Do total return swaps put emerging market countries at risk of a ‘zombie debt’ outbreak?

In the world of sovereign debt, three little letters – TRS – are generating an outsized amount of column inches and not a little controversy.

TRS, or total return swaps, and their close cousins, repurchase agreements, are gaining popularity among emerging market countries that would struggle to raise debt through more traditional channels like the eurobond market.

Sovereign issuers including Senegal, Angola, Nigeria, Argentina, Ecuador, and Colombia have all availed themselves of TRS and repos in recent years, raising billions of dollars from international banks at what they argue are much more affordable rates than they could hope to snag in a public debt raise.

But with TRS on the rise, prominent lawyers and academics have begun to raise the alarm over what they see as a lack of transparency and understanding around the risks of these transactions. The IMF is also paying attention, with Fund officials conducting capacity-building work to better understand TRS and their ilk, as my colleague Simon Schatzberg and I report in our feature on the topic.

These transactions vary, but they all have a shared theme: a country offers its own debt instruments, in many cases local bonds, to the bank as collateral for a synthetic loan.

Here’s the kicker: the value of the underlying collateral instruments offered is significantly greater than the value of the principal loan made out to the country. Take the example of Senegal, which has borrowed a total of 721 billion West African CFA Francs ($1.26 billion), collateralized by around XOF 1 trillion of its own XOF-denominated debt securities.

The underlying collateral debt is often not included by countries in their own accounting, leading some to characterize it as “zombie” debt. The debt could spring to life in a default scenario, creating a sudden jump in a country’s debt stock, among other potentially nasty effects including the risk of margin calls.

How this debt would be treated in a potential sovereign restructuring, meanwhile, is largely uncharted territory.

Senegal is arguably the most likely candidate for a near-term debt restructuring among the known issuers of TRS. Last week, the country’s National Assembly announced a cross-party parliamentary inquiry into the government’s use of these swaps and their impact on the public debt.

Look to Dakar, then, for a potential case study on what happens when “undead” bonds reanimate.