Default Risk Still High Despite Swap Proposal

The latest developments in Argentina's long-running legal battle against holdout investors - those who have refused restructuring offers on defaulted bonds - reaffirm our view that there is a growing possibility of a technical default on the country's restructured sovereign bonds in the next few weeks. Argentine Economy Minister Axel Kicillof announced on June 17 that the government would attempt to swap the country's New York law debt for local bonds, a scenario we had previously identified as a possible reaction to the US Supreme Court's June 16 action in favour of the holdouts ( see 'Default Risk Rises On Supreme Court Ruling', June 16). However, as we have previously highlighted, this course of action is quite risky, and we see a high potential for a unilateral swap of this nature to trigger a technical default and credit default swap (CDS) payout. Unsurprisingly, the price of default protection has soared since the court's decision, with the spread on Argentina's one-year sovereign CDS contract spiking to 5,991 basis points (bps) at one point on June 18 from 2,623bps on June 16.

Additionally, the yield is rising on Argentina's restructured bonds, reflecting growing concern about the fallout from the US court case. By refusing to hear an Argentine appeal, the US Supreme Court left in place a lower court decision that Argentina must pay holdouts in full or lose access to the US financial system for making coupon payments on the restructured debt. Bonds due in 2033 have seen the nominal yield increase from 10.7% on June 16 to 12.3% at one point on June 18.

The Argentine government has underscored in recent days its desire to keep making payments on the restructured debt, one reason we believe the reaction in the bond market has been relatively minor compared to the blowout in CDS spreads. However, we see risk of a much larger sell-off in these bonds, especially if market participants come to question the feasibility of the plan outline by Kicillof. We believe, in such a scenario, the yield on the 2033 bond could quickly rise to the 13.0-16.0% range, where it traded for much of 2013.

Default Risks Soaring
Argentina - One-Year Sovereign CDS Spread, bps

The latest developments in Argentina's long-running legal battle against holdout investors - those who have refused restructuring offers on defaulted bonds - reaffirm our view that there is a growing possibility of a technical default on the country's restructured sovereign bonds in the next few weeks. Argentine Economy Minister Axel Kicillof announced on June 17 that the government would attempt to swap the country's New York law debt for local bonds, a scenario we had previously identified as a possible reaction to the US Supreme Court's June 16 action in favour of the holdouts ( see 'Default Risk Rises On Supreme Court Ruling', June 16). However, as we have previously highlighted, this course of action is quite risky, and we see a high potential for a unilateral swap of this nature to trigger a technical default and credit default swap (CDS) payout. Unsurprisingly, the price of default protection has soared since the court's decision, with the spread on Argentina's one-year sovereign CDS contract spiking to 5,991 basis points (bps) at one point on June 18 from 2,623bps on June 16.

Default Risks Soaring
Argentina - One-Year Sovereign CDS Spread, bps

Additionally, the yield is rising on Argentina's restructured bonds, reflecting growing concern about the fallout from the US court case. By refusing to hear an Argentine appeal, the US Supreme Court left in place a lower court decision that Argentina must pay holdouts in full or lose access to the US financial system for making coupon payments on the restructured debt. Bonds due in 2033 have seen the nominal yield increase from 10.7% on June 16 to 12.3% at one point on June 18.

Yield Will Head Much Higher If Swap Appears Unworkable
Argentina - 2033 US Dollar-Denominated Sovereign Bond Yield, %

The Argentine government has underscored in recent days its desire to keep making payments on the restructured debt, one reason we believe the reaction in the bond market has been relatively minor compared to the blowout in CDS spreads. However, we see risk of a much larger sell-off in these bonds, especially if market participants come to question the feasibility of the plan outline by Kicillof. We believe, in such a scenario, the yield on the 2033 bond could quickly rise to the 13.0-16.0% range, where it traded for much of 2013.

An Uncertain Path Forward

Kicillof has announced the government's plan in only the broadest possible sense, and we highlight that there are many details to be worked out in the coming days. Government officials are reportedly meeting with lawmakers in order to facilitate the swap, and lawyers representing Argentina are reportedly planning on working with US courts in order to ensure the swap does not trigger a technical default. However, it is unclear what the willingness will be on the part of the holders of restructured debt to engage in a swap that seeks to evade a US court ruling, particularly those bondholders who are otherwise subject to US law. Indeed, we find it somewhat hard to believe that US courts would provide council to Argentine lawyers about how to implement a debt swap that is solely designed to evade a US court ruling.

It is possible that the discussion of a debt swap is a negotiating tactic, one designed to illustrate Argentina's willingness to use unorthodox measures to avoid paying the full amount owed to the holdouts. A side-deal between the holdouts and the Argentine government could allow the government to save face, but still ensure the holdouts get something after years of litigation. However, regardless of Argentine tactics at avoiding compliance with the full ruling, time is running out. The next coupon payment is due on June 30, and unless Argentina pays the holdouts in full - an outcome we view as unlikely - that payment will not be able to reach holders of restructured bonds via the US financial system. In such a scenario, Argentina could be ruled to be in default at the end of a 30-day grace period. Until there is greater clarity about the details of a debt swap or evidence of a negotiated settlement between Argentina and holdouts, we expect bond yields will continue to rise and CDS spreads to remain quite wide.

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Related sectors of this article: Economy, Finance, Fixed Income, External Debt
Geography: Argentina
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