How debt-for-nature swaps can affect sovereign credit

Buyback of sovereign bonds at discount can be viewed as default by Moody’s

The difficulties many emerging market sovereigns face in mobilising capital for climate-related initiatives, while already being saddled by high debt burdens, have increased attention on debt-for-nature swaps in some cases. These are transactions where a country’s debt burden to creditors is reduced, thereby enabling the country to spend at least part of this saving on climate or environmental conservation measures.

Moody’s assessments of debt-for-nature swaps have largely focused on whether they constitute an event of default.

This is because, to achieve a reduction in debt service for the debtor country, recent debt-for-nature swaps have involved buybacks of the country’s sovereign bonds at discounts to par, implying financial losses for creditors relative to the original contractual promise. According to Moody’s definition, if, in addition to this financial loss for creditors, the debt buyback also helps the debtor country to avoid a likely eventual default, Moody’s deems the bond buyback a distressed exchange and hence an event of default.

While participation in these debt buybacks is usually voluntary, as it is in the vast majority of all distressed exchanges, investors may be driven to participate by the fear of even greater losses if they do not. This may particularly be the case for sovereigns facing high credit risk as indicated by a credit rating of B2 or below or if bond yields to maturity are trading at stressed levels.

The country’s creditors by design receive less than the contractually defined payments in the associated debt buyback to achieve financial savings for the debtor country. This means the decision to view the buyback as a distressed exchange largely depends on whether the debt buyback allows the debtor country to avoid a likely eventual default, which is ultimately a judgement call. In assessing default avoidance, Moody’s considers the debtor country’s creditworthiness and the structure of the bond buyback offer.

In terms of creditworthiness, Moody’s uses fundamental credit analysis, examining whether the country is experiencing financial distress as indicated by liquidity pressures or debt service burdens that are untenable. Moody’s also takes into account the availability and effectiveness of crisis resolution mechanisms, central bank liquidity lines, international financial support and accompanying conditionality. Additionally, Moody’s examines debt maturity and interest payment schedules to understand whether the issuer has the ability and willingness to meet future debt service payments.

With regard to bond buyback offers, Moody’s analyses factors including the size of the buyback relative to total debt and/or market debt with the likelihood that larger transactions, affecting around 5% or more of outstanding debt, are more likely to help avoid an eventual default. Furthermore, the loss severity, measured as the discount to par, often signals the likelihood of the issuer being unable to meet its debt obligations and impacts the magnitude of debt reduction. Moody’s takes into account sources of cash used to buy back the debt. If new cash is being raised externally in the debt markets, this can signal that the issuer has access to the debt markets and is not in distress.

Several debt-for-nature swaps have taken place in recent years, including in Gabon and Ecuador in 2023, Barbados in 2022 and Belize in 2021. Moody’s deemed the debt buybacks as distressed exchanges for Ecuador and Belize but not for Gabon and Barbados. At the time of the transaction, our analysis did not point to Gabon and Barbados having an untenable debt structure or liquidity pressures, despite their Caa1 rating. This was also reflected in their bond yields at the time, which did not signal significant financial stress, hovering at around 8% for Barbados and 11% for Gabon.

By contrast, Belize had already missed debt payments a few months before the swap, indicating extreme credit stress at its Caa3 rating. Similarly-rated Ecuador appeared to lack market access as it was going through a period of severe political turmoil around the time of the transaction. Bond yields for both Ecuador and Belize were also at highly distressed levels, trading north of 20%. This was reflected in the deep discount that the bonds were bought back at, at 45% for Belize and over 60% for Ecuador.

Moody’s will continue to assess these swaps on a case-by-case basis, determining after a transaction has taken place whether it constitutes a distressed exchange.

Thorsten Nestmann is Group Credit Officer for Sovereign and Supranational Issuers at Moody’s Investors Service.

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