State-owned corporate bonds: there is no such thing as an implicit guarantee

A couple of weeks ago, state-owned International Bank of Azerbaijan (IBA) shocked its bondholders by announcing a surprise restructuring. The bank’s capital ratio turned negative at year-end 2016 due to large currency losses as a result of the depreciation of local-currency Manat (AZN). The International Bank of Azerbaijan bonds (IBAZAZ) 5.625% 2019 bonds were trading above par and dropped by 15 to 20 points on the news.

I watched the investor Q&A session hosted by the company, its restructuring advisor and the Minister of Finance of Azerbaijan himself. Some bond investors seemed surprised that the government of Azerbaijan backed the restructuring of a state-owned entity and did not provide additional support. For background, the government in the past couple of years provided strong support by both injecting a lot of equity in the company and creating a bad bank to clean up a large portion of problem loans. Apparently, it was not enough to fix the balance sheet issues of the largest bank in the country and the company is now proposing to exchange existing bonds into new sovereign debt or newly issued IBA bonds, at a haircut estimated at about 20%.

Sadly it’s not the first time that investors look at a state-owned (also called quasi-sovereign) bond with a view that the government will provide unconditional support (misleadingly called “implicit guarantee”) to the state entity regardless of the standalone corporate fundamentals and despite no legal government guarantee whatsoever. In 2009, the state-controlled Dubai World conglomerate ran into financial trouble and the government of Dubai clearly stated at this time that it had no legal obligation to financially support the company, adding that: “the lenders should bear part of the responsibility”. What was seen as a safe quasi-sovereign investment finally resulted in a painful and lengthy restructuring of the debt for bondholders.

We, bond investors, must make sure we carefully examine bond documentation to assess whether or not we are invested in a bond (“explicitly”) guaranteed at the sovereign level, i.e. with an “unconditional and irrevocable” guarantee in case of defaults. The problem is that the investor community often mixes a guarantee with likelihood of government support. The former is a legal obligation. The latter has nothing to do with a guarantee; it is merely an assessment of the ability and willingness of a government to provide support and how much bond spreads investors are willing to leave on the table when buying these bonds. Either a bond is guaranteed by its sovereign or it is not. There is no such thing as an implicit guarantee, just a likelihood of government support.