Advisory firm Lazard warned on Thursday that the rising use of complex sovereign borrowing instruments across emerging markets could push up the cost of borrowing and make debt restructurings more protracted and difficult. The firm said a wave of innovative, but often opaque, debt structures has proliferated since 2020 as aid was cut, borrowing costs rose and risk aversion increased amid shocks ranging from the COVID-19 pandemic to Russia's invasion of Ukraine.
In a paper published on Thursday, Lazard described the move toward collateral-backed loans, bonds with payments linked to economic growth or export receipts, and other contingent instruments as widespread - particularly among smaller, higher-risk "frontier" economies. While some investors have welcomed these structures as ways to broaden borrowing options, Lazard flagged a potential downside that could come back to haunt issuing countries.
"We need to simplify the whole thing, because it is becoming really complex, and inevitably, at some point, the borrowing countries will pay the price of that," said Pierre Cailleteau, managing director at Lazard. He said the proliferation of contingent instruments and unclear rules about creditor priority were changing the fundamental dynamics of sovereign debt.
The shift toward complex instruments has taken different forms in different countries. In Zambia and Sri Lanka, for example, contingent features were designed to align bond payouts with improvements in debt sustainability or with GDP performance, with the stated aim of speeding up restructurings. Other countries, including Angola, Nigeria and Senegal, have used total return swaps - effectively borrowing against the returns on their own debt - as an alternative to issuing international bonds. The International Monetary Fund has warned that such swaps can be opaque and represent complicated liabilities.
Lazard highlighted an additional layer of uncertainty stemming from questions over whether multilateral lenders will retain preferred creditor status in future restructurings. Preferred creditor status shields multilateral development banks and similar institutions from losses when sovereign borrowers default, and any ambiguity about the hierarchy of claims complicates creditor analysis, the firm said.
"The combination of a lack of clarity on the hierarchy of claims and the introduction or the proliferation of those types of contingent instruments makes in fact the debt very difficult to analyze for the creditors, to determine where they are in the hierarchy of claims," Cailleteau said, adding that this opacity is altering creditor behaviour and the broader debt landscape.
The paper noted that Zambia is in the process of buying back its contingent bond, illustrating the practical challenges these instruments can create during restructuring exercises. The World Bank has urged "radical transparency" on debt, and rising use of State Contingent Debt Instruments has been a prominent discussion point at recent meetings of the International Monetary Fund and the World Bank in Washington.
Cailleteau argued that greater transparency should be a condition for receiving financing from institutions such as the IMF and other multilateral development banks, which often act as lenders of last resort for countries experiencing debt distress. "We need to make transparency enforceable," he said.
Finally, Lazard noted that investor risk premia on emerging market debt were close to record lows, a situation the firm described as reflecting "some degree of exuberance" that could be underpricing the risks associated with increasingly complex sovereign liabilities.
Key takeaways
- The rise of contingent and complex sovereign debt instruments since 2020 has been driven by aid cuts, higher borrowing costs and increased risk aversion.
- These instruments - including GDP-linked bonds, collateral-backed loans and total return swaps - can complicate creditor analysis and delay restructurings.
- Unclear creditor hierarchies and low emerging market risk premia increase the potential for underpriced risk in affected markets.
Sectors affected: sovereign debt markets, multilateral development finance, and investors in emerging and frontier market bonds.
Risks and uncertainties
- Opaque contingent instruments may raise borrowing costs and make debt workouts longer and more complex - impacting sovereign borrowers and bond investors.
- Uncertainty over preferred creditor status complicates the hierarchy of claims, posing risks for creditors and potentially altering recovery expectations.
- Near-record low risk premia on emerging market debt could indicate investor exuberance that may underprice the true risks of complex sovereign liabilities.
Note: This article reports on Lazard's published analysis and comments by its managing director. It does not introduce new data or claims beyond those presented in the firm's paper.