The Big Idea
A midterm exam in LatAm sovereigns
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. This material does not constitute research.
The most interesting Latin American sovereigns are the ones with the high yields, but that makes holding a sustained view of their credit a slippery game. El Salvador and The Bahamas looked promising to start the year, and that has played out well. The Province of Buenos Aires also showed early promise and delivered. ‘BB’ sovereigns in LatAm remain my core recommendation. But not all prospects look equal.
El Salvador as one of my top picks has been the stellar outperformer among emerging market sovereigns with 57% total returns through June (Exhibit 1). I suggested taking profits on The Bahamas earlier this year at peak highs in February and 15% total returns since December. This was well-timed for the profit taking in March 2023 but allowed for an opportunity to buy into weakness in April. Both of these credits may downshift to carry returns in the second half of the year but still offering compelling double-digit current yield. The Province of Buenos Aires did not disappoint at 17% total returns and may exceed those impressive returns heading into the election cycle in the second half of this year.
Exhibit 1: Emerging market sovereign returns through June
Source Bloomberg, Santander US Capital Markets
The ‘BB’ credits remain my core recommendation for relative value, specifically credits like Costa Rica, Guatemala and the Dominican Republic for incremental yield that insulates against US Treasury risks as well as the positive credit rating momentum. Central America and the Caribbean has been unique for its rating upgrades throughout this year with 6% total returns in Costa Rica and Dominican Republic. This was the year of rating upgrades for Costa Rica with a unique 2-notch upgrade that allowed for convergence with illiquid BB credits (Exhibit 2). Guatemala has been somewhat of a disappointment for the flattish year-to-date returns and noisy election-related headlines; however, a democratic political transition and broader economic stability should allow for better prospective returns in the second half.
Exhibit 2: Emerging market sovereign credit rating actions
Source: Bloomberg (+/- one notch for upgrade/downgrade)
High yielders shifting to returns based largely on carry
The high beta credits require active management for the fluidity of their credit risk and the volatility of their return profile. The technicals were quite supportive to start the year on historic low, even default-level valuations after the disappointing 2022 performance. The strong external risk renewed appetite for yield; however, it’s the idiosyncratic risk that demands careful credit selection. It’s now a lower phase of event risk for countries like The Bahamas and El Salvador with more rational prices that reflect the manageable near-term liquidity risks. The normalization on credit spreads, or at least less distressed levels, suggest a slower phase for mostly carry returns in the second half of the year (Exhibit 3).
Exhibit 3: The normalization trade and paying for longer
Source: Bloomberg, Santander US Capital Markets
Argentina (Buenos) is maybe the exception
The default-level prices for the Province of Buenos Aires look misaligned to my no-default view after the political transition. The quasi-sovereigns remain trapped under the broader macro risks of the sovereign; however, these credits should start to differentiate on their own credit-specific fundamentals. The quasi-sovereigns should disproportionately benefit from their low gross financing needs and the positive terms of trade shock. The solvency indicators also boast stronger metrics relative to the sovereign since none of the quasi-sovereigns can deficit finance and accumulate debt. The quasi-sovereigns are not as vulnerable to execution risks of shock therapy and instead will benefit from immediate positive shock on lower convertibility risks. The Province of Buenos Aires may displace El Salvador as the top performer in the second half of the year.
Ecuador only tactical high beta trades
Ecuador was not my top pick for relative value heading into 2023 for the high political and policy risks and the low current yield. However, the high beta status and sensitivity to broader external risk still allows for periodic tactical appeal, especially on the initial phase of a risk-on rally. This was the main argument for our opportunistic recommendation for Ecuador’s value from November 2022 to January 2023. That, again for mostly technical reasons, explains my current expectations of a short-term bounce after the lagging performance last month, higher step-up coupons and lower political risk. Ecuador remains a mostly short-term opportunistic value with a bias to quickly take profits on latent dominant repayment risks beyond 2025.
Costa Rica converged with BB peers
The upgrade of Costa Rica represents a vote of confidence and clear differentiation amidst a trend of negative rating action across Latin America. The convergence of Costa Rica credit spreads to its illiquid ‘BB’ peers Guatemala and Paraguay represents a multi-year process of outperformance (Exhibit 4). Although this ‘BB’ spread convergence should slow the pace of gains for Costa Rica, there should still be potential for outperformance over a longer investment horizon as the country is maybe the only ‘BB’ credit on a trajectory towards investment grade.
Exhibit 4: Costa Rica converges with other ‘BB’ names on ratings upgrades
Source: Bloomberg, Santander US Capital Markets
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