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FTAV once heard a funny story about Uruguay's financial crisis involving Samurai bonds (offshore bonds issued by Uruguay denominated in Japanese yen).
Apparently, some German investors piled money into these bonds simply because they offered better yields than Uruguayan dollar-denominated bonds, even after hedging against different currencies. However, when the financial crisis hit and the solvency of many emerging markets came under scrutiny, Germans were left wondering what their legal protections were since all bond documents were written in Japanese. I panicked when I realized that no one knew. Confusion ensued.
This anecdote is completely in the realm of “too good to be true,” but it speaks to an unspoken truth about finance. Most investors don't actually read the details of what they're buying. That's understandable, given the boilerplate nature and insane length of modern bond prospectuses. And that's fine most of the time — Until it really isn't.
That's why this new paper by Stephen Choi, Mitu Gulati, Ugo Panizza, Robert Scott, and Mark Weidemaier caught our attention. Here's an overview:
Contract terms that improve or reduce the likelihood of debt repayment should affect the price of debt. That is the basis of economics. But what about contracts that are hundreds of pages long and contain long and complicated clauses that even lawyers don't want to read?
Believers in efficient markets believe that fluctuations that affect the likelihood of repayment in such ambiguous contract terms would have been priced in from the beginning if it were possible to profit from them. may be predicted. Another view is that little attention is paid to the fine print of highly standardized contracts until the likelihood of default becomes sufficiently salient that it is worth reading the fine print.
We use several contingent real-world experiments to examine the question of when and how variations that are assumed to be standardized with ambiguous contract terms are priced.
What makes this particularly interesting is that this study is based in part on two Alphaville posts written by several of the paper's authors, as well as a podcast on sovereign debt hosted by Gulati and Weidemaier.
These meetings discussed some strange clauses in some Ghanaian and Sri Lankan bonds that make restructuring easier (Ghana) or more difficult (Sri Lanka) than commonly assumed. I did. As the paper points out, this makes for an interesting natural experiment to examine whether investors actually read bond materials and what happens to bond prices when idiosyncratic aspects of a bond are publicly highlighted. connected.
Although we didn't think of it at the time, we inadvertently ran two pricing experiments and publicly announced the existence of unusual contract features that (we thought) contradicted the widely accepted view of bonds. I decided to do it. These presentations provided a potential way to assess differences between treatment and control bonds in Ghana and Sri Lanka.
The solid black line shows what happened with the Ghanaian bond in question.
This comes as Alphaville's post that the World Bank's partial guarantee may not actually be of much use as protection against restructuring suggests that investors may want to price Ghana's 2030 bonds in line with the rest of the country's debt stack. This indicates that this was the trigger for setting the price. Both bonds increased in value after the clause and controversy podcast, but the price of the control bond increased more than the price of the treatment bond.
Here's what happened to SriLankan Airlines bonds after discussing in a podcast and FTAV post how they were less vulnerable to restructuring than expected.
The paper notes that while some investors clearly read bond material, this is not always reflected in the price.
An extreme interpretation of the theories of efficient markets and efficient contracts shows that the landmines in the fine print of contracts should not exist. In the case of efficient contract theory, disciplinary pressures on highly compensated lawyers in competitive legal markets should result in very few instances of landmines on the scale we have described. And even if there are anomalies in the draft, the market must correct them through the pricing mechanism. In any case, contractual mines should not exist. Our serendipitous experiments suggest that they may exist.
The paper points out that these two examples are insufficient measures of how widespread inefficiency is. FTAV suspects they are a legion.
