UK Law Bonds and the Negative Pledge: Further Debt Subordination

In the continuing coverage of the Spanish bailout, it is time to consider further debt subordination. Earlier, I wrote about the Spanish bailout subordinating private sector creditors. Well, as it turns out, just as in the Greek PSI, UK law bonds and the Negative Pledge are coming back into play. The disparities in bond laws have essentially made UK law bondholders senior to non-UK law bondholders, and here is why.

As we saw in the Greek PSI, UK law bondholders were able to hold out because the Greek government could not retroactively insert collective action clauses into the bond indentures, thus requiring a super majority of bondholders to okay any change to the indenture. In this case, UK law once again becomes the great subordinator, with the Negative Pledge language of the indenture. A Negative Pledge is a clause in a contract in which a borrower issuing unsecured debt ensures that it cannot go out and take another loan from a different lender on the same specified assets. Even though it is an unsecured loan, it is still made against some assets, in this case the assets of the Kingdom of Spain.

The fact is that Spanish law bonds do not have this clause in them, while UK law bonds do. Thus, UK law bonds are in this case senior to Spanish law bonds, because they have to be paid out in full or by those assets in bankruptcy. Basically, the bailout loan is senior to all existing creditors, but then the UK law bonds would be next, with the Spanish law bonds subordinate to both.

Thus, traders should look to short Spanish law bonds and long international law bonds. It is true that only between 4.8 billion euros and 8 billion euros of Spanish debt is issued under international law, but there should be enough to go around. The biggest lots outstanding are the 4/17/17 3.133% Bullets (in JPY, ISIN XS0075681345) and the 4/21/17 3.1% Bullets (also in JPY, ISIN XS0075723360). For those looking for specifically UK exposure, look at the 4/6/29 5.25% Bullets (in GBP, ISIN XSoo96272355). This was a recent issuance of long-term paper under UK law and would allow investors to hedge away the subordination risk.