Chapter

Chapter V: Alternative Financial Instruments and Access to Capital Markets

Author(s):
International Monetary Fund. Monetary and Capital Markets Department
Published Date:
March 2002
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Over the past several years, emerging market borrowers have used a number of debt instruments, many of which embody innovative features, to maintain access to global capital markets and better manage their debt through risk diversification. While emerging market borrowers are quite likely to make use of alternative debt instruments1 at times of relative tranquility, the need for their use may increase at times of market turbulence or financial stress, when investor appetite for emerging market debt diminishes and costs of borrowing rise. In these circumstances, emerging market countries must maintain sound economic policies, both to signal their commitment to economic reform and adjustment and/or to differentiate themselves from the countries in crisis and limit the potential damage from contagion. Notwithstanding the adoption of those policies, to meet their financing needs and maintain access to capital markets, sovereigns could face the daunting task of issuing debt that on the one hand appeals to investors, but that on the other avoids locking themselves into high debt-service costs for prolonged periods of time and creating inflexible debt structures that could exacerbate future crises and have implications for financial stability, more generally.

It is evident from Table 5.1 that over the past several years, in addition to reopening and augmenting existing debt issues, emerging market sovereigns sought to reduce borrowing costs and extend the maturity of debt instruments through the use of collateral, warrants, and a greater reliance on derivatives—all common features in mature financial markets, but less common in the sovereign emerging market debt context.2 More recently, some of these instruments have been used less frequently, while others remain in common use.

Table 5.1.Emerging Market Sovereign Bond and Loan Issues by Type(In millions of U.S. dollars, unless otherwise specified)
19971998199920002001
Jan-JuneJuly-DecJan-JuneJuly-DecJan-JuneJuly-DecJan-JuneJuly-DecJan-JuneJuly-Dec
Regular34,83928,81841,65915,40421,99514,77329,24714,58821,211112,953
of which loans9,6467,20020,7397,8057,8092,45334,3252.3332,4533,654
number of transactions115811913258645880455144
Augmentations9,1395,0938,3382,83010,9086,1266,7775,5848,8917,178
number of transactions981715262414141919
Step-down1,6723,286416938
number of transactions5823
Step-up300405564162
number of transactions1111
Calls2,5471,0441501,550333001,120310300
of which loans11050185
number of transactions11081312471
Puts2,7423102,6951,3691,2331,310801,2152,062
of which loans4451101951639480185
number of transactions11754848163
Warrants1,0002,500**2
number of transactions131
Structured notes31,0001,750905
number of transactions223
Collateralized7,0595,4333,0425,6101,0161,9393,247860970530
of which loans6,7005,2332,9423,110931,2613,247860970530
number of transactions1263122116911663
Total56,62643,77561,48429,08338,78524,24740,47122,55731,37224,041
of which loans16,79212,65323,87611,1287,9023,5897,5623,5623,4234,184
Sources: Bondware and Loanware.Note: Includes all countries covered by the EMBI Global Index and covers issuance by all forms of government and the public sector.

Includes bonds and loans.

Panama issued warrants in the context of retiring/swapping some debt maturing in 2002.

Owing to the non-transparency associated with structured notes, coverage may be incomplete.

Sources: Bondware and Loanware.Note: Includes all countries covered by the EMBI Global Index and covers issuance by all forms of government and the public sector.

Includes bonds and loans.

Panama issued warrants in the context of retiring/swapping some debt maturing in 2002.

Owing to the non-transparency associated with structured notes, coverage may be incomplete.

While the role of alternative debt instruments in international finance and their implications for the new financial architecture have been discussed in earlier IMF studies, not much attention has been paid to comparing the relative merits of these instruments in enabling emerging market sovereigns to access capital markets or diversify risk on a sustained basis and the concerns they may raise for the management of sovereign debt, crisis resolution, and the functioning of emerging markets.34

This chapter focuses on the alternative debt instruments used by emerging market sovereigns to access capital markets from 1997 through 2001, a period marked by a number of financial crises. It examines the potential for conflict between a sovereign's desire to maintain access to capital markets and the principles of sound debt management practices recognized and endorsed by the international community. In particular, the analysis addresses the following questions:

  • What kinds of alternative instruments have been introduced, and what impact do they have on sovereign borrowing costs and on enabling access to capital markets on terms consistent with medium-term viability?

  • Is the use of various alternative debt instruments consistent with sound debt management practices or does it merely push risks and problems to the future?

  • Are these techniques consistent with efforts of the international community to involve the private sector in crisis resolution, both in terms of the private sector maintaining exposure to a country at times of crises and in terms of creating flexible debt structures?

Alternative Financial Instruments: What Are They and How Do They Work?

