Economy 2024 Featured

Can Sri Lanka’s New Debt Proposals Balance Risk with Recovery?

In 2024, Sri Lanka engaged in restructuring discussions with its bondholders, proposing several innovative financial instruments aimed at managing the country’s sovereign debt more sustainably. The proposals include Macro-Linked Bonds (MLBs) and potentially Governance Linked Bonds (GLBs), which tie the repayment terms to Sri Lanka’s economic performance and governance improvements. The Group’s March and April proposals outline different structures and terms for these MLBs, suggesting varying degrees of haircuts, adjustment mechanisms, and additional features like consent fees, all designed to align the debt repayment obligations with the actual economic conditions and governance outcomes of Sri Lanka.

In the bondholders’ March proposal, the focus is on the restructuring of Sri Lanka’s sovereign debt through Macro-Linked Bonds (MLBs), which exhibit a contingent financial structure based on economic performance metrics. The premise is structured as follows:

The accumulated Past Due Interest (PDI), quantified at $1,678 million, is not subject to any direct reduction. Instead, it is proposed to be capitalized into new instruments, essentially recalibrating the debt’s baseline. Subsequently, from 2024 to 2028, the bondholders are offered plain vanilla bonds—conventional fixed-rate bonds devoid of complexity—with annual coupons set at a consistent rate of 4%. These instruments, presenting annual installments of $270 million for the initial four years and an increment to $598 million in 2028, offer a static return profile up to the pre-defined juncture of 2027.

Transitioning to the MLB structure, a salient 20% nominal haircut is applied to the new issuances commencing in 2029, reducing the principal owed from, for instance, $1 billion to $800 million. This concessionary measure is intended to alleviate the debt burden by reducing the nominal obligations. The new bonds, aggregating to a principal sum of $10,040 million, extend the maturity of the debt to the year 2040, effectively postponing the commencement of principal amortization by two years relative to the previous terms.

The coupon rate on these MLBs is bifurcated into a 4% rate payable in cash up until 2027, transitioning to a 3% Payment-In-Kind (PIK) interest and an increased cash coupon rate that commences at 7.75% in 2028 for the first MLB instalment due in 2029. This elevated rate persists and incrementally escalates with the maturity of subsequent bond instalments, reflective of an augmented cost of debt servicing beyond the initiation period.

Central to the proposal is the GDP-linked adjustment mechanism, where the nominal value of the MLBs is correlated to the performance of Sri Lanka’s GDP against a series of thresholds calculated as an average over the years 2025 to 2027. Should the economic output surpass the IMF baseline, bondholders would not incur further reductions in principal, and the post-2028 coupon rate could ascend to a maximum average of 8.2% in the most favorable economic scenario where the GDP reaches $96.3 billion. This introduces a variable reward component for the bondholders akin to equity shareholders in a corporation, where returns are contingent upon the company’s financial performance.

Conversely, should the economic indicators wane and the GDP falls below the baseline to, say, $80.5 billion, the bondholders would absorb additional haircuts—up to a 36% reduction in the principal amount, with the coupon rate post-2028 attenuating to 5.0%. This creates a scenario where bondholders participate in downside risk, bearing a resemblance to the loss absorption commonly faced by equity investors during downturns.

    In sum, the proposal offers a risk-sharing model that tempers immediate fiscal pressure on Sri Lanka while introducing a potential for increased future payouts to bondholders in a thriving economic climate. However, the prospect of increased coupon rates and the contingent nature of the adjustments might not align with the government’s risk mitigation strategy, given the prevailing economic challenges.

    In response to the bondholders’ proposition, the Government of Sri Lanka (GoSL) countered with its own restructuring framework, presenting a mixed composition of debt instruments aimed at achieving fiscal stability while accounting for macroeconomic variability. The GoSL proposal introduces a bifurcated bond structure comprising “A-Bonds” and “B-Bonds,” each designed to fulfill specific fiscal objectives and economic contingencies.

