Lebanon's Defaulted Bonds Triple in Price Amid Recovery Hopes

Lebanon's government bonds, which have defaulted over the past year, have seen their prices nearly triple. While investors are betting on an economic recovery, the wide range of estimates for the potential value of these bonds post-reorganization could hinder further price increases. The "recovery value" of these bonds will only become clear once legislators determine the scale of losses that troubled domestic banks must bear, which in turn will affect the amount of funds the government can allocate to bondholders.

Lebanon has experienced over two years of government paralysis, exacerbating its economic crisis. With political shifts breaking the stalemate, government bond prices have risen from around 6 cents on the dollar a year ago to nearly 24 cents. The formation of a new government in February this year drove up bond prices, as investors hoped that the Lebanese authorities would push the country closer to securing reconstruction funds following destructive clashes between Israel and the Lebanese armed group Hezbollah.

However, some fixed-income analysts caution that the current rise may have exceeded reasonable levels given the numerous uncertainties, particularly the uncertainty surrounding the bonds' recovery value. This value refers to the actual worth of the bonds post the much-anticipated debt restructuring, which is crucial for Lebanon's economic recovery. Currently, estimates for the bonds' value vary widely. One asset management company, which holds Lebanese government bonds, suggests that the recovery value could range from 20 to 40 cents on the dollar, depending on the scenario. However, there are also more pessimistic scenarios where an agreement with the International Monetary Fund (IMF) might not be reached in the next year.

In March 2020, Lebanon defaulted on 31 billion dollars of unpaid international debt, leading to a rapid deterioration of its financial crisis. Bank balance sheets collapsed, and the currency depreciated by 99%. Hope for debt restructuring or crucial IMF aid faded, and government bond prices fell below 6 cents on the dollar. However, recent developments, such as the election of a new president in January and the passage of a long-awaited banking sector reform law in July, have given investors an opportunity to capitalize on the bonds' extremely low prices. Some investors, driven by the fear of missing out on potential gains, have entered the market without fully appreciating the potential scale of remaining obstacles.

The current pricing suggests a high probability of a positive resolution to remaining obstacles within the next 12 to 18 months. However, this pricing does not fully account for potential downside risks, which are largely tied to pending legislation that must clearly define the losses banks must bear. The Lebanese central bank has also warned that high global interest rates could complicate the country's international bond restructuring efforts.

The scale of losses that banks without the ability to pay must bear is known as the "financial gap," or the difference between a bank's liabilities and assets. Few expect legislators to pass key legislation determining this gap before the May 2026 elections. Despite the wide range of estimates and the complex, politically charged calculation process, this data is crucial for determining the bonds' recovery value. Two years ago, the IMF estimated that the Lebanese central bank, which accounts for the largest share of the financial gap, could ultimately have negative assets totaling 60 billion dollars. In March, the Institute of International Finance estimated that the central bank's negative assets had decreased from 76.4 billion dollars at the end of 2022 to 48.4 billion dollars.

The scale of debt the government must bear will influence the IMF's assessment of Lebanon's ability to sustainably repay bondholders and other creditors during the restructuring. Even if core data, including the financial gap, is clarified, the bonds' recovery value will still be affected by other factors, such as how 14.3 billion dollars in overdue interest is accounted for and the extent to which bondholders must accept a reduction in the value of their assets, known as a "haircut." One investment portfolio manager, whose company holds a small amount of Lebanese bonds, believes that the current bond pricing of over 22 cents on the dollar is already close to previous estimates of the recovery value. Despite the significant rise in other high-yield bonds, Lebanon's bonds remain relatively attractive. The positive developments in Lebanon, such as the formation of a new government and the passage of banking sector reform legislation, cannot be ignored and may further boost bond prices.

Currently, high-quality distressed asset investment opportunities are scarce, and the overall spread in emerging markets has narrowed due to rising risk premiums in the United States. This is one reason why investors' risk tolerance has increased, leading to demand for Lebanese bonds. The surge in non-performing loans underscores the severe state of Lebanon's economy and the urgent need for comprehensive economic reforms and political stability to address underlying issues. The international community has called for immediate action to prevent further deterioration, which could have broader regional implications. The Lebanese government must take decisive steps to restore confidence in the financial sector and implement measures to support economic growth.