Important Innovations in Sovereign Finance: the Arrival of Macro-Linked Bonds (MLBs) and Governance-linked Bonds (GLBs)

The Macro-Linked Bonds and Governance Linked Bonds introduced in the context of Sri Lanka’s recent debt restructuring include important innovations that significantly enhance the utility of state contingent debt instruments as a means of both accelerating the restructuring process and reducing the risk of future debt distress.

Preliminary indicative results provided by Sri Lanka on December 13, 2024 in respect of the outcome of its Consent Solicitation and Invitation to Exchange in respect of Sri Lanka’s existing Eurobonds provide massive evidence of the broad market acceptability of these innovative financial instruments engineered and proposed to Sri Lanka by the Steering Committee of international bondholders advised by Rothschild & Co.

A. Introduction

State-Contingent Debt Instruments (SCDIs) have long been recognized by policymakers , academics and market participants as a useful countercyclical and risk-sharing tool that can give issuers more fiscal space, reduce the risk of sovereign default and diversify opportunities for investors.

Notwithstanding these benefits, the actual take-up of these instruments in “normal times” has been undermined by a number of practical issues, including “novelty” premia, liquidity concerns and adverse selection. Rather, it is in the sovereign debt restructuring context that SCDIs have become more widely accepted. In particular, they have become a useful way of bridging debtor and creditor assessments regarding the sovereign’s future debt servicing capacity. They were initially relied upon as a means of implementing the Brady Plan (starting with Mexico US$49 billion debt restructuring in January 1990) and, since then, have been designed with a variety of features generally contingent upon GDP or Commodity Prices evolution. As is illustrated in Table 1, they can generally be split between a) Debt Service Adjustment prospect (Upside for creditors, Deferral for the benefit of issuers, Downside protection for issuers), b) Nature of the Instrument (Warrant vs Bond), and c) Trigger Variable (Commodity Prices, GDP or Natural Disaster).
Notwithstanding the relative frequent use of SCDI instruments in the debt restructuring context, there have been important limitations with respect to their design and implementation. In particular:

Index eligibility – The instruments that have generally been used to deliver contingent upside benefits to creditors have been Value Recovery Instruments (VRIs), which are triggered by GDP or commodity prices indexation formulas. These instruments, detachable (Warrant) or embedded in the bonds contracts, have not been eligible for inclusion in the major emerging market bonds indices because they involve continuous adjustments of debt service payments; they are therefore not considered “fixed income” instruments under the definitions used by these indices, but rather “equity-like”. An important consequence of this ineligibility is that these instruments cannot be held by institutional investors. This significantly impairs their utility in the debt restructuring context given the fact that these institutional investors typically own the largest portion of the bonds to be restructured. Just as importantly, these investors have historically played a constructive role in the restructuring process, having an interest in an orderly and rapid restructuring that returns the sovereign debtor to sustainability.

The need for symmetrical adjustment – With the exception of Barbados and Grenada (see Table 1), adjustments regarding the level of debt relief to be provided have been exclusively for the benefit of creditors; namely, the level of debt relief has been reduced if the macroeconomic outcomes are more favorable than anticipated under the IMF’s Debt Sustainability Analysis (DSA). While this approach has served to facilitate negotiations between the sovereign and its creditors, it does not address the risk of renewed debt distress that will arise if the outcomes are, in fact, more adverse than those projected under the IMF’s DSA. Given the very long time periods that are the subject IMF’s DSA projections and the accordant uncertainty that they create, these risks are significant. The inclusion of an adjustor that increases the level of debt relief to be provided by creditors in a more adverse scenario would not only address this risk but would, from a political economy perspective, make it easier for the government to present the overall package as being fair and for the benefit to the country.

B. The Macro-Linked Bonds used in the case of Sri Lanka

On 13 December 2024, the Democratic Socialist Republic of Sri Lanka announced the successful indicative results of its Consent Solicitation and Invitation to Exchange Offer for the restructuring of its International Sovereign Bonds (ISBs) totaling approximately US$12.55 billion, reaching a participation rate of approximately 96%. As a result of this Exchange Offer, and after giving effect to collective action clauses (CACs), all eligible holders of Sri Lanka’s existing ISBs will receive a package of new restructured securities.

These new instruments include Macro-Linked bonds, which were first conceptually discussed with the IMF staff during the 2023 IMF/WB Spring Meetings and subsequently officially proposed to Sri Lanka by the Steering Committee of the Ad Hoc Group of Sri Lanka Bondholders during the 2023 Annual Meetings in Marrakesh as a novel type of SCDI, to address the two deficiencies identified above. First, the MLBs are expected to be included in the main bond indices, by relying on a single test (discrete adjustment) with a pre-determined range of outcomes, thereby limiting uncertainty for both the investors and the sovereign debtor. Second, they provide for quasi symmetrical upside and downside adjustments, thereby balancing risks and rewards for both the sovereign debtor and its creditors. The MLBs therefore represent the closest market adaptation so far of the concept of GDP-Linked bonds introduced in 1993 & 2003 by Nobel Prize Laureate Robert Shiller.