    A-Bonds and PDI Bond:
    The A-Bonds constitute a series of seven bonds, accompanied by one additional bond dedicated to the capitalization of Past Due Interests (PDI). These A-Bonds are delineated as plain vanilla bonds, implying that they are standard debt instruments with no conditional features—such as adjustments based on economic indicators. These bonds offer fixed cash flows, ensuring predictable and stable debt servicing payments that do not fluctuate with macroeconomic developments. The PDI bond has an indicative amount of $1,341 million, to be progressively amortized from 2024 to 2028 at an interest rate of 3%.

    In contrast, the three B-Bonds incorporate financial terms that are adjustable and are set to be evaluated in early 2028 based on the cumulative real GDP growth from 2024 to 2027. This adjustment will be determined through a dual one-time test against predetermined GDP benchmarks, set at intervals of 5%, 10%, 15%, and 20% both below and above an established baseline, creating nine potential adjustment zones. The outcome of this test will condition the amendments to the bond payments, effectively linking the financial terms to actual economic performance. For instance, a B-Bond maturing in 2036 with a base value of $966 million carrying a 4% coupon rate could see its value and payments adjust upward or downward based on where Sri Lanka’s GDP stands in relation to the referenced levels.

    Financial Terms and Adjustments:
    The A-Bonds, slated for maturities ranging from 2029 to 2035, feature a scaling coupon rate structure. The rates commence at 4.5% and step up to 6% from 2029 until 2032, culminating in an elevated rate of 9% from 2033 until maturity. The B-Bonds, with maturities set for 2036 to 2038, start with a 4% coupon rate. Depending on the economic performance, these bonds could experience upward adjustments—resulting in an increase in principal, accelerated amortization schedules, and heightened coupon rates post-2028—or downward adjustments—where the principal could be reduced to a floor of zero, accompanied by decreased coupon rates. These adjustments are definitive and irrevocable, signifying a firm commitment to the bond terms once set.

    Examples of Adjustment Scenarios:
    For illustrative purposes, under an optimistic scenario where economic performance triggers the first tier of positive adjustments (Adjustors #1+), the B-Bond due in 2036 could see its capital increase to 120% of its original value, boosting the nominal value to $1,160 million. Conversely, under a less favorable economic outcome that activates the first tier of negative adjustments (Adjustors #1-), the same bond’s capital could decrease to 75% of its original value, reducing the nominal value to $725 million.

    In summation, the GoSL’s proposal presents a diversified bond strategy balancing predictable debt servicing with performance-linked adjustments that provide a direct correlation between the country’s economic health and its debt repayment obligations.

    In the bondholders’ April proposal, we observe a strategic adjustment to the previously presented terms, with the introduction of Macro-Linked Bonds (MLBs) now oriented to the IMF baseline for Sri Lanka’s economic outlook. The proposal is laid out with meticulous attention to financial detail and with specific consideration for the varying potential scenarios of Sri Lanka’s economic performance.

    At the core of the proposal, the bondholders maintain the Past Due Interest (PDI) at $1,678 million, affirming their expectation of full repayment. This PDI is not subjected to any haircut, contrasting with the principal amounts of the new bonds, which undergo a significant reduction. The instrument’s principal repayments begin with the issuance of several plain vanilla bonds, slated for the years 2024 to 2028, each set at a notional amount of $336 million. These carry a fixed coupon rate of 4%, payable in cash, which remains constant until 2027, thus offering a predictable financial obligation for Sri Lanka in the near term.

    Transitioning to the new bond installments, the proposal introduces a series of MLBs with principal repayments starting in 2029, with a collective notional value of $9,036 million. These bonds are subjected to a 28% haircut on their nominal value, reflecting a reduction in the debt burden. For example, a bond with a notional value of $1,000 million would be recalibrated to $720 million after this adjustment.

