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FTAV once heard a delightful financial-crisis tale about Uruguayan Samurai bonds — offshore sovereign debt issued by Uruguay denominated in Japanese yen.

Apparently some German investors had loaded up on them simply because they offered juicier yields than Uruguay’s dollar bonds even after hedging for the different currencies. But when the financial crisis struck and the solvency of many emerging markets came under scrutiny, the Germans panicked when they realised that the bond documents were all in Japanese, so no one really knew what their legal protections were. Chaos ensued.

This anecdote is firmly in “too-good-too-check” territory, but it speaks to an unspoken truth of finance: most investors don’t actually read the fine print of what they’re buying. Given the boilerplate nature and insane length of modern bond prospectuses that’s understandable. And most of the time that’s fine — until it really isn’t.

That’s why this new paper from Stephen Choi, Mitu Gulati, Ugo Panizza, Robert Scott and Mark Weidemaier caught our eye. Here’s the synopsis:

Contract terms that improve or reduce the likelihood of repayment of a debt should impact its price. That’s basic economics. But what about a contract that is hundreds of pages long and has lengthy and complex terms that even the lawyers are unwilling to read?

Believers in efficient markets might predict that variations that affect the likelihood of repayment in such obscure contract terms will be priced at the outset if there are profits to be made by exploiting these variations. An alternate view is that little attention is paid to the fine print in highly standardized contracts until the likelihood of default becomes sufficiently salient to make reading the fine print worthwhile.

Using several inadvertent real-world experiments, we examine the question of how and when variations that are assumed to be standardized in obscure contract terms are priced.

What makes this particularly intriguing is that the research is partly based on two Alphaville posts written by several of the paper’s authors, as well as a podcast on sovereign debt hosted by Gulati and Weidemaier.

These discussed some funky clauses in some Ghanaian and Sri Lankan bonds that either made them easier to restructure than commonly assumed (Ghana) or harder (Sri Lanka). As the paper notes, this led to a fascinating natural experiment to see whether investors actually read bond docs, and what happened to the prices of the bonds when their idiosyncratic aspects were highlighted publicly:

Although it did not occur to us at the time, we were inadvertently running two pricing experiments, publicly announcing the existence of unusual contract features that (we thought) contradicted widely-held views about the bonds. These announcements offered potential ways to assess the difference-in-difference between treatment and control bonds for Ghana and Sri Lanka.

Here’s what happened in the Ghana bond in question, shown by the solid black line.

This indicates that the Alphaville post on how a partial World Bank guarantee might not actually be much protection against a restructuring led investors to price the Ghanaian 2030 bond in line with the rest of the country’s debt stack. Both bonds increased in value after the Clauses and Controversies podcast, but the price of the control bonds increased more than that of the treatment bonds.

Here’s what happened to the Sri Lanka airline bond after the podcast and the FTAV post discussed how it was less vulnerable to a restructuring than might have been expected.

The paper notes that some investors clearly DO read the bond docs, but not enough for it to always be reflected in the prices.

Theories of efficient markets and efficient contracts, taken to their extreme, would tell us the landmines in the fine print of contracts should not exist. In the case of efficient contracting theory, disciplinary pressures on high priced lawyers in a competitive legal market should ensure few instances of landmines of the magnitude that we have described. And even if there are drafting anomalies, the markets should fix them via the pricing mechanism. In either event, contractual landmines should not exist. Our inadvertent experiments suggest that they can exist.

The paper notes that these two examples are a poor gauge of just how prevalent these inefficiencies are. FTAV suspects they are legion.

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