The Big Idea

A midterm exam in LatAm sovereigns

Siobhan Morden | July 14, 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 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

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

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.

Important Disclaimers

Copyright © 2023 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.

In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.

The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.

In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.

Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.