    A nuanced element of the proposal is the consent fee, which amounts to approximately 1.8% of the original principal claim (excluding PDIs, quantified as $225 million) to be settled upfront. This fee acts as a form of incentive for bondholders, compensating for the initial reduction in the bond’s nominal value and signaling the group’s expectation of a cooperative resolution.

    The updated MLB structure reflects a pivotal “shift” as it now aligns with the IMF baseline economic forecasts rather than an alternative scenario previously considered. This shift demonstrates a move towards a consensus-based outlook for the country’s economic trajectory. The adjustment mechanisms embedded within the MLBs are a central feature, offering a financial response to the actual economic performance against the IMF projections between 2025 and 2027.

    In an environment where Sri Lanka’s GDP outstrips the IMF baseline forecast, the proposal is structured to reward bondholders with an increase in the bond principal—up to 28.8% above the nominal value—should the GDP reach the optimistic projection of $96.3 billion. This would elevate the effective principal to 92.7% of the original claim and bolster the average coupon rate to 8.5% post-2028.

    Alternatively, if Sri Lanka’s economic growth falls short of expectations, hitting a low of $80.5 billion, a downturn adjustment mechanism is triggered. This could result in a decrease in the bond principal by up to 18.9%, reducing the effective principal to as little as 58.4% of the original claim, with the average coupon rate subsequently adjusted downward to 6.0%.

    The adjustment mechanisms detailed in the proposal indicate an irrevocable commitment to the recalibrated terms, which would become fixed post-2028. This reflects an acknowledgment of the economic vulnerabilities that Sri Lanka faces and demonstrates a collaborative approach by the bondholders to facilitate a more sustainable debt structure. By aligning bond performance with actual GDP outcomes, the proposal seeks to share the risk associated with economic fluctuations equitably, balancing the imperative of debt sustainability with the need for investor confidence.

    The concept of Governance-Linked Bonds (GLBs) represents an innovative financial instrument designed to incentivize and reward governance reforms in the issuing country. The proposal for GLBs includes integrating an Environmental, Social, and Governance (ESG) component into the debt treatment agreement, with a particular focus on governance. These bonds aim to bridge the financial objectives of sustainability-linked instruments with governance improvements, fostering responsible state actions.

    In essence, the GLB framework is tailored to promote better governance and reduce corruption vulnerability, thereby benefiting both the country and bondholders. The GLB operates under a coupon step-down structure, meaning the interest rates of the bonds can be reduced if the country meets certain predefined governance criteria.

    Two Key Performance Indicators (KPIs) drive the structure of these bonds:
    1. Quantitative KPI: This involves a specific target for government tax revenue-to-GDP ratio, which is a measurable and transparent criterion. For instance, the IMF program sets a tax revenue-to-GDP target at 14.0% in 2026 and 14.1% in 2027. Meeting these targets could trigger a coupon reduction, thus reducing the cost of debt servicing for Sri Lanka.
    2. Qualitative KPI: This KPI encompasses selected reforms under the current IMF program, known as “Structural Benchmarks.” These reforms could include measures such as the publication of public procurement contracts above a certain threshold and the publication of tax exemption information. These actions are expected to be verified by independent reviews and are aimed at enhancing fiscal transparency and accountability.

    The measurement date for assessing the performance against these KPIs is aligned with the MLBs, potentially in the first half of 2028, and is based on the performance in either 2026 or 2027. The adjustment date for the coupon step-down is anticipated to be in June 2028, contingent on meeting both the quantitative and qualitative targets.

    The adjustment mechanism is detailed and rigorous, with a potential 50 basis points reduction in the coupon rate if the KPIs are successfully met. Additionally, the proposal calls for an external review by an independent entity, which could include firms specializing in ESG solutions, to ensure objectivity in the assessment process.

    What’s pivotal here is the final structure of the bond is to be refined in close coordination with the Sri Lankan authorities, suggesting a collaborative approach to establishing and meeting governance criteria. The GLBs, therefore, represent not just a financial instrument, but a partnership that aligns the country’s economic incentives with broader governance objectives, embedding reform directly into its debt management strategy. This embeds a degree of fiscal discipline and transparency directly linked to the cost of borrowing, effectively incentivizing structural reforms within the nation.