Financial market turbulence or financial stress is typically characterized by a loss of investor appetite for emerging market debt and higher borrowing costs for some or all of the following reasons: (1) reduced liquidity in secondary markets for emerging market debt; (2) higher risk premiums that (temporarily) push up borrowing costs; (3) a rise in the perceived risk of default by sovereign borrowers; (4) increase in market uncertainty, including from risks of contagion; (5) increased risk aversion among investors; and (6) increased uncertainty about future prospects of the sovereign borrower.

In such circumstances, emerging market borrowers often have adjusted their debt management strategies, and have made use of debt instruments, embodying innovative features, to maintain access to capital markets and diversify risks (Table 5.2).5 The alternative debt instruments—which include debt augmentation, time varying and state contingent instruments, structured notes, and collateralized borrowing—seek to mitigate one or more of the above concerns by changing the nature of the debt instrument, its payoff, as well the commitment of the sovereign borrower to meet its debt obligations. The use of such instruments could, however, also be undertaken at times of relative tranquility provided they are consistent with the overarching and constant goals of improving fundamentals and sound debt management and build credibility with markets.

Table 5.2.Market Conditions and Alternative Financial Instruments
Financial Market ConditionsAlternative Financial InstrumentsAdvantagesDisadvantages
Diminished or uncertain secondary market liquidity.Augmentation: use of techniques for reopening of existing issues.Builds large fungible issues that promote secondary market liquidity.Bond covenants need to accommodate reopenings.
Reduced demand for new issuance.Allows sovereign to issue in smaller increments and to do so more seamlessly.If too large, may impact overall yield curve and spread of all outstanding issues.
Higher risk premiums that (temporarily) push up interest rate costs for the borrower.Time varying instruments:Step-up and step-downs: allow the sovereign to shape present and future cash flows differently.Sovereign can issue instruments with longer maturity without locking in high short-term rates.Provides investors with an upside potential reflected in higher average coupon rates.
Markets have different expectations (too pessimistic) compared to fundamental outlook of the authorities.State contingent instruments: Includes options and warrants.Sovereign can reduce borrowing costs by providing insurance to investors against adverse outcomes.Difficulty in pricing. Relatively high market premium.
Puts—the exercise by investors may compound the difficulties of debt managers in adverse outcomes.
Market spreads may be volatile or out of line with medium run trends.Structured notes: includes fixed income instruments linked to derivatives, such as swaps, caps, floors, and futures.Allow the sovereign to hedge market outcome risk or to provide a payoff to investors based on future economic conditions.Tend to be complex and may be difficult to price efficiently. Nontransparent. Need to be set into a sophisticated risk management strategy to avoid debt management risks.
Rise in the perceived risk of default by sovereign borrowers.Collateralized instruments: including instruments that borrow against future flows.Reduce spreads and improve rating of instrument. Could potentially provide significant market access when uncertainty is overwhelming and restricts other forms of market access.May result in rise in spreads of uncollateralized instruments by subordinating existing instruments. Inflexibility could complicate debt management. Could run counter to efforts to secure private sector involvement in crisis resolution.

Augmentations

Sovereign borrowers have become increasingly aware of the importance of well functioning secondary markets for their debt instruments. Liquidity of these markets can be improved through a practice of building large fungible issues along the yield curve by reopening and expanding existing debt, often termed “augmentation.” Reopening and expanding an existing issue with which investors are already familiar makes the existing stock of bonds more liquid—by widening the number of investors in a single issue, opportunities for secondary market transactions increase. It also makes it more likely that the larger bond stock will be included as a benchmark in several emerging market indices, thereby increasing the potential universe of portfolio investors. Liquid secondary markets, in turn, provide issuers with a benchmark for pricing new issues.

Augmentation offers advantages that are particularly useful in times of financial market turbulence. With reduced demand for new instruments in such circumstances, augmentation allows the sovereign to access capital markets in smaller amounts and across a series of bonds (as compared to a single large-size issue), helping the issuance to be more easily absorbed into the market and with minimum disruption (existing issues are already aligned with market conditions).6 Furthermore, augmentations can also be used to maintain liquid markets when shortages of a particular bond series arise owing to a technical market squeeze by short sellers.7 Reflecting these advantages, data presented in Table 5.1 show increasing use of augmentation, rising up from a share of only one-fifth in 1997, to more than one-third of all bond issuance in 1999 and 2001, suggesting that augmentation has been usefully deployed to maintain market access during difficult periods.89

Augmentations are not, however, without limitations. In particular, augmentations, like all bond issuance, dilute the claims of previous holders of the bond, and may put pressure on secondary market bond prices, increasing the spreads and cost of issuance and potentially disrupting secondary markets. Investors sometimes demand explicit protection against such risks, including by embedding rules in bond contracts to protect primary market buyers of bonded debt—such as by ensuring that augmentations take place when prices are close to par. In other cases, investors might require an additional premium ex ante to allow for future augmentation, which in turn could bear upon sovereign debt management strategy.10

Time-Varying Instruments

These include instruments in which coupon payments change over time.