Design of Adjustment Mechanism - Consistent with the July 2022 IMF Sovereign Risk and Debt Sustainability Framework (SRDSF) which replaced the Debt Sustainability Framework for Market Access Countries methodology, the key debt sustainability ratios underpinning the DSA for the IMF 2023 Program with Sri Lanka consist of Gross Financing Needs/GDP and Debt/GDP, both of which are obviously affected by US$ GDP growth volatility. If Sri Lanka’s growth underperforms relative to the baseline underpinning the IMF program period, payments under the MLBs starting in 2028 will be reduced through additional principal haircuts. Conversely, if Sri Lanka’s economy performs better than anticipated under the IMF program, payments linked to the MLBs after 2028 will increase through a combination of capital reinstatement and higher coupons, within limits respecting the two key DSA ratios until 2032.

For purposes of implementing the above adjustment, the country’s performance will be assessed on the basis of the 2025-2027 average USD nominal GDP, along with an additional control variable measuring cumulative real GDP growth from 2024 to 2027. This additional test ensures that the MLBs are linked not only to nominal GDP growth but also to real GDP growth, thus preventing higher debt service solely due to an appreciation of the Sri Lankan rupee (LKR).

Amount of Debt Relief - Under the IMF baseline, it is expected that Sri Lanka will benefit from an upfront debt stock reduction (Principal & PDIs) of approximately $3.6 billion, which could increase up to a maximum of $5.2 billion in case of an economic downturn (i.e. $1.6 billion additional debt stock relief) or decrease to a minimum of $2.2 billion if Sri Lanka’s economic performance exceeds the anticipated IMF projections (i.e. $1.4 billion reduced debt stock relief). More precisely:

• During the IMF program, Sri Lanka will achieve a $9.5 billion debt service payments reduction, thanks to a reduction by half of the average coupon rate of Sri Lanka's Bonds over this period, combined with an extension by approximately 5 ½ years of their average maturity. This translates into holders of the ISBs consenting to a present value concession of 37% (as a percentage of the original claim) in the IMF baseline scenario, calculated with an exit yield discount factor of 11%.
• In the event of an adverse scenario materializing where GDP would fall below Threshold #2 under the IMF baseline, the aggregate present value concession would increase to 44%. Put otherwise, bondholders will provide an additional debt service reduction totaling $2.1 billion over the remaining life of the MLBs in case of an adverse shock.
• In respect of the highest MLB threshold (resulting from the most significant economic outperformance), bondholders' present value concession will amount to 28%. It should be emphasized that, under all of the above scenarios, the two key DSA ratios will be largely met by a comfortable margin, helping Sri Lanka to achieve long term sovereign debt sustainability and hasten the country’s economic recovery and return to international capital markets.

C. Governance Linked Bonds

It is also worth noting that Sri Lanka’s debt restructuring includes a separate and also innovative SCDI: the Governance-Linked Bond (GLB). Under the terms of the debt exchange, creditors opted to receive a bond that provided Sri Lanka with some debt servicing relief in the event that it satisfies certain governance-related objectives, namely (i) the level of government revenues to GDP in 2026 and 2027 and (ii) the annual publication of a detailed Fiscal Strategy Statement in line with the country’s new Public Financial Management Act. Specifically, the rate of interest on these bonds will be automatically reduced by a step-down margin of 75 basis points in the event that both the conditions are met in 2028. Within the broader realm of ESG instruments, the GLB is the first-of-its-kind to feature governance-related indicator (G), offering new opportunities for issuers and investors beyond environmental (E) and social (S) objectives.

The inclusion of this feature takes into account the degree to which governance vulnerabilities in Sri Lanka, unless adequately addressed, will undermine Sri Lanka’s economic performance going forward. Indeed, it is for this reason that governance and fiscal reform is a significant feature of conditionality under the IMF Reform Program. Importantly, the inclusion of a Governance Linked Bond represents a recognition among creditors that Sri Lanka’s growth prospects – and therefore its debt service capacity will be enhanced by meaningful reform in this area.

D. Conclusion and Implications

MLBs which were engineered in March 2023 and proposed to Sri Lanka by the Steering Committee of international bondholders in September 2023 constitute a new generation of SCDIs providing issuers and investors with symmetric upside and downside adjustments while ensuring index eligibility in light of their discrete adjustment mechanism. Although the duration for elaboration and negotiations of these instruments exceeded 18 months considering their innovative features coupled with the first roll-out country case under the IMF SRDSF, one can expect that this template will contribute to the desired acceleration of future sovereign debt restructurings negotiations.

GLBs originally conceptualized by Sri Lanka based think-tank Verite Research were also re-engineered and proposed to Sri Lanka by the Steering Committee of international bondholders in September 2023. They constitute the first G-bond in the ESG Bonds triangle and will likely be used by new sovereign issuers in Emerging and Frontier markets in the years to come.

Table 1 - List of State-Contingent Debt Instruments issued in restructuring context

(√) Index Eligible

(≠) Index Non-Eligible

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^{[1] See Managing Volatility in Low-Income Countries: The Role and Potential for Contingent Financial Instruments” (IMF/WB, October 2011), Policy Paper on “State-Contingent Debt Instruments for Sovereigns” (IMF, May 2017), Staff Discussion Note on “The Role of State-Contingent Debt Instruments in Sovereign Debt Restructurings” (IMF, November 2020)}

^{[1] See Borensztein and Mauro (2002) and (2004), Barr, Bush and Pienkowski (2014), Benford, Best, Joy and Kruger (2016), Bowman and Naylor (2016)}