Are all foreign bonds created equal?

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Recent concerns about Russia defaulting on foreign debt in the face of international sanctions have focused renewed attention on the important role that jurisdiction plays in assessing bond risk. The message is clear: while Canadian law provides a solid framework for contracts covering bonds issued here, seeking a yield premium for bonds issued outside the country requires intimate knowledge of the jurisdiction where they are issued and can increase the financial impact of geopolitical and other risks.

“Across the world, all bonds are contracts between parties to lend money and to receive appropriate compensation according to that contract,” says Timothy Hicks, chief investment officer at Lysander Funds Limited, a Canadian investment fund manager offering funds that specialize in corporate bonds. “If that contract is fulfilled, no problem. But not all bond issuances go as planned and there’s always a risk that the company issuing a bond will go bankrupt.”

Lenders need to know where they stand in terms of receiving full or partial compensation in the case of bankruptcy in the country which that contract is enforceable.

“When you’re a Canadian borrower and a Canadian lender defaults, any disputes over the contract would be settled within the Canadian legal system, or potentially a Canadian court,” Hicks says. “The moment you cross national borders, it creates additional complexity and less certainty for lenders in being able to enforce what they believe are their rights.”

In pursuing those rights, a lender may also need to assume the cost of seeking qualified legal representation in the country where the bond was issued.

While some foreign-issued bonds may offer the potential for attractive returns, Canso Investment Counsel, the portfolio manager for certain Lysander Funds, will only consider buying bonds in countries where it has high confidence in the workings and outcomes of the legal system.

“While Canso will invest in U.S.-issued bonds, for example, it’s with the understanding that we don’t share the same bankruptcy laws,” Hicks says. “In Canada, bankruptcy judges have latitude to impose the remedy they see as most suitable to the situation, while U.S. bankruptcy laws are more prescriptive and rely heavily on precedent.”

The bankruptcy of U.S. auto rental giant Hertz Global Holdings Inc., for example, saw bondholders seeking compensation for bonds issued by the company. The judge overseeing Chapter 11 restructuring of the company ruled that Hertz’s unsecured bondholders weren’t entitled to collect interest payments at the contractual rate under U.S. bankruptcy law.

Countries have also been known to change the rules governing bond contracts retroactively. During the 2008 financial crisis, for example, Iceland’s banks had grown larger than the country’s entire economy. Unable to bail out the failing institutions, Iceland’s government allowed them to collapse and drafted legislation protecting domestic deposits at the expense of foreign debt.

Even sovereign debt is subject to potential default when a country fails to pay out a bond contract fully, in a timely fashion, or not at all. The Bank of Canada-Bank of England 2021 Sovereign Debt Database update estimates the total value of sovereign debt in default at US$443.2 billion in 2020.

“If you’re dealing with sovereign debt default you have little recourse,” Hicks says. “You can’t sue the government for defaulting on a bond.”

Currency also plays a role.

Countries who issue sovereign debt in their own currencies can resort to printing additional money to pay off their debt — albeit with inflated dollars that become worth less and less to the lender. Venezuela, on the other hand, which issues bonds in U.S. dollars, could not inflate its way out of debt — one of the reasons the country has recently found itself in default.

Countries in less established markets tend to offer yield premiums on sovereign debt to attract investors. Likewise, corporate bonds issued in those countries also tend to offer yield premiums.

“But even if a company issuing debt from within those countries is extremely stable and considered low risk, it’s tough to make a case that the company demonstrates equal or lower risk than the country itself,” Hicks says.

For Canso, a thorough understanding of risk is essential to choosing the bonds that comprise a fund’s portfolio. While it seeks opportunities primarily in Canadian-issued bonds, it will pursue exceptional opportunities in the U.S., the UK, Australia, New Zealand, Japan and select nations in western Europe.

“Canso understands the environment for issuing bonds in those jurisdictions, and has faith in their legal systems,” says Hicks. “That gives them the confidence to diversify outside of Canada when they see an opportunity.”

For more information on Lysander Funds, visit: www.lysanderfunds.com

The views and information expressed in this article are for informational purposes only. They are not intended as investment, financial, legal, accounting, tax or other advice and should not be relied upon in that regard. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated.

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