Are bondholders feeling generous?

| April 3, 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. This material does not constitute research.

The intensity of the economic shock around coronavirus has triggered a cash flow crisis across Latin America, especially for the fiscally vulnerable ‘B’ countries without access to savings or credit.  Foreign debt payments could get subordinated to critical domestic social services for countries with high underemployment and poverty.  The serial defaulters like Argentina and Ecuador clearly want to avoid the backlash of litigation and economic stress from a hard default, but pressure on cash flow continues to build. Are bondholders feeling generous?

Ecuador paid its Eurobond 2020 amortization on March 24 to put off the penalties of a hard default, and Argentina continues to pay its external debt through the debt negotiation process.  But there is immediate need for cash flow relief on near-term bond payments.  Will the majority grant a temporary standstill on coupon payments? What are the bondholder incentives? It’s not a decision based necessarily on humanitarian arguments but rather on what provides better optionality for future payments. Stronger investor goodwill for Ecuador should give the country better upside optionality relative to Argentina.

Let’s be clear.  There is high risk of a suspension of payments whether bondholders grant relief or not. This is why credits like Argentina and Ecuador trade below historic recovery value levels.  Argentina may be able to last a few months, dependent upon social and political stress and management of foreign exchange reserves. Cash flow pressure appears higher in Ecuador with a 30-day grace period expiring on April 26 after failing to pay the Eurobond’25 and Eurobond’30 coupons. The political and social pressures are also intense with loud debate about debt relief.

The question is whether these credits can avoid a disorderly default.  There is now more chatter about potential consent solicitations to request a temporary standstill on debt payments.  Governor Kicillof attempted and failed on this initiative earlier this year. There was not much bondholder goodwill when the Province of Buenos Aires could make the payment.  And they did. Circumstances have changed, and there is a serious need for temporary cash flow relief.

The temporary standstill is just that; a deferral of payments that only provides temporary relief and doesn’t in itself offer a solution.  This may discourage bondholder participation. There is no context for analysis of a medium-term solution. There’s too much uncertainty around global risk drivers like commodity prices, global demand, access to capital and cost of funding. Is there a U- or V-shaped global recovery or permanent damage? Will OPEC stabilize oil prices?

This is why the Argentina restructuring has hit an impasse. It’s particularly more uncertain for Ecuador ahead of the 2021 presidential elections.  These are exogenous determinants that the Moreno administration cannot control. The complicated debt restructuring requires thoughtful and thorough analysis of medium-term debt repayment capacity. Although bondholders prefer a medium-term solution, the logical solution to intense cash flow stress is a fast-track consent solicitation to defer near-term payments.

Ecuador is in a stronger position to request temporary relief.  The Moreno administration has chosen a policy of outward orientation. The country has strong diplomatic relations with the US and multilaterals and has pushed to improve trade and foreign direct investment. There was no debt crisis before  the pandemic shock. This was why Ecuador was one of the favorite overweight credits at the start of the year. Ecuador is arguably maybe the only country now to pursue pro-cyclical austerity while also benefiting from strong multilateral financial support.

What is the tradeoff for Ecuador’s bondholders? The choice is to either deny or grant relief and wait to see what happens after the elections. Either way, bondholders would likely have to forfeit coupons.  The question is what option provides better optionality for future payments. The difference is that an orderly restructuring may provide higher optionality for payments next year while a disorderly restructuring may worsen recovery value.

There are two potential paths that will likely determine recovery value on Ecuador:

  • Orderly restructuring that provides net cash flow relief and encourages sufficient external credit that the financing gap narrows this year and the intensity of the economic crisis ebbs
  • Disorderly default that discourages capital inflows for a net reduction in financing and a much worse economic crisis

A disorderly default could result in the resurgence of a far-left candidate and worse economic policy management after elections and less willingness to pay.  This isn’t to say that an orderly restructuring will provide a solution.  There are only cash flow savings of $1.4 billion against an estimated $5 billion budgetary shortfall at current oil prices.  However, it would lower the risks of a worse budgetary crisis and subsequent economic crisis.  The marketing push from the economic team would have to convince bondholders that debt relief and other measures will provide a near term solution and higher optionality for future debt repayment against the alternative of a disorderly hard default.

Argentina is in a weaker position to request temporary relief. The Argentina debt restructuring has reached an impasse with no chance anytime soon of negotiating an agreement with creditors.  The intensity of the external shock makes it difficult to quantify the medium-term debt repayment capacity and exposes a weak domestic policy framework with reluctance to embrace economic reform.  This complicates the repayment analysis and deters investors, who would have to commit to worse recovery value under the current circumstances, especially under the conditionality that high exit yields would require more debt relief. This almost seems like a poison pill to purposefully undermine a resolution. The economic team may then seek an alternative solution and request a temporary standstill on debt payments.  Investors seem less inclined to grant temporary relief. The current relations are tense after the recent shift towards a more aggressive proposal on debt restructuring.  This unwillingness to pay probably won’t improve whether it’s an orderly restructuring or disorderly default with recovery value skewed now to low historic levels. It’s almost a better tactic to hold out and see how many more coupons you can receive near term. There is still some optionality for near-term payments from monitoring low but resilient net foreign exchange reserves; however it’s not a sustainable strategy. GDP looks likely to decline 4%-6% thi year and the fiscal deficit rise to 5% of GDP.

There are relative value strategy implications that favor Ecuador over Argentina based on bondholder relations.  Another near-term push higher on Ecuador bond prices looks likely once they announce a consent solicitation. But deal risk still runs high because of the uncertainty of reaching the 75% threshold participation. There is still potential selling pressure on a the back of a successful restructuring because of the uncertainty of near-term liquidity management. There is no linear path towards recovery with near-term liquidity stress and unresolved election risks. However, some near-term gains are still possible except for Argentina, where bond prices are likely to remain trapped under a cloud of high risk of hard default and low recovery values.

john.killian@santander.us 1 (646) 776-7714

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