A backlash against governments using derivatives to borrow against their debt is gathering strength, after the IMF cracked down on a multibillion-dollar loan to Nigeria as risky and opaque.
The $5bn credit line, arranged through a “total return swap” between Nigeria and First Abu Dhabi Bank, has raised concerns at the fund and among rating agencies and investors about developing countries using these opaque mechanisms to take on new forms of debt.
They say the deals leave borrowers exposed to risks that are hidden from other lenders and conceal the true extent of their debt obligations. The Nigerian deal has become a lightning rod for such warnings after years of effort to make emerging market sovereign borrowing more transparent.
“The use of opaque borrowing has grown to a point where it presents a significant risk to that advancement, and the industry will respond,” said Samy Muaddi, debt portfolio manager at T Rowe Price. “To the extent these structures proliferate, there will be a Darwinian adaptation to respond to them.”
Total return swaps are agreements between two parties to swap returns on one asset for another. But they can be adapted by sovereigns to exchange their own bonds for cash, creating a collateralised loan.
They have previously been used by cash-strapped governments in Senegal and Angola to survive being locked out of international markets.
Nigeria is now set to draw down amounts from the $5bn credit line it signed earlier this year with the Gulf bank, despite easily being able to sell bonds at similar interest rates to those in the deal after receiving a series of credit rating upgrades.
Bondholders worry that more governments with market access will be tempted by the swaps. They are not counted fully in a country’s debt figures and carry obscure risks, such as being forced to pay cash in response to margin calls if the bonds fall in price, reducing their value as collateral.
The IMF has already begun putting pressure on one key accounting advantage of the swaps through its scrutiny of Nigeria’s deal, under which Africa’s most populous country has pledged $1.33 in naira-denominated bonds to back every dollar available to it under the deal.
Governments have generally opted to leave bonds used as collateral out of their overall debt figures, as they are technically kept in a frozen state with lenders.
But in a recent report on Nigeria, the IMF threw a spanner in the works by signalling that it would record as debt all of the nearly $6.7bn in bonds used as collateral in the Nigerian swap.
A spokesperson for the fund confirmed that “the IMF includes the full collateral in the debt stock for Nigeria”.
Nigeria’s finance minister Taiwo Oyedele, the Nigerian presidency and the country’s debt management office did not immediately respond to requests for comment.
Oyedele told the FT in May that Nigeria’s government was working “with a range of international counterparties on innovative financing solutions aimed at optimising the sovereign balance sheet, lowering the cost of capital, and enhancing fiscal flexibility”.
Africa’s biggest oil producer is using the swap to retire older, expensive crude-backed loans, people familiar with the matter said.
Investors say the deals represent a comeback for international banks in making loans to developing nations, after a long period when they were supplanted by the growth of bond markets.
Bond sales became more expensive as interest rates rose in recent years, creating an opening for banks to offer the swaps. But they depend on governments being willing to pledge outsized collateral.
“For lenders, the over-collateral reduces the capital they are required to hold against the loan on their balance sheet,” Moody’s analysts said. “This makes these transactions economically viable even at coupons below prevailing Eurobond yields.”
In another sign of how sovereign total return swaps are gaining market attention, both Moody’s and Fitch Ratings have recently flagged that the “procyclical” risks of margin calls and other features are becoming important for how they assess sovereign ratings.
Demands for cash would hit just as governments were finding it more expensive to borrow money, while any attempt by lenders to liquidate the bond collateral would cause prices to plunge further, they said.
“When a TRS is sufficiently large and its disclosed terms indicate meaningful margin call or early termination risk, this could weigh negatively” on sovereign ratings, Fitch analysts said.
The problem for investors is that the details of margin calls and lenders’ ability to demand early payment are not being disclosed, even where there is evidence that rating downgrades may themselves be triggers.
First Abu Dhabi Bank also has a €300mn swap with Senegal under which it can demand repayment if the country’s credit rating falls one notch below its current level, according to documentation for the loan seen by the FT.
Bondholders did not know about these or other preferential terms until they were reported by the FT earlier this year. Despite the issue gaining a bigger profile, investors say that governments are still not forthcoming about details when pressed.
“Ultimately, what we still do not understand as bondholders is the terms of particular swaps. We are still in the dark,” said Mohammed Elmi, emerging markets debt portfolio manager at Federated Hermes.
In theory, governments could avoid cash calls on their own debt by controlling local markets to prevent prices falling, but this would be a bad signal for creditworthiness, Elmi said.
In its report on Nigeria, the IMF also flagged the risk of “political constraints on monetary or exchange rate policy”, as any move to raise interest rates could cause bond prices to fall, triggering margin calls.