    When considering the bondholder proposals and the Government of Sri Lanka’s (GoSL) counter-proposals, a number of global and domestic economic variables could influence the viability and outcomes of these proposals. The following table presents few key economic variables along with examples of how each could potentially affect the proposals.

    Economic VariableGlobal Impact ExampleDomestic Impact Example
    GDP Growth RatesA global economic slowdown, potentially from trade conflicts or a downturn in major economies, can lead to lower investment and demand for developing countries’ bonds. For MLBs, this could make the economic performance clauses more challenging to meet, while GLBs could be viewed as riskier if governance improvements are deemed unlikely during global downturns.If Sri Lanka’s GDP growth exceeds forecasts due to successful reforms or increased foreign investment, it may improve its ability to meet the performance targets of MLBs and GLBs. Conversely, a domestic recession would strain public finances, potentially making the performance-linked aspects of MLBs more punitive and governance reforms stipulated in GLBs harder to implement.
    Inflation RatesRising global inflation can lead to increased commodity prices and global interest rates, increasing the cost of servicing debt for countries like Sri Lanka. This could make the terms of MLBs less attractive and increase the yield required by investors for GLBs.Elevated domestic inflation can erode the real value of government revenues, affecting Sri Lanka’s ability to meet the tax revenue targets tied to GLBs and potentially requiring renegotiation of MLB terms if inflation outpaces economic growth.
    Interest RatesIf leading central banks, like the US Federal Reserve, increase interest rates to combat inflation, it can result in higher global borrowing costs. This would raise the interest payments on new debt for Sri Lanka, affecting the viability of MLBs and making the step-down features of GLBs more critical.A domestic interest rate hike could increase the cost of borrowing internally, crowding out government spending on reforms and development projects. This can challenge the fiscal targets linked to GLBs and make MLBs less sustainable due to higher domestic financing costs.
    Exchange RatesSignificant currency fluctuations, especially in reserve currencies, can impact the debt repayment schedule for MLBs in USD terms. A strong dollar could increase the debt burden for Sri Lanka, making GLB targets more difficult to achieve due to increased external debt servicing costs.A devalued Sri Lankan rupee would make it more expensive to service USD-denominated MLBs and could also impact the import costs of goods, affecting domestic inflation and potentially limiting the government’s ability to meet GLB governance targets.
    Political StabilityGlobal political uncertainty, such as geopolitical conflicts or trade tensions, can affect investor sentiment and risk appetite, leading to increased yields on bonds from emerging markets. Such an environment could necessitate higher premiums for MLBs and GLBs from Sri Lanka.Domestic political instability or policy inconsistency could undermine investor confidence, reduce the effectiveness of governance reforms, and impair the government’s ability to meet the conditions for GLB coupon reductions.
    Commodity PricesA rise in global commodity prices, for instance, oil, could increase Sri Lanka’s import bill, adversely affecting the balance of payments and increasing the cost of servicing external debt like MLBs. For GLBs, the increased fiscal pressure could impede the government’s ability to achieve governance targets.High domestic commodity prices can lead to inflationary pressures, reduce disposable income, and increase production costs, challenging the government’s fiscal balance and potentially affecting its capacity to meet MLB and GLB criteria.
    ESG PerformanceA global shift toward ESG-compliant investment could lead to more favorable financing conditions for instruments like GLBs. If global investors increasingly seek out ESG bonds, Sri Lanka could benefit from lower borrowing costs for GLBs that demonstrate governance improvements.Domestic ESG advancements could enhance Sri Lanka’s credit rating and attract ESG-focused investment, supporting the GLB framework. Effective implementation of ESG initiatives can demonstrate commitment to governance, positively influencing investor sentiment towards MLBs and GLBs.

    By Sanjaya Ariyawansa
    Senior Economist 
    The Ceylon Chamber of Commerce

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