The Big Idea

Costa Rica | Eurobond issuance

| October 14, 2022

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.

Eurobond issuance is finally making progress in Costa Rica with the Legislative Assembly finally reaching consensus on a larger-than-expected but far from disruptive $6 billion issue. Improving demand, reflecting improving credit risk, should absorb the multi-year supply of Eurobonds. The issuance also requires Costa Rica to meet fiscal and debt targets while also using proceeds to rollover external debt or substitute for domestic debt. The funding program, if approved on final vote, should also provide financing flexibility and stronger governability that itself could translate into positive action from rating agencies.

The Assembly committee just reached consensus on granting approval for $6 billion in Eurobond issuance at a pace of $1.5 billion a year through 2026. The majority approval included support from the PUSC, PLN, PNR and PLP and overall representation that would reach the required two-thirds majority approval for a floor vote.

It’s never straightforward to reach absolute consensus, especially considering the party dissenters from within the commission and the untested governability of the minority Chaves administration. The PLN support with their 19 out of 57 deputies will be critical. There is still latent pushback among several parties to downsize the transaction maybe closer to $3 billion. However, the debate is not if but how many bonds to approve. The Eurobond authorization should encourage lobbying from the Chaves administration and provide flexibility to negotiate revisions necessary for compromise support. The timing of any new issuance would be opportunistic and dependent on favorable market conditions with bridge funds already allocated for the January Eurobond payment in case final approval or launch delay too late into the year.

Revisions to the program could focus on either the size of the transaction or the conditions attached to the Eurobond issuance. This includes specific fiscal and solvency metrics that serve as pre-requisites for annual $1.5 billion Eurobond issuance and a sole funding purpose to replace domestic debt or redeem external debt maturities. This should reassure about the concerns of doubling the debt stock and undermining the scarcity value of current outstanding $5.5 billion Eurobond stock. The initial tranche of $1.5 billion should rollover the $1 billion maturing in January.

The initial conditions through 2023 seem quite “light” and serve as minimal thresholds that are below conservative official targets and slightly above IMF targets. The later targets then more quickly escalate beyond the 2% primary surplus necessary for debt sustainability.  The fiscal criteria seem motivated to reassure for fiscal discipline after the mixed signals from the Chaves administration on revisions to the fiscal rule. This also serves the interests of bondholders that would uniquely benefit from the conditionality and subsequently motivate more demand for the new issuance.

Cooperation from the Assembly could also catalyze a review from rating agencies that have been reluctant to recognize the smooth political transition, successful fiscal consolidation and broad access to financing options that includes unprecedented strong IMF relations. The shelf registration for Eurobond issuance would expand financing beyond the deep local markets, the potential ESG-related funding, and the unparalleled access to the IMF through a normal access loan program and now one of the first countries to tap the resilience and sustainability trust (RST) loan facility.

This RST funding capacity would contradict the assessment from Fitch on “restricted access to external credit” or the S&P rating weakness of “securing approval for external debt financing.”  There is also a clear divergence on the path towards fiscal consolidation with none of the rating agencies expecting a 1%-2% of GDP primary surplus over the next few years. This contradicts from latest IMF statements that risks are biased to stronger fiscal performance and the 1H22 actual primary surplus of 1.3% of GDP. The rating agencies may all soon review the stable outlooks of the B/B2 ratings with larger funding access after the staff-level IMF agreement, broader governability and financing flexibility from the Assembly after approval of Eurobond issuance and fiscal performance that suggests a minimum 1% of GDP primary surplus this year.

The next debate shifts to valuations and whether all of the good news is already discounted on the convergence of Costa Rica with ‘BB’ credits in the region.  The 10-year sector of the curve definitely supports this view with Z-spreads trading through liquid ‘BB’ credits (DomRep) and approaching illiquid ‘BB’ credits (Paraguay, Guatemala). This sector of the curve should be particularly vulnerable to new issuance on a steep curve with Costa Rica careful to minimize funding costs as debt service crowds out 47% of the 2023 budget. The longer tenors offer higher relative premium and less vulnerability to supply risk.  The longer tenors would also express a medium-term bullish credit view. The rules-based culture under the fiscal rule and public employment reform should push the primary fiscal surplus to 2% of GDP and lower the debt ratios near 60% of GDP comparable to ‘BB’ credits. If Costa Rica can resolve its structural fiscal deficit, then the country would then be unique for this ‘BB’ credit category as the most ESG-friendly country with the strongest institutions, equitable social indicators, and the greenest environmental initiatives for highest ESG rating agency relevance scores.

Siobhan Morden
Santander Investment Securities
1 (212) 692-2539
siobhan.morden@santander.us

 

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Siobhan Morden
siobhan.morden@santander.us
1 (212) 692-2539

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