Bond Restructuring and Moral Hazard: Are Collective Action Clauses Costly?

Abstract

Many official groups (such as the G-7, G-10 and G-22 groups of countries) have recently endorsed the wider use by emerging market borrowers of collective action clauses, (CACs) in bond contracts. These clauses allow for a qualified majority of bondholders to restructure repayment terms in the event of financial distress, and to make these changes binding on dissenting bondholders. Proponents of CACs maintain that facilitating restructuring can reduce deadweight losses and benefit both borrowers and lenders. However, some have argued that such clauses will be associated with moral hazard, more frequent restructurings, and increased borrowing costs. This paper examines the important and unresolved question of how CACs are viewed and priced by financial markets, and whether the benefits of more orderly restructuring might outweigh the possible effects of borrower moral hazard. The main innovation of this paper is that it is the first to do a systematic study of the secondary market yields of a large sample of bonds issued in international markets. Secondary market data allow the researcher to analyze the pricing of a large number of existing bonds at particular points in time, including before and after different events that may have caused a reassessment of the costs and benefits of bond contracts that include CACs. For comparison with some earlier studies, we also estimate equations using primary market data for yields at the time of issuance. We find no evidence that the presence of CACs increases yields for either higher- or lower-rated issuers. Hence, we conclude that the perceived benefits of lower restructuring costs associated with CACs are at least as large as any costs from increased moral hazard.