The damages puzzle in government bonds

Abstract

‘It may be that contracts, and the law in general, play only a modest role in the sovereign debt markets. But that role is larger than the near zero level of attention that is generally given to it in the literature.’1 Assume the following hypothetical: A national government, a local municipality or a government company issues a series of 20-year non-callable bonds to finance their activities. A private investor, James, having paid the face value of the bond (say, $1,000) and an additional $20 fee to the bond trustee, is now awaiting the promised remuneration, ie the yield to maturity (YTM).2 Assume further that, after having paid promptly the first five annual coupon payments under the bond (say, of 5 per cent each) the issuer informs James that due to an acute financial hardship, it will not be able to pay the 15 remaining coupons on their due date. Even the repayment of the par, so the issuer admits, is uncertain. The issuer continues to say that it is furthering a restructuring of its national (or, for that matter, municipal) debt, under a wider economic reform. Following the expected restructuring, new and alternative financial instruments will be issued to all bondholders in the same category, but the expected YTM on the new instruments will be around 70 per cent of the yield originally expected. Finally, assume that no contractual exceptions or waivers are available to the issuer (eg covenants allowing early redemption) so that the anticipated failure to perform amounts to a breach of the indenture. In the face of such a paradigmatic breach, what are the damages to which James (and any similarly situated bondholder) is entitled?