Why and When Do Countries Default?

Countries can and do default on their sovereign debt, despite the fact that it is uncommon. This occurs when the government is unable or unwilling to fulfill its financial obligations to repay bondholders. Argentina, Russia, and Lebanon are just a few of the countries that have gone bankrupt in recent decades.

Naturally, not all defaults are created equal. In some cases, the government fails to make a principal or interest payment. Other times, it simply postpones a payment.

The government also has the option of exchanging the original notes for new ones with less favorable terms.

In this case, the holder must choose between accepting lower returns or taking a “haircut” on the loan, which means accepting a bond with a much lower par value.

Why and When Do Countries Default?

Factors Affecting Default Risk

Failure to repay loans has historically been a bigger issue for countries that borrow in a foreign currency rather than their own.

Many developing countries issue bonds in a different currency to attract investors – often in US dollars – but borrowing in a different currency increases the risk of default.

The reason for this is that when a country borrows foreign currency and runs into a budget deficit, it does not have the option of printing more currency.

Credit risk is also influenced by the nature of a country’s government. According to research, the presence of checks and balances leads to fiscal policies that maximize social welfare – and honoring debt held by domestic and foreign investors is part of that.

Governments made up of disproportionately powerful political groups, on the other hand, can lead to reckless spending and, eventually, default.

Countries like the United States, the United Kingdom, and Japan appear to be immune to sovereign default due to their ability to print their own money, but this is not always the case.

Despite having a stellar overall record, the United States has technically defaulted on a few occasions in its history. In 1979, for example, a clerical error caused the Treasury to miss interest payments on $122 million in debt.

Even if the government is able to pay its debts, as periodic clashes over the debt ceiling demonstrate, legislators may not be willing to do so.

Even if the country has not officially defaulted, investors may suffer a loss on government debt. When a country’s Treasury needs to print more money to meet its obligations, the total money supply grows, putting inflationary pressure on the economy.

Mitigating Risks

The consequences for bondholders when a country defaults on its debt can be severe. Defaulting has an impact on pension funds and other large investors with significant holdings, in addition to individual investors.

A credit default swap is a hedging strategy that institutional investors can use to protect themselves from catastrophic losses (CDS). A CDS is a contract in which the contract seller agrees to pay any remaining principal and interest on a debt if the country defaults.

In exchange, the buyer pays a fee similar to an insurance premium for period protection. Should a negative credit event occur, the protected party agrees to transfer the original bond, to its counterpart, which may have some residual value.

Swaps have become a popular way to speculate on a country’s credit risk, despite their origins as a form of protection or insurance. To put it another way, many of the people who trade CDS don’t own the underlying bonds they’re referencing.

An investor who believes the market has overestimated Greece’s credit problems, for example, could sell a contract and collect premiums, confident that no one will reimburse him.

Because credit default swaps are complex instruments that trade over-the-counter (OTC), it’s difficult for ordinary investors to get up-to-date market prices. This is one of the reasons why only institutional investors use them: they have a deeper understanding of the markets and access to special computer programs that capture transaction data.

Economic Impact

Countries that default – or risk default – face significantly higher borrowing costs, just as individuals who miss payments have a harder time finding affordable loans.

Rating agencies such as Moody’s, Standard & Poor’s, and Fitch are in charge of assessing the creditworthiness of countries around the world based on their economic and political prospects.

Countries with a higher credit rating, on average, have lower interest rates and thus lower borrowing costs.

It can take years for a country to recover after it defaults. Argentina is a perfect example, having defaulted on bond payments since 2001.

By 2012, the interest rate on its bonds was still more than 12% higher than the rate on US Treasury bonds. If a country defaults even once, borrowing becomes more difficult in the future, putting low-income countries at particular risk.

According to Masood Ahmed, a former senior executive at the IMF who is now the president of the Center for Global Development, 24 of the 59 countries classified by the IMF as low-income developing countries were in or on the verge of a debt crisis as of October 2018, nearly 40% more than in 2013.

The impact on the broader economy, however, is perhaps the most serious concern about a default. Many mortgages and student loans in the United States, for example, are tied to Treasury rates.

If borrowers face significantly higher payments as a result of a debt default, they will have significantly less disposable income with which to spend on goods and services.

Countries with close ties – particularly those that own a large portion of the country’s debt – will occasionally step in to prevent an outright default out of fear of contagion spreading to other economies.

This occurred in the mid-1990s when the US assisted in the bailout of Mexican bonds. Following the global financial crisis of 2008, the International Monetary Fund (IMF), European Union (EU), and European Central Bank (ECB) joined forces to provide Greece with much-needed liquidity and credit stability.

After Default: The Perfect Time to Invest?

While some investors see a financial crisis as a source of chaos and losses, others see it as a potential source of profit.

These investors believe that if a sovereign default occurs, government bonds will reach a bottoming-out point – or something close to it. The only logical direction for these bonds is up, according to the optimistic investor.

A number of so-called “vulture funds” specialize in buying bonds in this manner. These funds buy defaulted government bonds for a fraction of their original value, similar to how a debt collection agency buys personal credit accounts at a low cost.

Due to the broader economic ramifications of a sovereign default, investors frequently seek out undervalued stocks in that country.

Investing in defaulting countries is risky, because there’s no guarantee that the economy will recover, and the larger issues that led to the default may still exist or haven’t been fully resolved.

Those looking for absolute security in their portfolio should probably look elsewhere. Recent historical examples, on the other hand, are encouraging for growth-oriented investors.

In the aftermath of a bond crisis, for example, equity markets in Russia, Brazil, and Mexico have risen significantly in recent decades.

The key is to look for businesses that have a competitive advantage and a low price-to-earnings ratio that reflects their high risk.

The Bottomline

Over the last few decades, there has been a slew of government defaults, particularly among countries that borrow in foreign currencies. When the government defaults, the bond yields skyrocket, causing a ripple effect throughout the domestic, and often global, economy.

Leave a Comment