The Big Idea
El Salvador | Breakeven return analysis
Siobhan Morden | March 24, 2023
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 broad contagion across emerging markets now demands a reassessment of relative and absolute value. El Salvador was not the worst performer of the benchmark high yielders. Its illiquidity provided somewhat of a buffer. But more important are valuation and fundamentals. El Salvador’s distressed bond prices already discount a high probability of default and offer a buffer against the latest external risks. The base case scenario still includes low near-term liquidity risks and asymmetric positive upside on solvency risks. Stick with a core tactical overweight on El Salvador, my top pick among the high yielders.
El Salvador’s performance was unique through the latest bout of external contagion, especially compared to other high yielders. Latin America is initially vulnerable to indirect contagion from lower commodity prices or stressed global financial markets. On these metrics, El Salvador actually benefits from its dollarized economy, few if any cross-border financial flows and its status as a commodity importer. El Salvador benefits from higher current yield and lower event risks relative to peers. This would explain why El Salvador was a relative outperformer versus Argentina and Ecuador. However, the next question is whether global risks warrant lower bond prices.
The most logical interpretation of current prices suggests a few years of coupon payments and then a high probability of default. The investors would break even at current prices so long as recovery value offers around 30 after two years of coupon payments. This may oversimplify the default risks; however, it’s the only logical analysis on the high uncertainty of the economic plan that dictates both the probability of default and the aftermath of the recovery value. The interpretation of the recent price weakness now either accelerates the event of default or lowers the recovery value. The external backdrop remains uncertain; however, the base case remains unchanged on El Salvador paying for longer through at least 2025 if not longer or maybe even avoiding default.
There has been no contagion in local markets with consistent rollover of the treasury bills through a heavy month of redemptions. The 12-month tenors have spiked higher from 7.25% to 8.25%. However, this occurred in early January ahead of the heavy redemptions in the first quarter of 2023 and not correlated to broader market weakness this month.
There has been no backlash to rollover risks with financing capacity mostly isolated to domestic markets and occasional residual access to multilateral loans. The liquidity risks are now much lower after the 2023 and 2025 bond buybacks and final $604 million payment on the 2023 bonds in January. Eurobond debt service represents only 2% of GDP and competes above-the-line with other domestic US dollar payments. The pre-payment on Eurobonds shows the commitment of priority payments of external over domestic liabilities. There has been no coupon watch or concerns about monthly US dollar coupon payments.
The fiscal adjustment is critical. There is no other option at a phase of limited financing alternatives. The Bukele administration has to lower its gross financing needs on the practical response to their lower financing alternatives. The latest external contagion would have no impact on already restricted market access. The question is whether external shocks would threaten economic growth and lower fiscal revenues and then force a pro-active cycle of fiscal austerity. The revenue collection has reached a mature phase of cyclical and efficiency gains which then shifts fiscal adjustment on spending cutbacks. The latest relief in external markets should spill over and reduce any secondary threats to the domestic economy and budget management.
The average breakeven recovery is now quite low at 34 for January 2025 and 17.5 for January 2027 with current prices implying low historic recovery value in 2025 and not much potential for postponing default beyond 2025. These valuations reaffirm my tactical overweight recommendations with a strong track record of repayment, a process of fiscal adjustment with no radical economic policy measures. The low liquidity risks also reinforce the high current yield at 17% to 19.5% and much lower event risks compared to peers like Argentina (liquidity stress) and Ecuador (political stress). El Salvador stands apart compared to the recent disruptive headlines of impeachment risks in Ecuador and financing and USD liquidity stress in Argentina.