Article 3.6 Argentina row triggers interest in defaulted debt

By Elaine Moore

Financial Times July 2, 2014

1984 was not a good year for North Korea. That was the year western banks declared Pyongyang in default on debt it had sold in the previous decade, sealing off a possible avenue of funding for the reclusive state.

Yet the defaulted loan did not disappear. Instead, it was repackaged a decade later by French bank BNP into Swiss franc and Deutsche mark denominated debt and has been traded ever since.

North Korea's defaulted debt exists in a sort of twilight state, paying no interest but invested in by those who believe that the country cannot remain severed from the wider world forever. No payout on the loans is in sight, but prices on the securitised loan certificates have moved between 60 cents on the dollar to less than 10 cents over the years, depending on news from the country and indications about the future of sanctions.

Now the battle between Argentina and investors who hold the country's defaulted bonds has reawakened interest in markets such as those North Korean certificates, part of a small and illiquid world of hyper-exotic distressed debt.

If the ‘hold out' hedge fund investors receive the money that New York judge Thomas Griesa says is due to them, they could stand to profit not only from the discount at which they purchased the bonds but on unpaid interest due since the default.

So-called past due interest can be the source of spectacular gains to investors patient enough to wait for it.

When Iraq defaulted on sovereign bonds in the 1980s, borrowed in part to fund a war with Iran, the unpaid interest spanned over two decades before the country restructured its debt in 2006. Vietnam repaid past interest on loans that had traded at less than 5 cents on the dollar in the 1990s when it rejoined capital markets and Liberian debt, which also traded at less than 5 cents in the 1990s, was settled at close to six times that when it was restructured.

The prospect of harvesting these sort of returns is why some investors will consider buying non-performing debt from the tiny island of Nauru in the South Pacific, currently trading at 5 cents on the dollar, or debt issued by Sudan before civil war split the country north to south.

Exotic frontier debt is in vogue right now. Debut sovereign bonds issued by Rwanda and Kenya have attracted unexpected levels of interest from investors keen for yield. That has caused concern in some quarters.

‘There is an increasing lack of awareness about the illiquidity and implicit risk taken by investors as they move down the curve looking for yield in this zero interest world,' says Sam Vecht at BlackRock Frontiers investment trust.

But others say that long-term investment in defaulted sovereign debt is not neces­sarily the one-sided risk it might sound. The prospect of low-cost funding has also put pressure on countries such as Argentina to resolve outstanding debts if they are to tap global capital markets.

‘There is a big difference between a country and a corporation defaulting because the country won't disappear,' says Christopher Wyke, emerging market debt product manager at Schroders.

One of the markets long considered ripe for turnaround is Cuba, which defaulted on its debt in 1986. This year prices in the secondary market for the discounted debt rose from 6 cents on the dollar to 9 cents. Experts say unpaid due interest could far exceed the sums demanded by investors in Argentinian debt.

‘Opportunities [in distressed debt] will usually arise from a credit event such as the lifting of an embargo,' says Julian Adams, chief executive of investment fund Adelante. ‘But this market is shrinking as countries embrace capital markets and must sort out their older debts.'

Sovereign foreign currency defaults

* The rating on Seychelles was withdrawn while it was still in default

Source : Data from Thomson Reuters Datastream

FT

Source: Moore, E.

It is going to be much harder for holdouts to force governments to pay up in future - see Article 3.7.