Step-ups and Step-downs

In the period from 1997 through 1999, several key emerging market sovereigns issued bonds that included a step-down or step-up feature, where coupon payments are higher (lower) for a short initial time period, but then decrease (increase) over the medium to long term.11Table 5.1 shows that the issuance of stepdowns increased during the Asian crisis and peaked during the first half of 1998—owing in large part to the issuance prior to the creation of the Euro by Argentina, and to a lesser extent, Brazil, Venezuela, and Turkey, of bonds in various Euro-11 currencies and at coupons that had step-down features that would merge into one highly liquid euro-denominated benchmark—before declining following the onset of the Russia crisis.

The motivation for step-downs is that it allows debt instruments with initially high coupons, reflecting existing market conditions, to converge to the yields being paid on already existing sovereign debt. By doing so, the instrument usually becomes fungible with another bond issue and the two are traded as one. Thus, the issue achieves the benefits of longerterm borrowing and enhanced liquidity, while avoiding locking the borrower into continuous high debt-service costs after the market has returned to more normal conditions. Despite the potential benefits, a limitation of the stepdown feature is that it is considerably less flexible than a bond with an embedded call option (discussed below), because if the coupon rate that it steps down to is higher than the prevailing market rate at that future point in time, the issuer might find the initial choice less than optimal.

In contrast to step-downs, an embedded stepup feature in a bond reflects the willingness of the market to accept the sovereign's belief that economic prospects will improve over time, thereby improving the ability of the sovereign to service its debt. The cash-flow relief initially could help the borrower to put its house in order to ensure economic stability and growth. In this way, a step-up bond has positive risk diversification features. Step-up bonds are, in general, instruments with a long duration, and may appeal more to certain classes of investors who have a longer investment horizon. That said, the step-up feature in bond contracts have remained rare in recent new issuance, although Argentina used this feature in the context of a voluntary debt swap in June 2001.

State-Contingent Instruments

These include instruments in which the payments depend upon future economic and/or market conditions.

Options

A call option would normally be reflected as a covenant in the bond or loan contract, stating that on a certain date (or dates) prior to the maturity date of the instrument, at the discretion of the issuer, the debt can be redeemed at par. The call option provides an important advantage to the issuer by allowing the possibility to refinance at a substantially lower rate, if market conditions improve. Consequently, it is able to capture the benefits of improved economic conditions without taking on additional funding risks (as would be the case for put options exercisable at the discretion of the creditor). In return, however, the holder (the seller of the call option) will demand a higher yield, both because he is exposed to reinvestment risk pertaining to the principal and because the price appreciation potential for a callable bond is restricted. Furthermore, in certain cases, the call option, by making the instrument more complex or less easily tradable, will require an additional premium on liquidity grounds. Call options are particularly attractive when there exists asymmetric risk preference and information, because of which the market and the issuer disagree about the likely future path of the sovereign's borrowing cost.

Notwithstanding the apparent advantages of the instrument, they have not proved popular in the pure sovereign context since the onset of the Asian crisis and the last use of the instrument was in the second half of 1998.12 Arguably, difficulties in pricing the options efficiently to reflect their true value have deterred sovereigns from adopting this technique to access capital markets. It is also quite likely that market perception of a significant likelihood of a call option embedded in a new instrument issued at times of stress being exercised would lead investors to seek a large upfront premium that borrowers are unwilling to pay, thereby leading to a decline in their overall use.

In contrast to a call option, a put option in a bond or loan contract would provide the creditor with the right, but not the obligation, to redeem the debt instrument before the maturity date. Borrowers write put options as a means to achieve lower spread in the belief that over time spreads will decline, or at least remain stable, in which case the put would not be in the money, and would not be exercised.13 By issuing debt with an embedded put feature, however, the issuer risks being subject to a rapid increase in refinancing needs at times of emerging pressures, which could make a difficult situation worse. In the context of the Asian crisis, a number of emerging market borrowers, in the face of a total loss of access to international capital markets, faced significant pressures in their external accounts following creditors' decision to exercise put options. In the context of improvements in sovereign debt management strategy, put options have been relatively rare in their use in the pure sovereign context in recent times, although a number of public sector entities continue to use them.

