At a glance
- The emerging markets debt landscape has recently experienced a surge in innovative bond structures, particularly state-contingent debt instruments (SCDIs).
- SCDIs have primarily served as a bridge to resolve disagreements between creditors and the IMF regarding a defaulted government’s ability to service restructured debt.
- For investors, SCDIs can offer attractive, uncorrelated return opportunities as part of an EMD portfolio, especially when the market undervalues potential upside scenarios.
The universe of emerging markets debt (EMD) has expanded with the rise of innovative bond structures known as state-contingent debt instruments (SCDIs), which are designed to address the unique challenges faced by sovereign issuers and their creditors. SCDIs have proven valuable in resolving disagreements between creditors and official lenders like the International Monetary Fund (IMF) during debt restructurings.
For investors, understanding the mechanics and implications of these instruments is essential —not only for risk management, but also for uncovering uncorrelated return opportunities, particularly when the market misprices the likelihood of positive scenarios.
A new generation of instruments: The rise of SCDIs
SCDIs represent a significant evolution from the warrant structures used in past restructurings, such as those in Argentina and Ukraine. This new generation offers distinct advantages for both investors and issuers. Unlike older warrants, many new SCDIs are index-eligible, a crucial feature for many institutional investors. This is possible because they have a fixed principal value, whereas warrants did not.
For issuers, the advantage lies in the option-like design of SCDIs. Cash flows are linked to an economic variable at a future date. Once that variable is tested, the payment stream is locked in for the life of the bond. This structure gives sovereigns more clarity in managing their future debt obligations compared with warrants, where future cash flows could be unpredictable or even unbounded.
Case studies in innovation
Several recent examples from the EM universe highlight the diverse applications and characteristics of these instruments:
Zambia. During its recent debt restructuring, Zambia’s future debt-carrying capacity was a point of contention. The solution was the Zambia 2053, an SCDI designed to bridge the gap. Its coupons and amortization schedule would increase if Zambia’s debt-carrying capacity rating was upgraded from low to medium between 2026 and 2028, or if certain economic metrics exceeded IMF projections.
Following its issuance in June 2024, the instrument performed well as the market began to price in a higher probability of the upside case. However, sentiment has since moderated after a recent IMF staff report revised down a key projection. The instrument has delivered strong returns, but its ultimate success for Zambia depends on whether a potential debt carrying capacity upgrade reflects a genuine improvement in the country’s economic resilience.
Ukraine. Negotiations for Ukraine’s 2024 debt restructuring involved balancing creditors’ desire for upside potential against the country’s near-term payment constraints. The result included a contingent bond whose face value could nearly double in 2029 if GDP growth surpasses specific thresholds through 2028. This structure ensures that additional debt service is only due if the country’s repayment capacity improves.
While initially seen as having an underpriced upside, market-implied probabilities for the trigger rose significantly in early 2025. We believe the premium for this upside option may now be too high given the on-the-ground realities, as a potential ceasefire might not guarantee the robust GDP growth required to activate the trigger.
Sri Lanka. Sri Lanka’s restructuring introduced two distinct SCDIs:
- Macro-linked bonds (MLBs): Payments are tied to the country’s GDP performance. The bond’s face value and coupon adjust up or down based on whether the economy outperforms or underperforms IMF baseline projections, creating a risk-sharing mechanism.
- Governance-linked bonds (GLBs): This instrument incentivizes fiscal and governance reforms by offering a coupon reduction if Sri Lanka meets targets related to tax revenue and fiscal transparency.
The MLBs feature an asymmetric structure that appears to favor bondholders in upside scenarios, a view supported by strong recent GDP performance. Valuations have since increased, and much of the upside appears to be priced in.
Suriname. Suriname’s 2022 restructuring included a value recovery instrument (VRI) linked to the country’s offshore oil prospects. This warrant-like instrument gives creditors a share of government oil royalties once production begins. This structure helped bridge the gap between what Suriname could afford at the time and what creditors hoped to recover. The VRI offers a unique return profile, though it is a relatively illiquid security.
Self-imposed contingencies
SCDIs are also being used by countries outside of a restructuring context as a form of self-discipline.
- El Salvador: As part of a 2024 issuance, El Salvador included a security with a coupon that would step up from 0.25% to 4.0% if it failed to secure an IMF program or a credit rating upgrade by October 2025. This mechanism signaled commitment to reform, and the country reached a preliminary agreement with the IMF in December 2024.
- Uruguay: In 2022, this investment-grade sovereign issued a sustainability-linked bond that ties its coupon to environmental targets. This highlights Uruguay’s leadership in ESG and helps attract a dedicated ESG-focused investor base.
The bottom line
SCDIs represent a growing and increasingly sophisticated segment of the EMD asset class. For EMD investors, SCDIs offer a way to gain exposure to specific economic outcomes and potentially harvest risk premia when triggers are mispriced. However, navigating this space requires specialized knowledge to analyze the complex structures and underwrite the contingent scenarios. A selective approach focused on understanding the catalysts, valuation, and portfolio fit is key to capitalizing on the opportunities these instruments present.
