Ecuador | Innovative issuance
admin | January 17, 2020
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Ecuador – not typically an innovator of financial transactions – recently issued the first sovereign social bond, whose unique structure allowed Ecuador to lower their overall cost of funding by 225 bp. The 7.25% ECUASO social bond reflects the blended yield of an IADB secured A tranche at 3.75% and an unsecured B tranche at 12.25%. The significant spread premium of the B tranche is a function of a variety of legal and repayment risks embedded in this highly complex structure, though the novelty and scarcity value of the small issue could work to tighten spreads to the Eurobond curve.
A lower cost of funding but uncertain premium to Eurobond curve
The ECUASO social bond may have contaminated the USD Eurobond curve with lower prices to accommodate the supply; however there seems to be renewed focus on the attractive pricing of the unsecured B tranche ECUASO 0% 01/30/2035 at 12.25% yield or +275 bp pick-up against similar duration to the ECUA’24. Meanwhile, the Eurobond curve has shown some recovery on the relief that supply was an innovative social bond versus heavy benchmark Eurobond issuance. The ECUA’24 was the worst performer on +100 bp spread widening from 1/6 to 1/15. The structure of the ECUASO’35 is a zero coupon with a subsequent deep price discount with an average weighted life of only 4.1 years for the heavy amortization schedule that jumps from 7 points of amortization the first 12 months to 22 points on an annual basis from 7/30/2021 to 7/30/2023.
There are no other obvious comparisons for the unique sovereign structure as well as the first sovereign social bond. Ecuador is not typically the innovator of financial transactions; however the alternative structure allows Ecuador to lower their overall costs of funding at 7.25% (against 9.5% for ECUA’24) on the accessibility of the IADB guarantee for the secured tranche. The 7.25% of the social bond reflects the blended yield of the IADB secured tranche A at 3.75% and the unsecured tranche B at 12.25%. The Economy Ministry also emphasizes the social and economic benefits “to increase housing accessibility, enabling more than $1 billion worth of mortgage loans in 4 years and at the same time to boost the construction sector, generating employment and contributing about 0.4% to annual GDP if a conservative multiplier of 1.5 is used.”
The spread premium for the ECUASO tranche B remains a function of the legal and repayment risks with a complex structure that’s further penalized for the B- sovereign credit rating constraint. The legal risks focus on the subordination to any unanticipated liabilities, no rights to take direct action against issuer and limitations on the exercise of remedies upon an event of default under the repack trust indenture. The early redemption risk poses the more threatening risk with a schedule that shows an inferior principal claim amount under the following events: in the case of the Class B Notes only, a Republic Notes Acceleration Event; an IDB Guarantee Event; an IDB Purchase Redemption Event; and a Republic Notes Voluntary Prepayment Event.
The primary assessment then shifts to the payment risk on the heavy amortization period from July 2021 through July 2023 for a single B credit that still faces high rollover risk. The repayment risk is critical for the B- credit rating that reflects the high rollover risk for a high structural fiscal deficit and saturation of funding sources as per the high +10% yields in the Eurobond market that demands increasingly more creative funding alternatives. It’s also inconvenient that the current IMF program concludes in 2021 which also coincides with the high political risks of 2021 presidential elections. Argentina was a stark reminder about the importance of the election cycles on potential policy risk and whether there is commitment to maintain IMF relations as the lender of last resort following the political transition. The recent fiscal performance has also down-cycled from a fast pace of adjustment to only gradual adjustment with disappointment on 2019 performance for a central government fiscal deficit of $4.1 billion and only limited improvement at $3.4 billion for 2020. This then infers higher uncertainty on rollover risk for a heavier calendar of debt repayments in the 2022-2024 period.
The higher spread premium for the ECUASO may compensate against the lower recovery value and hence requires strong conviction about the repayment risks over the next 2-3 years, especially considering the small size of the issuance outstanding and illiquid secondary trading conditions. ECUASO almost represents a leveraged view on sovereign risk with the high premium dependent upon a successful fiscal adjustment and lower rollover risks. The novelty value and the absolute high yield may perhaps tighten the 275 bp differential to the Eurobond curve against the scarcity of only $326 million outstanding. However, the repayment risks remain an important determinant that requires still significant spread premium against the sovereign curve.