Warrants

An innovative feature, which has occasionally been used by emerging market sovereign borrowers, is the use of warrants embedded in new bond issues. Embedded warrants in nonsovereign bonds are fairly common and have usually been of the equity warrant type (i.e., they have included a call option that gives the bondholder the right, but not the obligation, to buy a certain amount of shares at a specified price). Bond warrants, in contrast, give the holder of the warrant the right, but not the obligation, to buy another sovereign bond (usually long term), at a predetermined price at some future date. Hence, warrants can be seen as sold call options by the sovereign issued out of the money (i.e., they become in the money if spreads come down faster than contracted before the exercise date) that are embedded in an otherwise plain vanilla bond. Argentina revived the use of bond warrants in November 1998 by embedding a warrant in a $1 billion bond issue. This structure, which previously had not been used in a sovereign context since the early eighties, was well-received and subsequently copied by other issuers, with some alterations (Box 5.1).

In effect, warrants allow the issuer to “buy down” the headline spread today, in return for a commitment to pay more in the future should the outlook for the country improve and spreads fall to the extent that the warrants become in the money. The country will then issue new debt in the improved economic environment at rates above the prevailing market rates. Conversely, in the event that spreads do not fall below the strike price, the warrant will not be exercised and the country will have benefited from lower initial issuing costs.14 Hence, by making debtservice payments countercyclical, warrants provide risk-shifting benefits, and entail risks only to the extent that effective borrowing costs in the future could increase if economic prospects improve sharply.

Market commentary has highlighted a number of technical benefits from this structure, including an increase in liquidity. Furthermore, warrants, being a type of call option paid for by the buyer, provide the owner of the warrant with a significant amount of extra leverage. They would appeal, in particular, to institutional investors who are forbidden by home market regulations to take regular option positions but are allowed to hold warrants that are attached to a bond. Another factor affecting the use of warrants is the perceived advantage of tailoring the instrument to a particular class of creditor. In the case of the Mexican sovereign bond issued in 1999, the warrant was immediately detachable, which according to market sources led relative value players to buy the bond plus warrant and immediately sell the bond, causing the bond price to drop immediately after syndication broke. In contrast, in the Argentine bond issue of February 1999, the warrant was first separable one month after the issue, and hence specifically targeted longer-term investors. Argentina's success in targeting the desired group of investors was also helped by excess demand for the issue, which allowed the lead managers to discriminate between new money accounts and switching accounts (investors that sell one Argentine bond to buy the one being issued, thereby shifting the yield curve in the process).

Box 5.1.Recent Bond Warrants

Following its introduction in the sovereign context by the Argentine government in November 1998, there have been several instances of sovereigns issuing a bond with an attached warrant.

Argentina I

On November 18, 1998, Argentina launched an unusual seven-year sovereign Eurobond that included a bond warrant. The bond was favorably received, and was increased from an initial $750 million to $1 billion, at a spread of 622 basis points. The Eurobond (the so-called “host bond”) included a warrant that gave the holder the right, but not the obligation, to buy the Argentine 2027 bond (the socalled “back bond”) at 93.3 percent of par. The value of the warrant was estimated at launch time to be 64 basis points, which was the sweetener provided by the issuer. The warrant, which was subsequendy exercised, had a maturity of approximately one year and expired in December 19, 1999.

Mexico

Mexico launched a $1 billion sovereign bond on February 5, 1999, which included a fairly complex warrant structure. The holder of the warrant was given the right, one year after the launch, to exchange some specific Brady bond issues into either: a yet to be issued floating rate note, due 2005, paying LIBOR plus 4.75 percent, or a reopening of the United Mexican States Bond, due 2016 with a 11.375 percent coupon. Exchange ratios, which provided for the exercise price of the warrant, were set at launch. Warrants were detachable at launch and could trade separately. The warrants were subsequently exercised.

Argentina II

Argentina issued its second bond with an embedded warrant attached in February 1999. The major difference between this warrant and the previous Argentine one was that it was issued during considerably improved market conditions and the warrant, allowing another $500 million to be issued, exercised into the host bond (maturing February 2009) instead of a different bond. Market reactions were reportedly positive, yet the size was limited to $1 billion in face of $2 billion worth of demand (allowing certain investors to be targeted). The warrant was valued around 20 to 30 basis points, resulting in a modest yield curve pickup of 20 basis points compared to the outstanding bonds maturing in 2017. The warrants, which were subsequently exercised, were not detachable until one month after launch.

Colombia

The Republic of Colombia launched in March 1999 a $500 million Eurobond with a 10.875 percent semiannual paying coupon maturing in March 2004. The bond issue also included a warrant giving the right to exercise the warrant, one year from the host bond's issue date, into a yet-to-be-issued Republic of Colombia bond, with a maturity of 19 years. The attached warrants are said to have saved 87 basis points of the headline spread of the bond issue. Warrants were subsequently exercised.

