It hides under the shadow of government protection, and has been growing rapidly. Sub-sovereign or quasi-government debt encompasses municipal debt, agencies, state-controlled banks and other entities.
To see its importance, look at Germany. According to IHSMarkit iBoxx data, there are about $1 trillion of federal German bonds, excluding short term debt. But when you include state banks such as KfW and regional issuers, this adds another $500 billion to the total.
As a rule of thumb, such debt should always be riskier than that of the equivalent sovereign. Rating agencies reflect this by notching sub-sovereign ratings down according to the level of support they expect governments to provide. This ranges from rock solid in the case of the UK, to more uncertain or unreliable, as in many emerging markets.
Investors typically agree. As we see with the Risky Finance sovereign tool, sub-sovereign issuers trade at slightly higher yields to their corresponding government. This difference can be very small as in the case of Germany’s regions or Canadian agencies, or larger when it comes to German state-guaranteed banks or Canada’s regions. The same story is observed in emerging markets too: sub-sovereign debt is invariably viewed as riskier than the sovereign.
But then we have the case of Argentina, whose foreign currency bonds are rated B- by S&P and Caa2 by Moody’s. Investors currently price these bonds at an average 50 cents on the dollar. Both rating agencies give an identical foreign currency rating to the city of Buenos Aires, but whose dollar bonds are priced at 99 cents. In other words, debt issued by the nation’s capital is valued at twice as much as that of default-prone Argentina itself.
Consider how sovereign restructuring works. For any government, central or local, making debt repayments is a matter of political will. Argentina has benefited from IMF generosity, but last October elected a new government determined to replace IMF-mandated austerity with a debt restructuring. Hence the low price of the country’s bonds.
Presumably this will involve some pain for the IMF as well as Argentina’s bondholders. But even if a majority of bondholders voluntarily agree to a restructuring, the price that Argentina will pay for such a concession is that it will be temporarily shut out of international bond markets. This ought to impact the regional issuers as well.
Of course, some regions in Argentina aren’t controlled by the governing political party, and don’t support the restructuring idea. For example, the City of Buenos Aires is still controlled by the previous government’s party, whose policy is to keep servicing international debt. Investors seem to think that the City will keep paying even if Argentina doesn’t. (The City should not be confused with the Province of Buenos Aires, which shares the central government’s view and trades at even more distressed levels than the sovereign)
And some parts of the country have payment flows that immunise them to some degree against the sharp currency declines which made dollar debt unsustainable. For example, Neuquen province in the far south west of the country contains much of the country’s oil, gas and mineral reserves – which can be extracted and sold in dollars.
Neuquen’s bonds trade at an average of 85 cents on the dollar, less than the City of Buenos Aires, but still significantly higher than Argentina itself. Similarly with the wine-exporting province of Mendoza which trades at 75 cents.
There are investors who don’t accept this narrative. They argue that if Argentina restructures, sub-sovereigns like Buenos Aires City or Neuquen would be shut out of the markets even if they want to keep paying on their bonds. Without any incentive to repay, it would be more rational for them to default as well.
Paul McNamara, who manages emerging market funds for GAM, articulates this view. “I find it very very hard to see these entities maintaining market access so the prices look illogical,” he says, noting that Argentina’s provinces defaulted a few years after the last sovereign default in 2001.
You can see McNamara has a point. A nation state should have a monopoly on relations with the outside world, including financial flows. If regions or cities can maintain capital market access in the wake of a host sovereign default, what is the point in them being part of the nation state in the first place?
And yet, Argentina with its chronic addiction to debt and default, may have pushed this thesis to breaking point. If a nation loses credibility, its parts are best viewed in isolation.