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El Salvador | High coupon new issuance

| July 10, 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.

Emerging markets issuance continues at a record pace. The second quarter saw $231 billion in new debt, and even ‘B’ credits like Bolivia are contemplating market access.  With no issuance from Latin America in the second quarter with a rating below ‘BB’ or a yield above 6%, the latest El Salvador issue comes somewhat as a surprise. The 9.5% coupon looks desperate compared to the country’s previous 7.125% issue in 2019, and the issue saw no tightening from earlier guidance on a 1.5x subscribed book. Success for the issue should depend on favorable external conditions, appetite for high yield and the possibility of an International Monetary Fund program.

Their ability to tap markets should lower El Salvador’s rollover and financing risks. However, it should raise concerns about solvency risks. The country already has high debt ratios and policy management that may put political priorities ahead of fiscal management in an important election cycle next year. Favorable external conditions, continued appetite for yield issuance and an IMF program would help.  This would allow for potential for El Salvador curve normalization. The short end of the curve remains undervalued for the flat El Salvador curve, especially considering the supply risk of long-dated issuance and the normalized and steeper Costa Rica curve.

The flatness of the El Salvador curve encouraged the new issuance to the long end to lengthen the debt maturity profile of the debt stock. The $1 billion long dated 32-year benchmark would be undervalued at 9.5% against 8.65% on the existing 30-year; if it weren’t for the significant 16-point price premium. There are no obvious comparisons of any recent high yield issuance where an issuer comes to the market at much higher coupons to a deeply discounted price curve.  Pemex is still the best reference for its high yield status and well developed curve with significant price disparity.

The typical formula for spread premium = [(1/Px1-1/Px2) * R * (1-R) * CDS] allows comparing the 16-point price differential hedged between the similar maturity theoretical CDS at around 800 bp and a recovery rate around 25%. This may work for investment grade issuers, but the absence of a CDS market and the high yield status would require a much higher spread for the higher implied probability of default.  This then biases the implied 25 bp much higher on referencing Pemex 47/50 6-point price differential at 40 bp or even the Pemex 46/50 11-point price differential at 110 bp. This explains the final guidance of 9.5% against the ELSALV’50 at 8.65% or higher cash price ELSALV’41 at 8.84%.  This high spread premium offers somewhat of a cushion against the still unclear credit risk during the pandemic and high debt ratios post-pandemic that require commitment to fiscal adjustment.

The small El Salvador economy at $25 billion remains vulnerable to any new issuance with concerns about the approval of $3.6 billion funding program this year at 14% of GDP and insistent pressure from the legislature on better transparency on budgetary spending and quicker opening of the economy to minimize loss on tax revenues. The markets would be willing to forgive the Bukele Administration for the pro-cyclical fiscal stimulus if there were future guidance about commitment to medium-term fiscal discipline.  The IMF warnings were clear that the Rapid Financing Instrument loan assumed proactive measures at 2.5% of GDP would be necessary to stabilize the now worse debt dynamics. This is even now more the case after the recent Eurobond issuance with an upside risk to the IMF forecasts of the 8.7% fiscal deficit this year as more funding implies more spending under dollarization. There has not been a detailed breakdown of the pre-Covid and post-Covid 2020 budget. But the latest analysis from the IMF forecasts a fiscal deficit of 8.7% of GDP and gross financing needs of $2.2 billion, which now increases to $3.2 billion after the recent $1 billion issuance or perhaps a fiscal deficit close to 12% of GDP and debt ratios near 90% of GDP.

The post-pandemic adjustment may even require a formal IMF program similar to the initial commitment in Costa Rica. The IMF program may conflict with the dominant political agenda of President Bukele ahead of mid-term legislative elections. There is no urgency near-term for the closure of the 2020 financing program and ahead of the 2021 elections.  The constant tensions between President Bukele and the legislature suggest priority for majority control that would further consolidate executive authority.  The nagging question for bondholders is what defines the Bukele game plan with unnecessary political tensions that may undermine investment and no clear medium term growth model, especially if fiscal discipline continues to erode the debt dynamics. It’ll be important to convince investors about a medium-term strategy that allows for stable growth and fiscal restraint and that would likely have to include plans for a formal IMF program.  There has yet been no public debate about IMF relations since the RFI disbursement.  The negotiations should look difficult considering the recent IMF recommendations including a combination of tax hikes and spending cuts of 2.5% of GDP from 2021 to 2023 beyond reversal of the temporary spending and revenue loss. The timing for an IMF program would be opportune post-February 2021 elections under the assumption of stronger governability of still a popular Bukele administration.

There was only cautious reception to the new 32-year issue for the high price premium, but these funds provide some near-term breathing room as the economic team nears completion of their financing program for the year.  The lower rollover risk should benefit the front end tenors that still trade with a significant premium to ‘B’ peers for the still flat curve. The ELSAL’23 remains inverted at near 10% compared to the 6% yield of the COSTAR’23.  The favorable externals and appetite for yield should also provide some support but with upside dependent upon commitment of an IMF program.

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