Panama

On June 26, 2001, Panama offered to purchase for cash and warrants up to $245 million aggregate principal amount of its 7.875 percent notes due February 13, 2002, in order to minimize the carrying cost of this issue. The offer was to expire on July 10, 2001, or once the $245 million aggregate principal of the 2002 notes was validly tendered, whichever came first. Under the terms of the offer, if Panama would purchase any 2002 notes, the tenderer would receive, for each $1,000 principal amount of 2002 notes purchased, a cash payment of $1,039,375 and two warrants, each of which would entitle the holder, on January 16, 2002, to exercise an option to purchase $1,000 principal amount of Panama's newly issued 9.375 percent Global Bonds due July 23, 2012 (the “2012 Bonds”) for cash at an exercise price of $990. If, however, the number of warrants exercised on January 16, 2002, would result in the issuance of less than $100,000,000 aggregate principal amount of 2012 Bonds, Panama would instead issue and deliver, in respect of each warrant exercised, $943.10 principal amount of its outstanding 9.625 percent Global Bonds due February 8, 2011 (the “2011 Bonds”). These 2011 Bonds, if issued would be a further issue of and form a single series with outstanding 2011 Bonds.

Finally, warrants were in the money and $182 million (57 percent of the total) were exercised.

Despite their potential benefits, the use of warrants by sovereign issuers has significantly diminished in recent years—although Panama used this feature in 2001 in the context of retiring/ swapping some bonds maturing in 2002—in large part because of the difficulty, and potential inefficiency, in the pricing of debt instruments containing warrants.15 However, because of their risk diversification features (sweetener would only need to be paid in the “good” state of the world), emerging market sovereigns might consider the use of warrants in the future.

Structured Notes

In the aftermath of the Asian crisis, structured notes became a popular means for emerging market borrowers to access international capital markets, although their popularity has waned significantly in recent years. These instruments are powerful tools for intermediating credit and risk, and can be used to achieve virtually any risk/reward profile, but their complexity and nonuniformity pose distinct challenges for emerging market borrowers and lenders.

Structured notes are fixed income securities linked to derivatives. The embedded derivative transactions are most commonly swaps, although options, futures/forwards, credit-linked derivatives, caps, and floors can be used as well. As such, they are often fairly complex transactions with varying contingent payoffs.16 For emerging markets, structured notes have so far been issued by Argentina, Colombia, the Philippines, and Ukraine. These transactions have in total amounted to about $3.7 billion, with a spike in issuance during the second half of 1998. Since then, however, they have seldom been used.

Structured notes allow for the hedging of almost any risk, and could be designed such that the payoff on the note is linked to the payment capacity of the issuer. Therefore, structured notes are unique in their ability to diversify risks and payments across states. In addition, since structured notes combine traditional debt instruments with derivatives, investors that might otherwise be off limits to derivative markets can obtain indirect access to these markets. The market for this innovative financial instrument, however, is rather nontransparent. More often than not, structured notes are tailor made to suit specific investors and sold in relative obscurity. As a result, general market information relating to issuance of structured notes, the availability of various types, and information on market participants is hard to come by, which in turn renders the pricing of these instruments very difficult. A further limitation arising from tailor-making these instruments relates to liquidity. Given that they are customized, it is not surprising that structured notes are not very liquid instruments in secondary markets, and this would imply that potential buyers, despite the customization of the instrument, would expect a liquidity discount. From the sovereign's point of view, a structured transaction would only make sense when it has some benchmark bonds that would provide guidance in the pricing process of the structured note.

Collateralization

Under some conditions of market stress, sovereigns could face prohibitive borrowing costs. In such circumstances, some emerging market borrowers have adjusted their debt management strategies to offer collateralized instruments. The use of collateral to back financial instruments is a common feature of private market borrowing, but outside of project financing, it has been less common in the sovereign context. In most cases, collateral has taken the form of current assets, or assets created or acquired using borrowed funds. In addition to traditional forms of collateralized borrowing, more recently, future flows of hard currency receipts have served as collateral for borrowing by a number of public enterprises, and this development could potentially have significant implications for sovereign market borrowers. The remainder of this section focuses on collateralization through the use of future flows, although the discussion of the costs and benefits applies equally to other forms of collateralized borrowing.

Borrowing Against Future Flows

Following the Mexican crisis in late 1994, there was an increase in borrowing against the future flow of hard currency income from the export of goods and services (Box 5.2).17 A number of these transactions have been backed by exports of goods, typically oil, but including metals, minerals, auto parts, plastics, and liquor. Other forms of collateral have included tourismgenerated credit card receivables, workers' remittances, receipts from long-distance telephone calls, and airline ticket receivables from foreign routes.

