Lily Hsu
A sovereign debt default occurs when a nation fails to meet its debt obligations, either by missing scheduled interest payments or by failing to repay the principal amount of its debt. As one of the world’s leading fixed income index providers, FTSE Russell continuously monitors sovereign defaults in order to reflect such events accurately in our indices.
- Investor Strategy Shift – More investors now hold sovereign bonds through restructuring instead of selling post-default, anticipating price recovery.
- FTSE Russell’s Index Update – Index rules now retain defaulted bonds, ensuring they reflect real market behavior during debt restructuring.
- Sri Lanka’s Bond Market Impact – Post-default restructuring led to improved bond returns, highlighting the benefits of patience in distressed markets.
In the case of several recent sovereign debt defaults, many investors have chosen to continue holding bonds that are undergoing debt restructurings, rather than selling such bonds immediately after the default. In these investors’ view, the fixed income securities’ prices may recover in the long term, even if the default triggers initial losses. The logic of the decision is that by participating in debt restructurings, investors can benefit from the defaulting country's subsequent economic recovery, especially once the burden of the restructured debt becomes more manageable.
Reflecting such changes in investor preferences, in August 2022 FTSE Russell changed the rules for defaulting foreign currency government bonds in FTSE fixed income indices (the rule change took effect from the end of the next month).
Rather than immediately removing the bonds of a defaulting government issuer from an index, we decided to retain them in the index and to continue to update their prices according to the prevailing secondary market. And in the event of a subsequent debt restructuring, we said we would reflect the economic reality of the restructuring transaction in the index calculations, to the extent that this was feasible.
In August 2024 we announced an additional change: with effect from the November 2024 index profiles, the minimum time to maturity for foreign currency emerging market government bonds in FTSE fixed income indices changed from one year to one month. This change helped ensure that index users, who increasingly participate in sovereign debt restructurings, could retain defaulting securities with relatively short maturities in their portfolios.
To illustrate the practical implications of these changes to our index rules, in this blog we examine the recent sovereign default of Sri Lanka. We cover the sequence of events, the bond restructuring process, the reactions of rating agencies and the impact of the default and subsequent debt restructuring on bond prices and returns.
Sri Lanka’s December 2024 debt exchange
By early 2022, a balance of payments crisis had led to a significant decline in Sri Lanka’s foreign exchange reserves, making it difficult for the country to pay for essential imports such as fuel and food. In April of the same year, Sri Lanka missed interest payments on its $1.25bn international sovereign bonds, defaulting for the first time ever.
Credit rating agencies responded to the crisis by cutting Sri Lanka’s rating: in April, 2022, Moody’s downgraded Sri Lanka from Caa2 (“very high credit risk”) to Ca (a rating for bonds that are in or very near default), while in the same month S&P placed Sri Lanka’s rating in the “selective default” category.
Sri Lanka’s economic crisis reached a peak in 2022. Given the country’s severe liquidity problems, its unsustainable debt burden and political instability, Sri Lanka began a long and complex debt restructuring process. After intensive negotiations with creditors, Sri Lanka moved forward with a key milestone: a debt exchange in late 2024.
In the exchange, Sri Lanka swapped existing US dollar-denominated sovereign bonds for new bonds with longer tenors, lower coupon rates and reductions (“haircuts”) in the principal amount. These new terms, which were more manageable for Sri Lanka, eased the country’s debt burden. For the bondholders, while the new terms were less favourable than the terms of the original (defaulted) debt, they still represented a better outcome than a total default. After the debt exchange, the face value of the newly issued bonds (USD 10,961 million) was about 87% of the face value of the exchanged bonds (USD 12,550 million).
