Ecuador’s principal reinstatement clause: A reason not to default in February?

Anybody puzzling over price movements in Ecuador’s 2030 bonds might want to remind themselves that the 2030s carry a peculiar piece of legalese known as a “principal reinstatement clause”.

Ecuador restructured its bonds in July 2000, under finance minister Jorge Gallardo, who explains the clause here:

Ecuador tried to convey to the bondholders that a new default would be unlikely, since a default will mean a reinstatement of the principal. Under the 2030 bonds, a payment default occurring in the first 10 years that continues uncured for a period of 12 months will automatically result in the issuance of additional 2030 bonds to the holders in a specified percentage; an additional 30 percent if the event occurs during the first four years after issuance, 20 percent during the next three years, and 10 percent during the last three years of this period.

Since we’re now more than six years into the post-restructuring era, if Ecuador defaulted on its February 15 coupon payment, that would raise the possibility that holders of the 2030s might eventually be owed 120 cents on the dollar. If Ecuador instead made the February 15 payment, then a default on August 15 would mean the maximum principal due on the 2030s falling to 110 cents. The difference is $269 million – enough money that it’s worth caring about.

In general, a default on February 15 would mean an extra incentive for holders of the 2030s to stay out of any restructuring deal, since they get extra principal if they stay out for more than a year after the default. So Ecuador would have to offer holders of the 2030s a bit of extra sweetener in order to persuade them to go into any restucturing deal.

What would happen if Ecuador defaulted on May 15, when the next coupon payment on the 2012s is due? The 2012s don’t have a principal reinstatement clause, but the 2030s carry a cross-default clause. If I was Ecuador, I wouldn’t worry about the cross-default clause, however, since it requires that the holders of the 2012s accelerate their bonds in order for there to be a credit event on the 2030s. And precisely because of the principal reinstatement clause, I see no chance of the holders of the 2012s voting to accelerate before July 27, 2007 – even if the May coupon payment is missed. Such a vote would only serve to decrease their own share of principal outstanding.

Conclusion? Ecuador will make the $134 million February 15 coupon payment. The May 15 payment is uncertain, but it’s relatively small: only $30 million. After that, there’s another $30 million due on the 2015s in June, and that’s followed by the big August coupon on the 2030s. Any of those are more likely dates for an Ecuador default than February 15.

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