Citigroup Warns of Restructuring on Local Debt: Argentina Credit

Argentina’s plummeting foreign reserves are a sign to Citigroup Inc. that the least-creditworthy borrower in emerging markets may decide to impose losses on bondholders of $5.8 billion of debt.

Dollar-denominated bonds due in 2015 and sold under Argentine legislation have risen to a 17-month high of 95.39 cents as investors switched from notes governed by New York law on speculation the local debt will be insulated from holdout creditors suing in U.S. courts. Citigroup says bondholders, which include AllianceBernstein LP and MFS Investment Management, are underestimating the risk of losses after reserves that are used for debt payments fell at the fastest pace in more than a decade to a six-year low of $37 billion.

The probability that Argentina, which defaulted on $95 billion in 2001, will seek debt relief by either paying holders of the local-law bonds in pesos at the official rate, offering a smaller amount in dollars, or swapping them into notes with longer maturities means that fair value is closer to 87.2 cents, according to Jeff Williams, a strategist at Citigroup. The New York-based bank estimates the central bank’s reserves will fall below $25 billion by the end of 2015.

“Things are moving in that direction,” Jorge Piedrahita, chief executive officer at Torino Capital LLC, said in a telephone interview from New York. “This is a risk investors should definitely be considering. It’s a significant possibility and those probabilities are increasing day by day.”

Capital Outflows

Citigroup’s Williams estimates that the likelihood Argentina will restructure the 2015 bonds is now 37.5 percent, according to a report to clients dated Aug. 9.

Norma Madeo, a spokeswoman for the Economy Ministry, declined to comment on whether Argentina is considering restructuring the local-law notes.

AllianceBernstein, MFS and Fidelity Investments are among holders of the 2015 notes, according to June 30 filing data compiled by Bloomberg.

With investors demanding an average 13 percent to hold their dollar-denominated notes -- the highest in emerging markets -- Argentina hasn’t sold bonds internationally since its 2001 default.

Argentina relies on its international reserves to make debt payments, including those to bondholders that agreed to take 70 percent losses in two restructurings in 2005 and 2010.

Default Swaps

Argentina already has the highest probability of default in the world, according to five-year credit-default swaps. The contracts that protect holders of the nation’s debt against non-payment rose two basis points to 2,371 basis points at 4 p.m. in New York, according to data compiled by CMA Ltd.

Since her re-election, Fernandez has tightened restrictions on access to foreign currency after the nation lost $21.5 billion in capital outflows in 2011. Still, reserves have continued to drop at the fastest pace since the default.

During its financial crisis over a decade ago, Argentina converted dollar deposits and loans into pesos, a move dubbed pesofication. In June 2012, speculation lawmakers were planning to convert dollar-denominated contracts into pesos pushed the yield on the bonds due 2015 to a three-year high of 21 percent.

Four months later, the northern province of Chaco repaid its dollar-denominated bonds in pesos because the central bank denied its request to buy foreign currency.

‘Legal Risk’

A U.S. appeals court said Oct. 26 Argentina can’t make payments on its overseas bonds unless it repays holdout investors from the country’s default. The ruling pushed the yields on New York-law bonds above those on Argentine-law debt, which isn’t affected by the ruling, for the first time ever. Before then, local-law bonds due 2017, known as bonars, yielded an average 1.67 percentage points more than similar-maturity bonds sold under New York law.

“All eyes shifted to the legal risk, but the underlying risks of a potential restructuring on the Boden 15s and Bonar 17s has not disappeared,” Citigroup’s Williams wrote in the report. “If anything those risks are now greater.”

Citigroup estimates by the end of 2015, the central bank’s net reserves, which exclude dollar deposits, could fall to $12.5 billion and cover just two months of import demand.

If a restructuring were to occur today, investors could lose half of their principal should the government decide to repay them in pesos at the official exchange rate, Williams wrote. Investors would be left having to buy dollars in a parallel market, where the peso could be as much as 53 percent weaker than in the official market due to restructuring concerns, he wrote. The dollar cost 5.5510 pesos in the official market and 8.5056 pesos in the parallel market at 4:30 p.m. in New York.

‘Better Jurisdiction’

The government has an incentive to stay current on its local law bonds if it is ultimately prevented from making bond payments on New York law bonds, according to Steffen Reichold, an economist at Stone Harbor Investment Partners LP. The appeals court is now deciding if Argentina must pay holdouts in full, which the country has vowed never to do, and if third parties should be barred from distributing payments.

“They would want to make the case that Argentina is a better jurisdiction for bonds than the U.S. is,” Reichold, whose firm oversees $60 billion in assets including Argentine bonds, said in a telephone interview from New York. “They would love to make that political statement and that investors are better off holding local law than being subject to some jurisdiction which delivers questionable rulings.”

For investors in Argentine government bonds, it’s become impossible to find a haven, according to Russ Dallen, head bond trader at Caracas Capital Markets in Miami.

The push into local law bonds is “meant to make Argentina investments immune from any adverse U.S. court ruling,” Dallen said in an e-mailed response to questions. “At the same time, sadly, it makes them more susceptible to the vagaries of Argentina’s shifting needs and policies.”

Before it's here, it's on the Bloomberg Terminal.