As a result of the implicit insurance investors derive from the collateral, issues backed by future flows typically are rated above the sovereign foreign-currency rating, and have spreads below the sovereign spread, reflecting the belief of rating agencies and markets that these securities are de facto senior to sovereign international bonds. In addition to being securitized, a number of these transactions have been supported by private bond insurance, which among other things enhances the creditworthiness of the instrument. The insurance company's guarantee of repayment raises the insured issue's credit rating to AAA, a practice common for industrial country municipal issues.18

A pledge of future flows as collateral can have benefits for both borrowers and lenders, often reflects normal commercial practice, and may foster a more efficient allocation of trade and external financing. Collateral increases the costs of default by increasing recovery ratios should default occur and enhances the willingness to repay, thereby signaling a commitment to policies that allow repayment. The decline in the probability of default lowers spreads and increases the range of creditors able and willing to hold the asset. During a period of financial turmoil, use of collateralization may help encourage new credits by effectively subordinating existing debt and ensuring that new creditors are repaid first. Collateralization, however, brings risks and costs—including the creation of less flexible debt structures, the potential delinking of the pursuit of good policies from market financing, and possibly increasing the cost of unsecured borrowing—that require close monitoring (see following section for further detail).

Box 5.2.The Structure of Future-Flow Securitizations—Modalities and the Case of PEMEX

In a typical securitization against future receivables, income is typically assigned to an offshore subsidiary created specifically for this purpose, called a special purpose vehicle, which issues the bond. The borrower provides irrevocable instructions to foreign importers that purchase its exports requiring them to make payments to an account controlled by the transaction's trustee. The trustee first pays debt service to investors and transfers to the special purpose vehicle any excess receipts (the transactions are typically overcollateralized three to four times). These documents can have the force of contracts in foreign jurisdictions, binding companies such as Exxon, Mobil, AT&T, Visa, and MasterCard to make payments into the trustee account. The transaction shifts jurisdiction over hard currency payments to a court system trusted by investors; otherwise, borrowing against future flow of export income parallels industrial country finance institutions' practice of securitizing their loan receivables. The rating of the bond issued by the special purpose vehicle is determined by many factors, including the nature of the receivable, the degree of over-collateralization, redirection of payment risk, the rating of the sovereign, and the rating of the receivable generating process. Ratings of individual tranches can be further enhanced by the use of mono-line insurers and/or subordination.

In one prominent example, PEMEX, the Mexican state-owned oil and gas company, issued $4.1 billion of bonds in December 1998, February 1999 and July 1999 secured by future oil export receivables.1 These transactions are notable for a number of reasons. First, they accounted for 24 percent of all emerging market issues backed by future flows of income. Second, PEMEX is an important source of tax and nontax revenue for the Mexican government. Finally, a bond insurance company, MBIA-Ambac guaranteed $1.35 billion of the issues, raising the credit rating to AAA rating (S&P), while the nonguaranteed portions received a BBB rating (S&P). The sovereign credit rating for Mexico at that time was (and still is) BB (S&P).

1 Specifically, PEMEX issued the bonds through a special purpose financing vehicle, PEMEX Finance, incorporated in the Cayman Islands. The issues are secured by PEMEX's account receivables from foreign clients, through a contract (a “receivables purchase agreement”) that gives PEMEX Finance the right to purchase, from time to time, accounts receivables that have been generated or will be generated in the future.

Policy Implications

To maintain sustained access to capital markets on terms consistent with medium-term viability as well as for purposes of risk diversification, emerging market borrowers may wish to make use of alternative debt instruments embodying innovative features. Pressures to do so may increase at times of financial crises, when access to capital markets is significantly reduced. The issuance of such debt, however, must be consistent with sound debt management practices—among other things to ensure that efforts to maintain market access do not come at an excessive cost, either in terms of an inflexible debt structure or in terms of increasing effective borrowing costs. From a policy perspective, use of innovations must also be compatible with efforts of the international community to secure private sector involvement in the resolution of crises and improve the international financial architecture more generally.

Augmentations provide sovereign borrowers a simple means, reflecting sound debt management practice and devoid of significant costs, to maintain (and reaccess) capital markets. Their continued use over the past several years is a clear reflection of this realization. By improving the liquidity of existing debt instruments, and by catering to the specific needs of investors, augmentations enable sovereigns to maintain access to capital markets in a series of small steps until market sentiment improves. The successful use of augmentations in the context of financial crises will, however, depend among other things on whether the issuing sovereign is the source of a crisis or is a victim of contagion. If the sovereign is the source of a crisis, it is quite likely that markets would dictate the need for other types of enhancements for the sovereign to regain access on favorable terms, while if the sovereign is a victim of contagion, augmentations may be sufficient for the sovereign to maintain access to capital markets.

