The Big Idea
Lessons learned in Latin America in 2021
Siobhan Morden | December 17, 2021
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 approaching New Year is typically a moment of reflection. There are always hits and misses throughout the year and lessons learned that can make an investor better. In Latin America, those lessons point to the importance of identifying idiosyncratic risks and using higher carry to buffer the risk of higher US Treasury rates. The last year showed that the risk of higher global volatility requires a nimble approach. And it showed that the role of the International Monetary Fund has become more complicated and serves as less of an anchor.
Exhibit 1: EMBIG returns dropped in 2021 for most of Latin America
#1 Deja vu
This past year’s performance provides a likely preview to next year. The higher EMBIG yields are probably still not enough to offset persistent US Treasury risk as the Fed starts the slow unwind of liquidity. EMBIG total returns are down 1.6% year-to-date through December 15, with returns from carry insufficient to buffer 18 bp of widening in spreads and higher US Treasury yields (Exhibit 1). This looks to be the same overall dynamic next year. Yields on investment grade sovereigns look too low for a region suffering from the pandemic overhang of weaker credit ratings and higher debt ratios (Exhibit 2). Recession fatigue and election cycles also undermine the commitment to fiscal austerity needed to improve debt sustainability. Just a few credits showed positive returns this year including Ecuador, Belize, Suriname, Costa Rica and Bolivia. The valuations now offer better a better balance of risk-and-reward among the high yielders, and Amherst Pierpont begins the year having opportunistically covered underweight positions. But it is still the same advice heading into next year: choose wisely. Look for high yielders with lower correlation to US Treasury risk but take care to immunize against higher external volatility.
Exhibit 2: Latin America net credit ratings fell in 2021
#2 It’s not the same IMF anchor
IMF programs became the catalyst for positive returns in 2021, especially in Costa Rica and earlier in the year for El Salvador. This is not the case for 2022. IMF programs are at a more mature phase and execution risk is higher. To characterize IMF relations across the region: no IMF program in El Salvador, weak IMF programs in Costa Rica and Argentina and a strong IMF program in Ecuador. There is still potential for another 10% gains in Argentina if the country finalizes an IMF program early next year. There is similar potential upside for Ecuador on normalization from near 10% yields closer to 8%. Relations between Ecuador and the IMF look robust through next year thanks to success on tax reform. The umbrella tax reform not only complies with a difficult structural benchmark but should more than deliver the budgeted revenues needed to comply with IMF fiscal performance criteria as well as open the oil sector to private investment. There is no other country approving tax reform and no other country that could deliver Ecuador’s impressive near-3%-of-GDP fiscal consolidation from 2021 to 2022 that improves beyond 2019 pre-pandemic levels.
#3 Restructuring helps
Credits restructured in 2021 have become top 2022 picks. Effective policy management looks likely in a few places, with a fast turn in Ecuador and a slow turn in Argentina. Ecuador was one of the few outperformers this year, but persistent distressed yields suggest potential for further outperformance. Argentina has been a disappointment with consistent underperformance through the Fernandez administration; however, policy management is now undergoing an important shift during current IMF negotiations. Midterm elections triggered a slow transformation away from Kirchnerismo and towards policy moderation. Valuations are also attractive with current prices still at historic lows compared to recovery value. Quasi-sovereigns like the Province of Buenos Aires should offer the same positive convexity as the sovereign, with higher current yield to compensate for the slow transformation.
#4 Better be nimble
It’s always important to be nimble to handle fluid policy and political risks. Credit risk is most fluid for the weaker ‘B’ credits with unstable equilibriums and sharply different possible outcomes that complicate 12-month investment horizons. Election cycles remain critical influences on total returns, shaping policy management and often uncovering polarization among candidates in runoff rounds. This was certainly the explanation for the impressive rally for Ecuador in early 2021 and recent gains in Argentina. We are closely following the approaching presidential elections in Costa Rica with more than 50% undecided voters and 25 registered candidates. There are yet no dominant frontrunners, and the IMF program remains in limbo. The current valuations have not yet adjusted for political risk on the assumption that the IMF program was broadly socialized across the political establishment and will resume after elections with only marginal revisions. We were able to navigate through the fluidity of El Salvador policy risk throughout most of last year with a shift from overweight to underweight last June. However, we were premature in our shift back to neutral in late September with the credit still underperforming through December. The break below prices of 60 for El Salvador on the long end of the Eurobond curve might reflect thin December trading and hesitancy to take risk. However, current prices appear oversold and seem to anticipate a high probability of default despite near-term manageable debt service and reasonable liquidity options.
#5 Get off the benchmark
It is all about idiosyncratic risks with off-benchmark credits. The off-benchmark, high carry trade is attractive against the alternatives of the high beta of the high yielders or the high US Treasury risk of the low yielders. Uruguay inflation linkers (UI’2028) were our top pick last year and it did not disappoint with 12.5% foreign-exchange-adjusted total returns through mid-December. The Bahamas is our off-index top pick next year with 8.5% to 10% yields and lower correlation to external risk for its off-benchmark status and lower liquidity. These near-distressed yields seem to exaggerate the repayment risks in light of low debt service and a lengthy 24 months until the next amortization. The Bahamas benefits from an unblemished track record of repayment and openly qualifies debt payments as sacrosanct. The liquidity and rollover risks should also improve on the shift towards domestic and multilateral funds while also reducing the supply risk overhang in Eurobond markets.