Argentina | High yield exit
admin | January 24, 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.
The debate about the right yield for Argentina debt looks set to intensify as it exits restructuring. Some argue for a normalized yield closer to 8%, others for distressed levels at 10% to 12% for a country that will not exit debt crisis even after restructuring. The right level depends on the balance between liquidity and solvency, a credible plan for growing the economy and managing foreign exchange reserves and the execution risk in all of this.
There are a few factors that will determine this outcome. If restructuring emphasizes liquidity over solvency relief, then the exit yields become a function of a coherent medium-term economic plan. Is there a plan? There has understandably been more focus on near-term damage control than a longer-term stabilization. The Fernandez administration also faces a credibility deficit on economic management because of the ideological constraints of Kirchnerismo. There is a potential repayment strategy that emphasizes rebuilding foreign exchange reserves as opposed to fiscal discipline or growth through private investment. It seems more like a muddling through approach with suboptimal growth/inflation that avoids a crisis relapse and targets wealth redistribution between Macri and Fernandez voters. There are high risks to any heterodox approach that includes foreign exchange and capital controls and direct central bank monetization to rebuild liquidity ratios. The high execution risk for a medium term (and heterodox) approach to improve liquidity/solvency indicators suggest high exit yields post restructuring closer to the high end of the 10%-12% range. This also faces the counter forces on positioning risks that may attract new investors for the high relative yields for negative global rates and divestment from trapped long and skeptical investors.
There is an inverse relationship between debt relief and the exit yield. If we assume a friendly restructuring offer than emphasizes liquidity over solvency relief than exit yields should trade at a higher range of 10% to 12% on the medium term uncertainty of future debt repayment. It’s a tradeoff between front loaded solvency relief from an explicit haircut on capital/coupons or back loaded solvency relief that only improves through the gradual improvement of debt repayment capacity. The creditors would not self-impose an upfront loss but rather request minimal debt relief with uncertain future debt repayment capacity as a preferential alternative to large haircuts on principal. The fast track deadline from Argentina suggests a friendlier approach with consultative discussions and higher recovery value with an emphasis on liquidity (maturity extension) as opposed to solvency (haircut on capital) relief. This strategy would provide a temporary fix for the debt restructuring but the postponement of the liabilities still requires high credit risk until there is clarity on the medium term repayment strategy.
The foreign exchange reserve accumulation is critical. The external debt sustainability analysis is probably the most realistic approach for debt repayment assessment. We assume the fiscal debt sustainability analysis is somewhat constrained for the uncertain commitment to fiscal discipline and prospects for low growth (1-2%). If the central bank is able to accumulate foreign exchange reserves via excess private sector flows (primarily exports) with suppression of capital flight, imports and tourism from foreign exchange or capital controls, then this could offer the most viable strategy for future debt repayment capacity. This heterodox approach implies higher execution risks on the medium term effectiveness of capital controls, the inflationary risks of quasi fiscal deficits from central bank direct monetization and the political risks on whether the Fernandez administration can withstand the low growth/high inflation tradeoff. These higher execution risks from a heterodox approach to debt repayment capacity will require higher exit yields post debt restructuring and only a gradual decline in synch with relative economic stability and foreign exchange reserve accumulation.
Our base case scenario includes a successful sovereign debt restructuring close to the end March deadline; however conviction risks are low for the deal risk of logistical and legal constraints. It also requires good faith from the Fernandez administration to offer reasonable terms with recovery value above current market prices. If the debt restructuring team assumes low exit yields – closer to 8% than 12% – then this would undermine the bondholder participation with latent skepticism on future debt repayment capacity. The investment strategy focuses on selling into strength of a successful debt restructuring and then perhaps assessment among corporates or quasi-sovereigns for potential value and carry trade opportunities. The restructuring proposal probably includes partial interest accrual which will lower the carry trade as it shifts the leverage to the medium term debt repayment. There are probably also trapped and disillusioned real money investors that look for a divestment opportunity on the relief rally of higher bond prices. If the sovereign can avert relapse into crisis this may shift opportunities to alternative opportunities for stronger quasi-sovereign credits that remain current on their debt service.