The Great Sovereign Bond Bust

One of the most pronounced bubbles in 19th century finance was a boom in emerging market debt that hazardously swelled during the 1820s. During that decade, sovereign bonds were issued by several newly independent countries following Latin America’s successful revolt against Spanish colonial rule. These newborn borrowers found a strong market for their first bonds across the sea in London as investors there looked for new sources of investment returns in the face of declining interest rates. Eventually, the sovereign bond boom turned into a sovereign bond bust. By the end of that decade, nearly every single new emerging market issuer had defaulted.

Starved for Yield

In London in the early 1820s, the financial markets were distinguished by compressing returns on lower-risk assets. This was most evident in the steady erosion of bond yields. Take the case of the consols, the perpetual obligations issued by the British government. They were earning just 3.5% in 1823, down from 5% eight years earlier. In fact, yields had been as high as 6% just before the turn of the century. Though these levels do not seem all that high when compared to those of a century earlier or those seen in the late 20th century, they were remarkable at the time. These were the highest yields on British state bonds in at least several decades and they would not be matched until a century later.

The previously high returns were driven in part by the inflation and fiscal deficits that accompanied the French Revolutionary Wars and those fought against Napoleon immediately thereafter. The military spending of the era caused British state indebtedness to rise as high as 230% of GDP by the late 1810s; annual state borrowing was frequently around 15% of GDP. This situation reversed after Napoleon’s defeat at Waterloo brought peace to Europe. Thereafter, the supply of consols dwindled as deficits were eliminated and the government began to pay down its massive debt. The British Treasury was regularly setting aside money that went into a sinking fund that periodically bought bonds to extinguish the state’s liability.

Because the Bank of England was also buying consols, the decade after the end of the wars saw a dwindling supply of bonds available to private investors. The reduced issuance and central bank purchases caused interest rates to slide lower. Indeed, the Bank of England cut rates by 1% in 1822. Once again, this may not sound like a terrific move but it was the first cut in the bank’s discount rate in slightly over a century. Returns on other assets were also falling. Dividend yields contracted as stock prices rose. Indexes constructed by financial archeologists show the London stock market rose 75% between 1817 and 1825. Return data collected by British charities on their endowments also show diminishing returns on private debt and real estate. The high prices for safe and risky assets alike set the stage for the boom and bust to come.

America

Another outcome of the Napoleonic Wars, one that played out far from London, was the independence of most of Spain’s American colonies. When France invaded Spain in 1807 and installed Napoleon’s brother Joseph Bonaparte as King, governance of the colonies fell into the hands of local rulers who increasingly favored separation from Spain. The resulting wars of independence led to the creation of several new countries that would fight amongst each other for control of resources over the succeeding century.

To finance their civilian administrations and their armies, these countries relied heavily on debt financing. The two biggest borrowers were Mexico and Gran Colombia; the latter country then included modern-day Ecuador, Colombia, and Venezuela. Gran Colombia was among the first to be welcomed to the London sovereign bond markets. The country floated a £2 million issue paying 6% interest in 1822. However, the bonds sold at a price of just 84% of face value and thus yielded over 7% in reality. Though this first issue was placed by the firm Herring, Graham and Powles, Gran Colombia found more success with the underwriter B. A. Goldschmidt which managed to get 88.5% of face value on a larger offering in 1824.

Because of the higher interest rates and steep discounts to face value, the cost of borrowing for these Latin American sovereigns was high. However, this only attracted more yield-starved investors and other nations followed Gran Colombia’s entry into the London bond markets. Mexico sold £3.2 million of 5% coupon bonds in 1824. They were issued at a whopping 42% discount to face value. Once again, it was B. A. Goldschmidt that placed the ultra-speculative bonds. A year later, Mexico issued a 6% coupon bond at 89.75% of face value. Though they were smaller borrowers, Argentina, Chile, Guatemala, and Peru also found London firms to place their bonds. Investor appetite was strong despite, or rather because of, the sharp discounts.

These discounts to face value were a characteristic of all the offerings. The average Latin American government bond was selling at a discount of 25%. In the early part of the 1820s, there was little distinction made by investors between the bonds; news from Latin America was scarce and investors could generally not tell which nations’ obligations were the better credits. Pricing was more a factor of size, the interest rate on the bonds, and the prestige of the arranging firm than a reflection of risk.

This lack of meaningful information led to what is illustratively called the ‘lemon problem’ as uncreditworthy nations were able to borrow excessively because of investor ignorance. In truth, the borrowing was still small relative to the British state debt of £800 million. Collectively, the Spanish American nations issued perhaps £40 million in sovereign bonds during the 1820s. Nonetheless, the years leading to the French Revolution were still fresh in everyone’s memory. That history showed that fiscal meltdown can be brought on by even small debts. This was especially true for nations with weak political and economic institutions.

