Unwarranted restructuring November 30, 2010 at 8:17 am

Prisoner of Restructuring

Brendan Moynihan (no, not Brian Lenihan) has an interesting suggestion for Eurozone debt restructuring on Bloomberg:

European countries should reduce the principal amount they owe by issuing gross domestic product-linked sovereign bonds as an incentive to creditors to take a haircut on the debt. Bondholders would accept, say, 70 cents on the dollar on their bonds and receive new debt paying the German bund rate and with a warrant that pays a coupon tied to the amount each country‚Äôs respective GDP exceeds, say, 2 percent. The warrants could have an assigned value at inception — based on a long-term call option on GDP — and be detachable and traded separately.

This is like a debt-for-converts swap. Existing bond holders are offered new bonds plus the warrants. If the warrants are long dated enough, you can reduce the principal sufficiently that the burden of payment drops signifcantly. A 30% haircut, as Brian suggests, is perfectly possible.

The problem, though, is that the warrants would be really attractive to hedge funds only if they were hedgeable, and you can’t short GDP easily. I wonder if inflation is a reasonable proxy. If instead the warrants paid out based on ten year cumulative inflation, then dealers could hedged using inflation-linked bonds, and the effect might be similar. This would also likely have the desirable side effect of making the linker market more liquid and hence decreasing linker issuer costs for governments. (I have not had time to look at inflation volatility and price up the option, but given the forward inflation curve is quite steep I imagine the maths could be made to work.)

Update. I couldn’t resist pricing up the warrant (which in itself wasn’t easy – you have to think hard about the replicating portfolio to get the right answer), and with a plausible HICP vol a 2% strike 10 year inflation warrant does indeed come out as being worth 30%. So the trade described above passes at least the first sanity check…

3 Responses to “Unwarranted restructuring”

  1. Would you mind expanding a bit on how you priced these warrants? I’m pretty curious about this.

  2. I treated it as a quanto option in the manner of the Jarrow-Yildirim model – real and nominal rates are correlated one-factor stochastic processes. Vols were derived for real rates via HICP caps. (HICP is lognormally distributed under the nominal measure in this setting so pricing is straightforward once you have calibrated.) A (slightly) better approach would be to use a Hull and White 2 factor model incorporating mean reversion. Search on ‘Jarrow Yildirim’ for more details.

  3. Thanks David!