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Outline what happens as a result of a sovereign default.

FRM® Part I · Valuation and Risk Models · Country Risk: Determinants, Measures, and Implications · FRM1.VR.5.d

The idea

A sovereign default has no bankruptcy court, because creditors cannot liquidate a country. The outcome is a negotiated restructuring in which they accept a haircut, longer maturities or lower coupons. The true loss is the haircut in present value terms, discounting the new cash flows at the market yield. It is larger than the nominal reduction in face value when the new coupons are below the market yield, as they usually are after coupon cuts and maturity extensions. The sovereign typically loses market access for a time and faces higher borrowing costs, and its ratings fall to default categories. Domestic effects follow. Banks and pension funds holding government bonds suffer losses, credit contracts, investment and output fall, and trade finance and capital inflows suffer. Defaulters usually return to the markets in time, so exclusion is not permanent. For the exam, link the default to its channels: creditors, the banking system, financing costs and growth.

Formulas

Present value haircut in a sovereign restructuring

haircut = 1 − PV(new bond) ÷ old face

PV(new bond)
the new bond's coupons and principal discounted at the market yield
old face
the face value of the old claim exchanged

Discount at the market yield, not the new coupon. When the new coupon is below the market yield, the PV haircut exceeds the cut in face value.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which of the following is a typical consequence for a sovereign that defaults on its bonds?

  1. Permanent exclusion from international borrowingWhy not: Defaulted sovereigns generally return to markets after a period.
  2. Liquidation of state assets by a bankruptcy court and distribution to bondholdersWhy not: No bankruptcy court exists for sovereigns; assets cannot be liquidated and distributed this way.
  3. Loss of market access for a period and higher borrowing costs, with ratings cut to default levels - correct
  4. Immediately lower borrowing costs, because the lower debt burden after restructuring restores confidenceWhy not: Ignores that the credibility damage raises, not lowers, the cost of new borrowing.

A sovereign default damages creditworthiness: ratings drop, market access is lost for a time and borrowing costs rise. Exclusion is not permanent, and there is no bankruptcy court that liquidates sovereign assets.

A harder one

Why does sovereign default often damage the domestic economy as well as government finances?

  1. Default cancels all private-sector debts as well, which forces a wave of corporate bankruptciesWhy not: Default affects the sovereign's own debt; it does not cancel private debt.
  2. Default always strengthens the currency, which hurts exportersWhy not: Defaults are usually followed by depreciation and capital outflows, not a stronger currency.
  3. Default legally freezes all foreign trade for a fixed period set by creditorsWhy not: No such automatic legal freeze exists; trade suffers through financing and confidence channels.
  4. Banks and pension funds holding government bonds take losses, credit and confidence fall, and fiscal tightening follows - correct

The damage spreads through banks and institutions that hold government bonds, falling credit supply and investment, and the fiscal tightening that follows loss of access to financing. These channels reduce output after default.

The hardest tier

In a debt exchange, each 100 face of old bonds is swapped for a new 5-year bond with face 70 and an annual coupon of 6% of the new face. The market yield for the new bond is 10%. The haircut measured in present value against the old par of 100 is closest to:

  1. 40.6% - correct
  2. 30.0%Why not: Reports only the nominal reduction in face value, ignoring that the new coupon is lower and the exit yield is higher.
  3. 59.4%Why not: Reports the present value of the new bond as if it were the haircut.
  4. 56.5%Why not: Discounts only the new principal and leaves out the coupons.

New coupon = 0.06 x 70 = 4.2 a year. PV at 10% = 4.2 x 3.7908 + 70 / 1.1^5 = 15.92 + 43.46 = 59.38. Haircut = 1 - 59.38 / 100 = 40.6%, larger than the nominal 30%.

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