Time varying and state-contingent financial instruments, including step-downs and embedded call options, can provide market access at headline spreads and allow for a reasonable balance between the provision of enhancements to entice investors and the opportunity for the sovereign debtor to lower debt-servicing costs in the future. Neither technique, however, provides much in the way of risk diversification. In the case of call options, the future interest rate is uncertain, while in the step-down it is contracted ahead of time.19 The proper timing of a call option is inherently difficult to determine before hand since it depends quite critically on the existence of asymmetric risk preference and information between the sovereign debtor and investors. However, because of the likelihood that the sovereign will have superior information than the market, the market will compensate by demanding a higher price for the option. Therefore, only in a select few circumstances, when the quality of the sovereign's information is better than anticipated (i.e., the information asymmetry is unexpectedly large) or when the risk preferences diverge significantly, will the sovereign find it advantageous to issue a bond with an embedded call option.

The use of put options in debt instruments, while providing emerging market borrowers access to capital markets on favorable terms, could come at a significant cost in terms of increasing the debt-service burden of borrowers at times of financial stress, and could thereby make a difficult situation worse. Therefore, from the sovereign's perspective, put options need to be carefully considered to ensure consistency with sound debt management practices, in particular, the management of debt profiles and risks arising from the possible exercise of the options.

In contrast to step-downs and options, bond warrants provide risk diversification to emerging market sovereigns by offering the opportunity to issue debt that “buys down” headline spreads prevailing at times of crises or contagion in return for an explicit commitment to pay higher spreads—on new bonds—in the future, if economic prospects and market sentiment improve, leading to a decline in market spreads on sovereign bonds. Without creating an inflexible debt instrument, warrants can provide significant riskshifting benefits and breathing room at times of crises by lowering debt service in the near term, and only expose the sovereign to risk in terms of higher borrowing rates (than market rates) in the future when strong economic adjustment facilitates sharp economic recovery. As a result, from the sovereign borrower's perspective, warrants may be more cost-effective and consistent with sound debt management in the context of countries in crises, rather than for those suffering from contagion, since the upside potential for these countries will probably take time to manifest itself. Warrants are, however, more complex than conventional bonds, underscoring the importance for sovereigns to make thorough assessments of the associated benefits and risks prior to using them. Nonetheless, if properly understood and fairly priced, they can provide an important source of risk insurance for emerging market borrowers.

As with other derivative products, structured notes can be used to either manage existing risk or assume new risk. Among the numerous fixed income securities available in the market, structured notes are special in that they can be customized to satisfy the unique requirement of individual investors, allowing for the possibility of exotic payoffs and higher-than-market yields under certain scenarios, including links to any currency, interest rate, stock index or combination thereof, and exposure to different market sectors within one packaged security. In general, from a market access perspective, structured notes could play a useful role in expanding the interested emerging market investor class, by particularly catering to previously unsatisfied pockets of demand. There are, however, significant risks and impediment to their wider use. Owing to their complexity and nontransparency, structured instruments can be difficult to price, while the underlying structure could be inflexible. Therefore, like warrants, structured instruments, when properly understood, fairly priced, and issued in moderate amounts, can provide an important means for emerging market borrowers to maintain market access to capital markets.

Collateralized borrowing, by subordinating other forms of debt and providing insurance to assure creditors that debts to them will be serviced, could potentially provide the sovereign borrower significant market access, and possibly at terms consistent with medium-term viability, especially at times of financial stress and when overwhelming uncertainty restricts other forms of market access. Care and restraint is, however, required in their use since the costs that such borrowing will impose on the sovereign borrower could be significant.

In an unsecured sovereign bond issue, market access and spreads are determined by the level of confidence that investors have in the country's underlying policies and prospects, thus exerting crucial market discipline.20 Collateralized borrowing can, however, weaken the link between the availability of finance and the quality of policies, as investors are assured of payment regardless of the policies pursued by the government. This weakens the incentives for sovereigns to adhere to appropriate policies, thereby eroding the quality of unsecured credits. Also, to the extent that such borrowing subordinates other forms of debt, it could increase the costs of unenhanced borrowing. Furthermore, since collateralized debt is effectively unreschedulable, it limits a country's room for maneuver in the event of future payment difficulties. In addition, the successful use of collateralized instruments by one emerging market sovereign to regain market access may lead to a proliferation of their use, including by other emerging market borrowers, as investors seek deals with similar security, thereby widening the scope of a potential financial crisis as debt structures become more inflexible.

Finally, by reducing the net exposure of the private sector to sovereign risk, collateralized borrowing also runs counter to the efforts of the international financial community to involve the private sector in the resolution of crises, while in light of their role in creating less flexible debt structures, they could be inimical to the efforts of the international community in encouraging a wider use of financial instruments that can facilitate a restructuring of sovereign debt in extreme circumstances.

