Pakistan’s weird bond premium

Mark Weidemaier and Mitu Gulati, of the University of North Carolina and University of Virginia Law Schools, host the Clauses and Controversies podcast and often teach a joint course on sovereign debt.

Several months ago, an email from a credit analyst prompted us to start looking at the terms of Pakistan’s sukuk bond, which matures in 2029. We are not specialists in Islamic finance, but the bond was trading at small premium over Pakistani eurobonds. The Pakistani sukuk is not technically issued by the sovereign but is essentially a sovereign credit. We assumed the price difference was due to some temporary difference in liquidity.

Pakistan’s debt crisis has steadily worsened. As happens near default, prices reflect expectations of recovery in a default scenario. No sovereign sukuk has ever been restructured before but, as the chart below shows, the market seems to think that the sukuk will get a higher payout than the eurobonds.

Why? Most international securities issued from 2014, including Pakistan’s, have aggregated collective action clauses. These clauses allow the eurobonds and the sukuk to be restructured together on essentially the same economic terms. Instruments that expect the same deal should trade the same. Yet, they do not. Is there something about Pakistan’s 2029 sukuk that makes it difficult to aggregate with Pakistan’s multiple outstanding eurobonds?

Sovereign sukuk have been around for at least two decades but remain a small corner of the sovereign debt world. We haven’t seen any published discussion of how a restructuring might aggregate sukuk and eurobonds. But the terms of the bonds would seem to allow this.

We’ll focus on the 2029 sukuk and the 2031 eurobond.

The legal provisions of both the sukuk and the eurobond allow the securities to be restructured in an aggregated fashion along with other “Debt Securities Capable of Aggregation.” (The sukuk omits the word “debt”). The term is defined as follows:

[Debt] Securities Capable of Aggregation means those securities which include or incorporate by reference this Condition 15 and Condition 16 or provisions substantially in these terms which provide for the securities which include such provisions to be capable of being aggregated for voting purposes with other series of securities.

Conditions 15 and 16 are identical in the sukuk and the eurobond. Nor is there a difference stemming from the fact that the sukuk refer only to “securities” rather than “debt securities” (since the payment of interest is not allowed for the sukuk). In both cases, the term encompasses sukuk and eurobonds issued directly or indirectly by Pakistan. Here is the relevant text from the eurobond:

Any reference to debt securities means any notes (including the Notes), bonds, debentures or other debt securities (which for these purposes shall be deemed to include any sukuk or other trust certificates representing the credit of the Issuer) issued directly or indirectly by the Issuer in one or more series with an original stated maturity of more than one year.

The provision in the sukuk is functionally the same. It omits “debt” and substitutes “Trustee or Government” for Issuer, but the meaning appears identical. Sukuk are different from eurobonds in many respects, but their aggregation provisions seem to be the same. And, if aggregated via the collective action clause, the eurobond and sukuk must get equivalent treatment. That leaves us with the premium puzzle that we began with.

We can imagine at least three explanations for the pricing difference. The explanations are distinct but related; more than one might be in play.

1. The fact that the sukuk and the eurobonds can be aggregated does not mean that they will be. If the holders of the sukuk are better organised and co-ordinated, they could more effectively hold out. Knowing that, it might be in Pakistan’s interest to leave them out of the restructuring and pay them in full. Of course, the market would also have to understand this dynamic and to have information about who has invested in the sukuk.

2. Sukuk investors might be affinity investors — perhaps influential domestic parties. If so, maybe Pakistan would want to offer them a special deal. But that will be controversial given current drama about equal treatment in sovereign restructurings. Whatever special place sukuk have in the heart of the Pakistani government, it is hard to see the IMF, China, the Paris Club or bondholders agreeing for them to get special treatment.

3. Perhaps the sukuk market is slower to incorporate pricing information. If sukuk investors generally buy and hold – perhaps most are Middle Eastern sovereign wealth funds – and rarely sell to distressed debt investors, sukuk pricing might be slower to incorporate information about default. That would especially be true if trading by distressed debt funds is what causes price movements in the eurobond market.

Whatever the explanation, the growing market in sukuk means that these issues will come up more and more frequently in sovereign restructurings. And over time, it is hard to believe that sukuk will consistently receive better treatment. But if Pakistan does have to restructure, as seems increasingly likely, we will get an early preview. Someone is going to get a rude surprise.