Latin America | Finding relative value

Siobhan Morden | June 23, 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.

Emerging markets debt along with other risk assets is tightening to the US Treasury curve, and relative value is shifting in Latin America. Potential returns in The Bahamas and Costa Rica look promising. El Salvador may not be able to stay on its impressive year-to-date pace of 58% total returns. And Ecuador looks likely to lag behind its high yield peers.

The Bahamas: Laggard Bounce

The Bahamas has experienced a significant shift in fiscal data, moving from a deficit to a surplus in the first quarter of 2023. Unlike other countries in the region, tax revenue in The Bahamas is booming, leading to stronger-than-expected results for the fiscal year. However, challenges lie ahead as the country aims to reduce a deficit of 3.8% of GDP and bring revenue and spending into balance. The high debt ratio of 83% of GDP leaves no room for error. If external risk remain at bay and fiscal data meets expectations, the yield curve is likely to bull steepen from its current flat-to-distressed levels. Bonds maturing in 2028 and 2029 may outperform, particularly with an upcoming amortization in January 2024. The Bahamas has been the second top performer in the region, with impressive year-to-date total returns of 6.2% for the EMUSTRUU index. Despite its high yields of approximately 12%, The Bahamas benefits from lower event risk compared to countries like Argentina and Ecuador. Recent headlines about a potential debt-for-nature swap could lead to catch-up gains for The Bahamas.

Costa Rica: BB Convergence

A recent rate cut in Costa Rica serves as a reminder of the country’s strong fundamentals. With inflation below trend and still leading in terms of growth among regional countries, Costa Rica’s fiscal performance remains robust. Further rating upgrades may be on the horizon, as the country maintains a 2% of GDP primary surplus this year. Valuations have become a key point of discussion following Costa Rica’s full convergence to the illiquid BB peer group. Relative supply risk becomes a factor as Guatemala recently completed its funding needs with a $1 billion Eurobond, while Costa Rica plans to issue $1.5 billion in the second half of 2023. Although recent profit-taking has led to underperformance, the supply is not expected to disrupt the strong fundamentals of Costa Rica. Real money European and crossover investors hold core underweight positions, and there is still confidence that the country can trade close to its peer group. In the long term, Costa Rica is on track to reduce its debt burden to around 40% to 50% of GDP, positioning itself for an investment grade rating.

El Salvador: Paying for Much Longer?

El Salvador continues to experience a rise in prices driven by supportive technical factors. With impressive year-to-date total returns of 58%, El Salvador leads among emerging markets. The country benefits from high carry and low event risk, while liquidity management remains strong after debt buybacks and pension reform. Recent headlines suggest plans for a $1 billion domestic debt exchange, swapping short-term bonds (LETES/CETES) for longer tenor bonds. The current bond prices, which have surpassed initial targets and reached the 60s, indicate payment capacity beyond 2027 and higher recovery values. While the technical factors continue to support an overweight recommendation, the conviction is lower due to the impressive year-to-date returns and less favorable risk and reward at higher bond prices. Avoiding default requires further fiscal consolidation throughout the current economic slowdown and in preparation for the general elections next year. Achieving fiscal consolidation is a gradual process that requires consistent effort, including cutbacks of transfers from downsized municipal governments.

Ecuador: Frontrunner Candidates

Eurobond prices in Ecuador remain stagnant as investors await clarity on the political and policy risks leading up to the general elections. There is skepticism regarding the potential for a heterodox policy bias under Correismo or weak governability during a moderate political transition. The country faces challenges due to its culturally leftist political establishment and a dollarized economy. Recent setbacks, such as the rejection of an urgent economic decree for a free trade zone by the constitutional court, highlight the broad-based resistance to economic reform. The lack of discussion regarding a medium-term economic plan to finance debt amortizations beyond 2025 adds to the concerns. The base case scenario includes an opposing candidate winning against Correismo in the runoff round in October. The first polls, to be released soon, will provide insights into voter preferences and the potential candidate to face Correismo. The most likely scenarios suggest weak governability under a moderate candidate, prioritizing politics over economics for a short 15-month interim mandate. Until there is a shift toward economic reform or fiscal discipline, Ecuador’s bond prices are expected to lag behind its high-yield peers during the recent rally.