The Big Idea
Latin America | Credit trends
Siobhan Morden | June 2, 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.
Stability in emerging markets spreads argues for continuing to combine high-quality ‘BB’ credits and select high-yield opportunities. Illiquid ‘BB’ credits offer lower beta and higher carry than investment-grade alternatives. And some of the high yield opportunities add to portfolio income.
Illiquid ‘BB’ credits in particular continue to offer a combination of lower beta and higher carry than investment-grade credits. Costa Rica, among the ‘BB’ bonds, has been a strong performer after nearly converging with peers such as Guatemala. However, overall fund flows remains uncertain, with net outflows from ETFs and mutual fund outflows, sub-trend emerging markets debt issuance and prospects of lower trading volume through upcoming summer holidays.
Among the high-yield options, El Salvador stands out as a top pick due to its likely access to domestic financing. Conversely, Ecuador faces disappointment due to persistent political and policy risks. Argentina notably has seen a significant bounce in bond prices, showing resilience despite ongoing foreign exchange stress and decoupling from domestic financial contagion. The Bahamas has also demonstrated stealth resiliency and attractive carry over the past two months.
Dominican Republic fiscal watch
The fiscal data merits close scrutiny on the economic slowdown and approaching political cycle; however, a track record of fiscal discipline should reassure for maintaining the deficit within the 3% to 3.5% of GDP range this year. The spending and revenues are on track at 25% of the budget through the first quarter of 2023, though it will be important to monitor whether spending remains restrained under higher debt service and seasonal higher capex spending at year end.
There is no threat to the recently achieved ‘BB’ rating and, more interesting, is the trajectory for additional upgrades with fiscal reform. There is some warranted skepticism on expecting any near-term progress ahead of 2024 elections. However, tax reform should become a priority under an incumbent re-election and ambition to reach an investment grade rating.
The full release of the Article IV IMF staff report may provide some interesting guidelines with the summary recommendations for the adoption of a fiscal responsibility law “alongside efforts to durably increase revenues through broadening the tax base and reducing exemptions can also support fiscal sustainability.” Last year’s report recommends a primary surplus of 1%-1.5% of GDP (depending on interest rate) for debt to reduce close to 50% of GDP to accommodate any external shocks that prevents debt from exceeding the comfort threshold of 70% of GDP. The targeted adjustment may now be closer to 2% of GDP dependent upon whether the fiscal deficit tightens to 3% of GDP or remains closer to 3.5% of GDP this year. Meanwhile, the 10Y sector of the curve has underperformed across credits and intra-curve on maybe prospects of new Eurobond issuance.
Ecuador political risk
The election cycle may offer a break from the current policy paralysis; however, there is high uncertainty on runoff candidates and the post-election governability. The default level valuations continue to offer technical support with bond prices still stumbling within a low trading range. It’s difficult to have much conviction with many scenarios of still weak governability or a radical policy shift. The early polls predictably provide the advantage to the core 30% Correistas, 25% prior candidate Yaku Perez and then not much definition thereafter. It could be wide field of candidate under June 10 deadline and limited campaign cycle ahead of August 20 first round elections. The latest headlines suggest that former Deputy Luisa Gonzalez could emerge as the Correista candidate. There are prospects for optimism under a moderate candidate; however, governability remains highly uncertain under a large Correista block as well as still radical factions of Pachakutik under the Iza candidacy. There is no political consensus for a medium-term economic plan that includes labor reform and structural fiscal consolidation and no recognition of weak and incomplete dollarization. There are still many potential scenarios that should narrow once voting intentions narrow with latest CEDATOS polls showing a high 83% voter indecision and latest Click polls showing still a high 68% rejection rate for Correismo. The high voter discontent at 65% should favor non-traditional candidates with subsequent difficulty on bridging a legislative coalition and still weak governability.
El Salvador’s liquidity risk
The data transparency remains a concern; however more analysis emerges from local consultants that suggests that the debt liability relief from pension funds could provide even more breathing room at near $1 billion a year for the next four years. These revenues nearly double the earlier S&P estimates and more than covers the fiscal deficit this year. There is yet no medium-term plan for debt sustainability; however, the liquidity relief would sustain our base case of “paying for longer” beyond 2025.
The implied probability of default is slowly shifting beyond 2025 as ELSALV’25s crawl towards 85 while breakeven returns in 2025 exceed the average 30 recovery value as expectations shift towards 2027. There is still room for higher prices across the curve (maybe 5 points for 30 breakeven recovery value in 2027) if expectations firmly shift towards avoiding near-term default. The tactical overweight recommendation remains dependent upon not only the short-term financing options but also the commitment to further fiscal consolidation (albeit at a slower phase through elections). The fiscal data through 1Q23 remains supportive as does the high 15% carry, the low event risks, the smooth amortization profile (2% of GDP annual Eurobond coupon payments) and implied optimism on bond prices (recent pull to par trajectory on the ELSALV’2025).