The powers that be tell us that countries like Ireland, Greece and Portugal can’t even contemplate burning the bondholders of our sovereign debt. In Ireland after our ill-advised full bank guarantee, the situation is more complicated, as we’re not even supposed to think about giving a haircut to holders of private bank bonds.
All things being equal, this is advice intended to upheld the country’s financial reputation, avoid further stressing an already stressed euro zone and not create a moral hazard situation. In the course of normal business you try your best to honour your debts.
However, all things are not equal and business is far from normal. The fact is that a huge number of Irish sovereign and bank bonds have changed hands over the last few years. Anybody who sold bonds did so at a considerable discount and, as such, can be be viewed as already having been burned. This was a calculated risk that they took. Now we have to ask where have all those bonds gone. In some cases, they have been bought back by governments or the ECB, but in the majority of cases they are now held by hedge funds and other similar financial vehicles. These funds bought the bonds at heavily discounted prices and avail of the six-monthly coupons at the rate set during issue. They then expect to cash in the face value at expiration. The discounted purchase price builds in a risk that the bonds may default before expiration. To blithely ignore this possibility and expect a guaranteed return much higher than the risk-free rate flies in the face of the “No Arbitrage” principle, which is a basic tenet of functioning markets.
With that in mind maybe there is an equitable solution to applying haircuts to bondholders. Firstly, bondholders must be classified according to their status: secured senior, unsecured senior, junior, etc. There is nothing new here and junior bondholders have already taken a hit in many cases. The second and critical part is to analyse the trade history of the bonds. Since anybody who has bought recently has already been the beneficiary of a generous discount, this should be taken into account. Such bondholders must take the brunt of any haircut and realistically can’t expect to do any better than getting their money back. And let’s not forget that they have also been receiving regular coupon payments, so would not be coming away with nothing. Bondholders who have held the bonds since issue should have the highest rating and every effort should be made to honour the face value in full in these cases. Of course, there probably aren’t very many such bondholders as the bond market is very active. This leaves a large group of bondholders who bought after the intial issue but before the recent crisis of confidence. These trades probably took place with little discount and consequently these bondholders need to be treated in an intermediate fashion.
So a recipe might be to rank bondholders by the price they actually paid for the bonds and to use these prices to distribute the discounts that would be applied in any default-type situation. Those that paid the most get the most back. In the best situation, applying discounts down to the trade price may be enough and should allow the amount of moral hazard to be minimised. If more discount is required, at least it can be applied in an equitable manner.
There are some practical issues. It may not be possible to determine the trade price of each bond but based on the change of ownership transaction, it should be possible to determine the average trade price at the time. It is often difficult to determine exactly who owns the bonds but since coupons are paid regularly and presumably end up in the right bank accounts, it must be possible to identify the owners or at least their accounts and transfer any proceeds accordingly. Obviously default is a last desperate measure, but it seems inevitable that it will happen in some euro-zone countries over the short-to-medium term. The ideas described in this article at least provide an equitable and transparent mechanism to manage default situations.