Table 1: Sri Lankan sovereign bonds exchanged on December 20, 2024
| ISIN (144A) | Coupon (%) | Maturity Date | Tenor (years) | Amount before Exchange (USD Million) | Exchanged Amount (USD Million) |
|---|---|---|---|---|---|
| US85227SAV88 | 5.75 | 4/18/2023 | 5 | 1,250 | 1,250 |
| US85227SAY28 | 6.85 | 3/14/2024 | 5 | 1,000 | 1,000 |
| US85227SBA33 | 6.35 | 6/28/2024 | 5 | 500 | 500 |
| US85227SAT33 | 6.2 | 5/11/2027 | 10 | 1,500 | 1,500 |
| US85227SAW61 | 6.75 | 4/18/2028 | 10 | 1,250 | 1,250 |
| US85227SAZ92 | 7.85 | 3/14/2029 | 10 | 1,400 | 1,400 |
| US85227SBB16 | 7.55 | 3/28/2030 | 11 | 1,500 | 1,500 |
| US85227SAN62 | 6.125 | 6/3/2025 | 10 | 650 | 650 |
| US85227SAQ93 | 6.85 | 11/3/2025 | 10 | 1,500 | 1,500 |
| US85227SAR76 | 6.825 | 7/18/2026 | 10 | 1,000 | 1,000 |
| US85227SAK24 | 5.875 | 7/25/2022 | 10 | 1,000 | 731 |
| Total | 12,550 |
Source: Sri Lanka Ministry of Finance
Table 2: New sovereign bonds issued after the debt exchange
| ISIN (144A) | Coupon (%) | Maturity Date | Tenor (years) | Issued Amount (USD Million) |
|---|---|---|---|---|
| XS2966241528 | 3.1 | 1/15/2030 | 6 | 1,087 |
| XS2966241791 | 3.35 | 3/15/2033 | 9 | 2,132 |
| XS2966241874 | 3.6 | 5/15/2036 | 12 | 999 |
| XS2966242252 | 3.6 | 2/15/2038 | 14 | 1,999 |
| XS2966242336 | 3.6 | 6/15/2035 | 11 | 1,440 |
| XS2966242419 | 4 | 4/15/2028 | 4 | 1,648 |
| XS2966242765 | 1 | 6/15/2038 | 14 | 1,126 |
| Local LKR Bonds | - | - | - | 530* |
| Total (USD) | 10,961 |
* LKR 155,729 million, converted to USD using exchange rate as of December 20, 2024
Source: Sri Lanka Ministry of Finance
The 2022 default and the subsequent debt restructuring had significant effects on both Sri Lankan government bond prices and the exchange rate of the Sri Lankan Rupee. In Chart 1, we illustrate this by showing the price movement throughout the default and restructuring process of a short-maturity Sri Lankan government bond (6.85% of 3 November 2025). On the right axis, we also show the exchange rate of the Sri Lankan rupee against the US dollar over the same period. The chart gives an insight into the typical dynamics of interest and exchange rates during a sovereign default and subsequent debt restructuring.
Chart 1: Price of Sri Lanka 6.85% 2025 and LKR/USD exchange rate (right-hand scale)
Source: Refinitiv. Past performance is no guarantee of future results.
Chart 1 illustrates that as Sri Lanka’s external liquidity position worsened in late 2021 and early 2022, the country’s 2025 bond price started to fall. In December 2021, Fitch pre-empted other credit rating agencies by downgrading Sri Lanka’s foreign sovereign rating to ‘CC’ from ‘CCC’, citing a growing risk of debt default in 2022. Although the central bank of Sri Lanka stated that Fitch’s downgrade was a hasty move, the bond price continued to fall.
In April 2022, Sri Lanka defaulted, announcing that it would postpone interest payments on its foreign sovereign bonds, causing the bond price to drop further. The price decline continued until the end of 2022 amidst uncertainty over a debt restructuring plan. Meanwhile, the Sri Lankan rupee depreciated by 42.5% against the US dollar in early 2022 and reached its lowest level after the April default, further worsening the country's financial crisis.
By late 2022, however, Sri Lanka reached preliminary agreement with the IMF for a bailout package, and the country began talks on restructuring its foreign debt. As a result, government bond prices started to increase slowly. By the end of 2023, the 2025 bond’s price had recovered to the levels seen right before the default; the price then rose further as the debt exchange approached.
For an investor, there was a huge difference in returns between selling the bond immediately after the announcement of the default and holding the bond and waiting for the debt restructuring. A hypothetical passive (index-tracking) investor who prefers not to hold defaulted bonds would have incurred an immediate 17% loss in April 2022 (i.e., assuming that the index investor had sold the bond at the end of that month).
However, if the investor had held the bond until the late-2024 debt exchange, the return from end of March 2022 would have been +26%, reflecting the steady price recovery from late 2022 onwards. Episodes like this explain why a growing number of investors, rather than selling bonds at the time of a sovereign default, prefer to keep them in hope of a longer-term recovery.
Conclusion
FTSE Russell’s recent decision to update its treatment of defaulted foreign currency sovereign bonds represents a significant shift in how sovereign defaults are handled in fixed income indices. Other index providers have adopted a similar treatment, indicating a consensus within the industry on handling sovereign defaults in foreign currency-denominated debt.
As more investors now prefer to hold onto defaulting bonds until debt restructurings are finalised, rather than selling those bonds immediately, FTSE Russell’s update has ensured that our fixed income indices reflect this evolving investment strategy.The case of Sri Lanka’s default gave an example of how holding bonds through the debt restructuring process could lead to better returns. By changing the minimum time to maturity for index inclusion from one year to one month, FTSE now keeps more defaulted securities in the index during the restructuring period than before. This change also enables users to wait for a longer-term price recovery in distressed bonds.
Nevertheless, tracking an index that includes defaulted bonds is not a free lunch. The illiquidity of defaulted bonds in the secondary market and the lack of reliable pricing inputs could lead to higher tracking error and transaction costs. In the event of the absence of an eventual restructuring and where a defaulted foreign currency government bond market is no longer functioning (and FTSE Russell deems that a ‘market disruption’ event has taken place), we will reference our FTSE Fixed Income Statement of Principles to determine the appropriate index treatment for the impacted securities.
At a client’s request, FTSE foreign currency sovereign fixed income indices can also be customised to exclude defaulted securities. This satisfies the needs of those investors who do not want to embark on the lengthy and uncertain journey of debt restructuring.
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