities have made necessary policy changes.
Government defaults are difficult to resolve. Debt relief is complicated and painful. There is no bankruptcy court for most government entities, which complicates restructurings. Look at Argentina, which continues to battle a small minority of investors who refused the country’s exchange offer.
Investors in government bonds also need to recognize that many corporate restructurings and some government ones (Brady programs) involve investors putting in new cash even after taking a cut to principal, a maturity extension or a cut in coupon. This does make restructuring bonds more difficult, especially if the owners of the debt can hold defaulted securities in their portfolios but can’t buy CCC-rated bonds. But just because a problem is difficult does not mean it should be avoided altogether.
Face the Music
Debt loads appear unsustainable in a variety of countries, and the opposing parties directly involved in the contracts face tough challenges. Both need to arrive at the view that the longer-term solution involves a combination of debt relief, better macro policies and structural reform.
Instead, we see creditors working too hard to ensure that government entities don’t default on their debt. But in the long run, letting governments default and shift their primary focus to reform and growth, rather than fiscal rectitude, is best for all parties—debtors and investors alike.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