Some issuers had no institutions at all. Indeed, one ‘country’ selling bonds in London was Poyais, a fictional country in Central America. Poyais was the invention of Gregor MacGregor, a Scottish fortune seeker and fraudster. Nonetheless, he was able to find a bank willing to place £200,000 in bonds issued by his made-up country. Indeed, the bonds were sold to the public at prices comparable to those of real countries. By the middle of the decade, Poyais was just one of many sovereign bond issuers active in London. While in 1820, there was only one foreign sovereign bond issue trading in London, excluding bonds issued elsewhere but cross-listed there, by 1826 there were over twenty.

Europe

Latin American countries were not the only ones turning to London to float bonds in the 1820s. In Europe, there was a surge in sovereign debt issuance both during and after the Napoleonic Wars. Countries were seeking to consolidate and refinance their wartime debts at a lower cost by issuing their own long dated bonds in the style of the consols. These were issued by France and Prussia and many other nations and they were almost all issued in London, a centralization quite new in financial markets. While some of these issuers were large and more creditworthy there were also some smaller and more speculative issuers new to the market as well.

Closer to home, several Southern European countries sold bonds in London to raise money from the increasingly risk-tolerant investors there. For example, a year after Portugal was introduced to London by B.A. Goldschmidt, the newly independent Greece floated an £800,000 offering there in 1824. The bonds were placed by Loughman, O’Brien, Ellice & Co and seemed to be a raw deal for Greece. They were issued at a price of just 59% of face value and £123,000 was charged by the bank for placing the debt. Thus, Greece only received a measly £348,000 in proceeds from the issuance. Nonetheless, other Southern European states followed Greece to London. An inaugural offering for the Kingdom of Naples was organized by N.M. Rothschild the same year and Greece returned to the market in 1825, albeit with a new underwriter.

Bonds

Most of the London offerings were designed to mimic the consols. For one, they were mostly structured as perpetual bonds, without a maturity date. They typically paid a 5% or 6% coupon; only Denmark came to market with anything less than a 5% rate on its bonds. This was designed to offer investors a sizable premium to the British consols. The bonds also occasionally came with sinking funds into which the borrowing nation would make occasional deposits to set aside money for the eventual repayment of the notes. The use of sinking funds was a British peculiarity and their presence in more offerings reflect London’s importance in the market for sovereign debt.

Bust

After the course of just a few short years the sovereign bond boom of the early 1820s turned to bust. It came abruptly; in April 1826, the government of Peru missed a bond payment and became the first South American sovereign government to default. By January 1828, following an Argentine default, every Spanish American government that issued sovereign bonds in London was bankrupt. Argentina had been seen as one of the more creditworthy countries but its default left Brazil the only South American government with performing bonds.

The wave of defaults included European issuers as well. Greece missed a payment on its debt in January 1827 and they were followed by Portugal in June 1828; the latter of these defaults closed out the spate of bankruptcies seen during that miserable decade for emerging market investors. That said, by this point, bond prices had been firmly in freefall for a couple of years. However, for the first time, there was also a dispersion of prices as investors began to understand the credit differences of the borrowers. Whereas all the Latin American bonds yielded close to 7% in 1824, creditors began to take a more discerning eye to these bonds following the Peruvian default. Within two years, some bonds issued by the likes of Colombia and Peru were yielding 20%, while others issued by Brazil saw their yields rise more modestly, staying below 10%.

Many of the bankrupt borrowers suffered from ineffective tax systems and poor governance. Expensive military conflicts with their neighbors certainly didn’t help matters. However, not all borrowers defaulted. Indeed, the crisis helped secure the reputation of the firm N.M. Rothschild as prudent underwriters because they underwrote only successful bonds. True, many of their clients in the 1820s included the relatively safe and prosperous nations of Austria and Prussia but the bank also arranged a bond offering for Brazil and Naples. These were the only credits from South America and Southern European respectively that did not default. Clearly, prudence counted for something but it was in short supply in London among many sovereign bond investors.

Lesson

Sovereign debt crises usually come in waves. Whether in Latin America in the 1980s, Asia and Russia in the 1990s, or Europe in the 2010s there rarely is only a single country in distress in any instance. However, the emerging market sovereign debt bust of the 1820s was nonetheless particularly large. The crisis saw the default of no fewer than a half dozen countries on three continents. All this happened in an era when financial markets were far smaller and supposedly less connected. Markets may very well have been less connected then; after all, investors in foreign bonds usually struggled to get any good information. However, markets were nonetheless connected enough to bring together lenders and borrowers separated by an ocean and cause a crisis that shook those on both sides.

More from the Tontine Coffee-House

Consider reading about the birth of the sovereign bond market and another Greek default, and learn more about the phony issuer Poyais mentioned above.