Concluding Remarks

Emerging market sovereigns may face significant risks in relying on debt issuance denominated in foreign currency. Therefore, prudent sovereign debt management practices would limit additional risks that arise from borrowing using debt instruments that create, among other things, inflexible debt structures and further shift risks to the sovereign borrower. A number of alternative debt instruments, including augmentations and those embedded with risk diversification features, such as warrants, can potentially provide emerging market borrowers with access to capital markets without posing significant costs and can allow debt-service payments to be countercyclical, thereby contributing to the maintenance of economic and financial stability. Some debt instruments, including bonds with put options and collateralized instruments, however, can pose significant risks (and costs). Hence, emerging market sovereign borrowers need to develop appropriate policies to assess risks associated with borrowing using alternative financial instruments prior to using them to maintain access to capital markets, both during normal market conditions and at times of financial stress.

The term alternative financial instruments is broadly defined to capture various debt instruments (bonds and loans) other than new “plain vanilla” bonds and regular (unenhanced) loan issues used by emerging market sovereigns.

The analysis focuses on sovereign borrowing (including the public sector) since the discussion of the role of innovations is intertwined with issues relating to sovereign debt management strategy and private sector involvement in the resolution of crises.

See the IMF's “Involving the Private Sector in Forestalling and Resolving Financial Crises—Background Paper,” available at http://www.imf.org/external/pubs/ft/series/01/index.htm

A key conclusion that has emerged from earlier discussions of the role of alternative debt instruments is that there is a potential for greater risk shifting, but at the same time, a concern that such instruments could burden emerging market sovereigns with an excessively rigid debt structure—an issue that comes back to haunt when the sovereign faces a financial crisis.

Risk diversification refers to linking debt-service costs to the underlying ability to pay.

Recently, South Africa augmented by $250 million one of its global bonds—in the wake of pressures on the Rand, one could interpret this as a “testing of the waters” for market access.

Augmentations of this sort, which Argentina and others have used, are called “reverse inquiries.”

EMBI spreads increased sharply in 1999 to average 1,032 basis points, while in 2001, spreads averaged 890 basis points.

Reflecting some of the benefits accruing from a well-developed yield curve, there has been a proliferation of augmentations of debt denominated in U.S. dollars relative to debt denominated in other currencies.

For augmentations to be viable, some minimum number of bonds of an appropriate maturity need to be outstanding, while the bond documentation needs to incorporate a tap feature that allows the size of the issue to be increased at the discretion of the debtor.

A bond can have several steps (e.g., some older Brady bonds had numerous steps). However, the recent sovereign emerging market bonds generally have only one step.

Refers to borrowing solely by the central government. They continue to be used, however, by quasi-sovereign borrowers.

Such options would be exercised when they are “in the money”—that is, in circumstances in which the secondary market price of the underlying debt instrument (identical in every respect except for the absence of the put option) is below the put price (usually par).

If there is a need to restructure the issued bond before the exercise date, it seems clear that the warrant would be worthless and hence be ignored from the standpoint of pricing the restructured instrument.

The absence of sufficient liquidity among other things affects adversely the fair pricing of warrants.

Since their inception in 1983, structured notes rapidly increased in volume globally and, including secondary structured notes, amount in notional terms to more than $300 billion. With maturities ranging anywhere from three months to as long as 10 years, structured notes have been mostly denominated in U.S. dollars and issued by corporations, financial institutions, including banks, specialized government agencies, sovereigns, and multilateral institutions, such as the World Bank. U.S. government agencies are among the largest issuers of structured notes, and the most active of these agencies are the Federal Home Loans Banks (FHLB).

The technique was first used in an emerging market context by Telmex in 1987 to borrow against its net long-distance receivables from AT&T.

MBIA-Ambac is nearly the sole supplier of bond insurance for emerging market debt, having guaranteed over $3 billion, including $1.75 billion of PEMEX‘s’ oil-backed issue.

Between a bond embedded with a step-down feature and a plain vanilla bond, the choice for the sovereign is basically the same, except that with the plain vanilla bond the yield curve can be augmented, while with the step-down the new instrument can simply merge with an existing bond. Hence, the trade-off is between a better-defined yield curve and a more liquid benchmark-like bond (the merger of the new bond and the existing one).

This approach is mirrored in the IMF (and World Bank) policy of not demanding collateral for use of resources, but instead looking to the quality of macroeconomic and structural policies to provide “collateral.” Collateralization may also raise a “safeguard” issue for international financial institutions since the earmarking of assets could affect the capacity of a sovereign debtor to service its financial obligations to them.

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