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Defusing Global Bond Risk

A new form of coverage for debt securities is starting to make offerings in Third World hot spots less explosive.

In the 1980s and ’90s, companies looking to launch a bond offering in an emerging market were often hamstrung by their inability to protect institutional investors from the kind of political shocks that had become all too familiar. While political risk insurance (PRI) did exist, it was available mainly to the corporations and banks making loans in less-stable countries, and not in the more complex world of corporate bonds.

But lately, a PRI product for corporate debt securities in political hot spots has been catching on, in a form devised by Washington, D.C.-based Overseas Private Investment Corp. (OPIC). Others have taken notice, and PRI is now being offered, to good reviews, by several private insurers and two other U.S. public agencies.

Historically, PRI coverage for lenders has proven quite useful. Over the past 20 years, there have been more than 150 instances of emerging-market countries restructuring their debt, often interrupting loan payments. From mid-1994 to mid-1996, for example, Venezuela imposed foreign currency controls that disrupted numerous deals. And in 1998 came Russia’s moratorium on the payment of its private external debt, and Malaysia’s restrictions on converting local currency into dollars.

Those last two events triggered the final collapse of confidence in uninsured investments within risky nations, and led to “the drying up of emerging markets for commercial corporate bond issues,” says OPIC president George Muñoz. So, “after the Russian and Malaysian interventions,” he says, “the bond rating community started asking questions about political risk insurance.”

Specifically, bond raters sought a way to reopen those markets to investment by neutralizing the risk created by uncertain government monetary policies. In response, OPIC, an independent agency of the federal government that sells investment services to U.S. businesses around the world, analyzed the situation and “came up with a tool that surgically removes the risk from these investments,” says Muñoz.

A Closed FX Window

The surgery was in the form of PRI designed especially for the bond market, and aimed primarily at easing worries about monetary convertibility and transferability–the risk that a local government might restrict the conversion of its currency into dollars (or be unable to convert the currency), or that it might refuse to let dollars leave the country. When either convertibility or transferability is restricted, a firm that has sold its bonds in an emerging-market country suddenly finds itself strapped for dollars and unable to pay the bondholders.

“Inconvertibility and nontransferability are like closing the window for foreign exchange,” says Rick Jenney, a former assistant general counsel at OPIC and now a partner with Morrison & Foerster, a Washington, D.C., law firm that specializes in PRI. “It’s all about the supply and demand for hard currency.” What OPIC did, he says, was to perform “the role of the [emerging nation's] central bank when the central bank wouldn’t, or couldn’t, do it.”

The hedge that PRI creates, though, relates only to deterioration due to political events, he notes, and not market forces. And the insurance protects firms against currency devaluation only if a prior contract exists that calls for payment at a particular exchange rate. “The devaluation risk is with the [borrowing company], not the bondholders,” says Jenney. “The coverage is specifically against political risk, not commercial risk.”

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