Euro Area Sovereign Bonds: CACs or no-CACs?
Mitu Gulati and Mark Weidemaier
Beginning January 1, 2013, Euro Area authorities required member countries to include “collective action clauses,” or “CACs,” in sovereign bonds with a maturity over one year. CACs are a voting mechanism by which a bondholder supermajority (e.g., 66.67% or 75%) can restructure bond terms in a vote that binds dissenters. Before 2013, the vast majority of sovereign bonds issued by Euro area countries not only lacked CACs; they essentially said nothing about restructuring. For much more on CACs, European and otherwise, see here, here and here.
Because of this policy change in 2013, almost every Euro Area sovereign has two sets of bonds outstanding: CAC bonds and no-CAC bonds. Is either type of bond safer for investors to hold in the event of a restructuring?
Italy just slipped into recession and has a gargantuan debt stock. Lorenzo Codogno, former chief economist at the Italian finance ministry, sees a crisis around the corner. To quote him (via the Guardian):
“All the leading indicators suggest the first quarter of the year will be as bad as the last, and the second quarter will be flat. It’s likely things will pick up from there, but even then, it will mean the economy finishes the year in a weak position”
If Italy or another Euro Area country needs to restructure, the difference between CAC and no-CAC bonds will become important. As an initial matter, it is tempting to think that the no-CAC bonds protect investors from restructuring, because these bonds implicitly give each bondholder the right to veto a restructuring of the bond. To be clear, the no-CAC bonds don’t actually say that investors have this right--the bonds say nothing at all--but this isn’t an unreasonable interpretation. But even if so interpreted, it isn’t clear that the no-CAC bonds really offer more protection. The reason is that almost all of the bonds—CAC and no-CAC—are governed by the local law of the issuing sovereign. And the sovereign can change that law to facilitate a restructuring. (For discussions of the local-law advantage, see here and here.)
The crucial question, then, is whether CAC and no-CAC bonds differ in terms of the protection they offer investors against changes to local law. It seems to us that this question depends on the answer to a number of other, subsidiary questions:
First, when the bond is governed by the issuing sovereign’s law, to what extent do CACs protect investors against adverse changes to this law? We previously wrote about this question when considering the risk of currency redenomination. Our question then was whether CAC bonds, which also require a super-majority vote to change the currency of payment (see the definition of “reserved matter”), protect against redenomination risk. This question may prove important in the event that Italy’s financial situation worsens. To broaden our focus beyond redenomination, perhaps CAC bonds give investors some meaningful protection--though hardly complete immunity--from changes to the governing law.
Second, when a bond includes a CAC, must the issuing government use it? Or can the government restructure via some other method (such as imposing a restructuring by fiat via a change to local law)? If the former, CACs would offer investors more protection. We’d expect CAC bonds to trade at higher prices (lower yields) than no-CAC bonds, because they are safer.
Third, do no-CAC bonds in fact give each investor the right to veto a restructuring that would affect their bond? As noted above, we think this is a reasonable interpretation, but there is no clear answer as yet. We suspect this is how many investors understand the bonds, and it corresponds to what many Euro Area policy makers thought about the mandate. (For reports on interviews, see here.)
Euro Area authorities have said very little about how the new CACs will work in a restructuring. Perhaps they do not want to give any indication that another restructuring is in the works. (The official line is mostly that there will never be another debt restructuring in the Euro Area and any question that implies otherwise is terribly stupid.)
Several research papers recently examine the CAC vs. no-CAC question in the context of local-law Euro Area bonds. The papers are by a group of researchers at the ESM, (Picarelli, Erce & Jiang - here), a group from the ECB and the Central Bank of France (Steffen, Grund & Schumacher -- here), and by a group of academics (Carletti, Colla, Ongena & Gulati - here). The papers all use somewhat different datasets and empirical strategies. But the bottom line is the same every time. CAC bonds are viewed by the market as less risky.
These studies, however, don’t give a definitive answer as to whether CAC bonds are safer, and they certainly don’t explain why they would be safer. Leaving aside suspicions about whether markets price legal risk efficiently, we are still looking for a coherent legal theory to explain why local-law CAC bonds offer more protection than local-law no-CAC bonds. If there is an Italian debt restructuring, this question will play a central role.
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