Sri Lanka, which defaulted on its foreign debt in May 2022, has received a proposal from its private creditors to restructure $12 billion of overseas bonds, according to two sources with direct knowledge of the matter. The proposal includes a new type of bond that would reduce interest payments if the country fails to meet certain economic targets.
A haircut on capital and interest
The proposal, which was sent on Oct. 2, provides a write-down, or haircut, on both capital and interest of the existing bonds, the sources said. They declined to be named because the talks are private.
The haircut would vary depending on the option chosen by the creditors, who hold about 70% of the outstanding bonds. One option combines regular sovereign bonds with a new instrument called Macro Linked Bonds (MLBs), while another option offers regular bonds with a Value Recovery Instrument (VRI).
The MLBs are designed to ease the debt burden in case of future economic pressure. They would automatically lower coupon payments starting in 2027 if Sri Lanka fails to meet some of the economic targets linked to its International Monetary Fund (IMF) programme.
The VRI, on the other hand, would provide an upside potential for creditors if Sri Lanka’s economy performs better than expected. It would pay additional interest based on a formula that takes into account the country’s growth rate and debt level.
A first-of-its-kind bond
The MLBs are a novel feature in the debt restructuring proposal. They would be the first time such step-down bonds are being used in a debt restructuring, the sources said.
The trigger of the step-down payments on the MLBs would be linked to indicators such as Sri Lanka’s gross financing needs (GFN) to gross domestic product (GDP) ratio and debt to GDP ratio, one of the sources said.
If the GFN/GDP ratio rises above 4.5% in 2027, coupons will adjust downwards, the source added. The GFN/GDP ratio measures the amount of money the government needs to borrow or refinance in a given year relative to the size of its economy.
The MLBs were included to ensure the new instruments would be index eligible, the sources said. Bonds included in an index generally have more liquidity and demand from investors.
A crucial step for Sri Lanka
The proposal would be a crucial step for Sri Lanka, which is facing its worst financial crisis since independence from Britain in 1948. The country of 22 million people tipped into its first foreign debt default in May 2022, after a severe shortage of dollars and a sharp depreciation of its currency.
The default triggered rating downgrades, capital flight and legal action from some creditors. It also jeopardized Sri Lanka’s access to international markets and foreign aid.
In March 2023, Sri Lanka secured a $2.9 billion IMF bailout to stabilize its economy and restore market confidence. The IMF programme requires Sri Lanka to provide assurances of debt restructuring from bondholders and key bilateral lenders including China, Japan and India.
The restructuring proposal is based on parameters from the debt sustainability analysis that the IMF produced when it agreed the programme for the battered economy. A copy of the proposal was also sent to the IMF and the Paris club secretariat, one of the sources said.
Bondholders and the government remain in discussions through financial and legal advisers, so they are still not restricted to trade the country’s securities.
