The Big Idea
Out-of-consensus calls on Latin American sovereigns in 2024
Siobhan Morden | November 17, 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 mature phase of the US rate cycle should provide some relief to emerging market sovereign credit next year. Carry should drive returns across Latin America, and ‘BB’ credits should again provide an ideal balance of risk and reward. The strategy: build a core holding in ‘BB’ credits, especially candidates for a rating upgrade, while looking for positive surprise among higher beta sovereigns.
The demand for the nearly 9% yield on the recently issued Colombia 30-year bond shows the market’s optimistic expectations of lower volatility and higher carry. But credit selection should dominate again next year. This was the clear case this year. Returns on the EMUSTRUU index have come in flat so far bracketed by gains of 105% for El Salvador, a loss of 28% for Bolivia and a wide disparity in between of winners and losers (Exhibit 1).
Exhibit 1A: The now higher yielding liquid BB credits (YTM/duration)
Exhibit 1B: LATAM (EMUSTRUU) % total returns
The opportunities in sovereigns across Latin America should play out in three tiers of credit:
- ‘BB’ credits, with a focus on rising angels
- Stressed credits, with a focus on commitment to a fiscal anchor
- Distressed credits, with a focus on avoiding default.
Which country can commit to spending cutbacks of 2% of GDP? The fiscal anchor remains the dominant theme across all credits. All face a more difficult post-pandemic phase of higher debt ratios, higher debt service and persistent social pressures. This question will decide the relative outperformance next year. My top picks for this year—El Salvador, the Bahamas and Costa Rica—are all reaching a mature phase of alpha gains and demand reassessment for a slower phase of outperformance next year.
Who among the ‘BB’ credits are on path towards investment grade? This may not be the obvious question after the recent cycle of negative rating actions and several years of fallen angels across the region (Exhibit 2). However, the upside surprise comes from the Central American and Caribbean credits, with positive rating actions this past year and several countries either with a plan or path for an investment grade rating. The majority of credits should benefit from relative stability within the ‘BB’ category, like Guatemala and Colombia. However, there are a few credits like Costa Rica or maybe even the Dominican Republic that could break away from the pack.
Exhibit 2A: Latin America net credit rating downgrades – DomRep, Costa Rica, Guatemala, Uruguay buck the trend
Exhibit 2B: Credit rating action 2020-2023 – upgrade/downgrade (+1/-1)
Costa Rica was one of my top picks this year and the only credit with consecutive positive returns from 2021 through 2023. The impressive outperformance should slow after reaching credit spread convergence with ‘BB’ peers after the 2-notch rating upgrades. However, its low-risk status and positive medium-term trajectory still merits core exposure as the only credit with a plan and path towards an investment grade rating.
The Dominican Republic could represent the upside surprise if the next administration successfully launches and approves tax reform. This would provide the catalyst for an investment grade trajectory and A breakaway from other liquid ‘BB’ credits like Colombia that are stable but stagnant within the ‘BB’ category. There has already been a 1-notch upgrade from S&P this year to ‘BB’ for the Dominican Republic with further positive momentum on the improving governance criteria and the submission of a fiscal rule as the precursor for tax reform next year.
An anchor among stressed credits
Who among the stressed credits can commit to a fiscal anchor? El Salvador and the Bahamas have reached spread convergence and are the top regional performers this year. They were my top picks heading into 2023. There is no comparison within emerging markets to the 105% total returns this year for El Salvador, and the Bahamas have returned 17% so far this year. However, the average 11% to 12% yields on these sovereigns remain at distressed levels, and there is an unstable equilibrium between credit spread normalization and credit distress (Exhibit 3). The high debt service is not ideal for debt sustainability and complicates liquidity risk with restricted external market access. The gross financing needs remain quite small with a demonstrated commitment to repay bondholders, and the Bahamas soon should have some breathing room after its January Eurobond amortization.
Exhibit 3A: El Salvador passive cashflow/debt dynamics
Exhibit 3B: Bahamas optimistic cashflow/debt dynamics
However, both credits are soon reaching a critical juncture. The Bahamas will have to clarify if they can commit to tax reform to achieve an ambitious fiscal target in FY2023/24 and El Salvador should also clarify its IMF relations after its February 2024 elections.
El Salvador’s IMF program is now a real option with the Bukele administration shifting priorities towards an economic agenda. The goal is to lower the cost of financing and boost growth led by foreign direct investment. This would translate into another tightening of credit spreads maybe even below the 10% yield threshold as markets unwind default risk and benefit from the final phase of alpha returns (Exhibit 4).
Exhibit 4A: Not yet discounting an IMF program
Exhibit 4B: El Salvador FULL convergence with the Bahamas
There is lower conviction on whether the Bahamas would commit to tax reform as the necessary adjustment to achieve their ambitious FY2023/24 fiscal targets. The current fiscal trends do not suggest a structural break lower from the current 4% of GDP fiscal deficit down to the -0.8% of GDP targeted FY2023/24 deficit. The inability to reduce the fiscal deficit would represent a serious setback on the trajectory to stabilize the high 80% of GDP debt ratios and potentially undermine the high carry returns with profit taking on the unresolved liquidity and solvency risks.
Avoiding default amidst distress
Who among the distressed credits can postpone or avoid default? There are no obvious candidates that could replicate the El Salvador alpha returns of this year. But there could be upside surprise among those credits that are already trading at default levels including Argentina, Province of Buenos Aires and Ecuador. The political transitions in Argentina and Ecuador should allow for a policy transition at a difficult juncture of acute cash flow stress and ahead of heavy sovereign Eurobond payments in 2025. The initial guidance from the Noboa-elect administration is not overly encouraging. Political constraints discourage fiscal austerity. This is what traps bond prices at low levels, albeit with some positive optionality (Exhibit 5). Bonds could bounce off the lows on pro-growth investment reforms or other options that could delay or reduce default risk.
Exhibit 5A: The optionality of distressed credits – prices trading at recovery value
Exhibit 5B: Argentina coupon/sinking fund payments
Argentina is quite unique. Not only does the political establishment recognize the fiscal problem, but there is broad consensus to fix it. It’s also notable that all sovereign and quasi-sovereign credits have remained current on debt payments through the worst of the fiscal and external liquidity stress this year. There is not the same knee-jerk reaction to default to bondholders and instead a renewed shift towards burden sharing and the need to reduce domestic liabilities.
There is room for optimism. The recipe is the same no matter who wins with a fiscal anchor dependent on both the commitment and the successful execution of spending cutbacks. Stagflation remains a threat and could increase social and political pressures. However, you cannot spend what you cannot borrow. There is no access to external credit and only minimal access to domestic credit in light of underdeveloped local markets and limited support from the central bank. The memory of crisis and hyperinflation should discourage crossing the red line of deficit monetization from the central bank. There has been a full recognition of the policy failure under Kirchnerismo and a shift towards policy orthodoxy and fiscal discipline. There is no quick fix for Argentina’s large structural fiscal deficit, but the momentum should shift towards a credibility shock including a technocrat economic team and front-loaded fiscal adjustment in 2024. This should all suggest upside potential that maybe even breaks above the year-to-date trading range and adds to gains depending on the follow-through on spending cutbacks.
The quasi-sovereign credits offer even a better balance of risk-and-reward. The quasi-sovereigns cannot deficit finance and so cannot run large fiscal deficits or accumulate leverage. The Province Buenos Aires offers stronger liquidity and solvency metrics and a track record of higher recovery value relative to the sovereign. The wide differential to the sovereign (BUENOS’37A-ARGENT’41) assumes a similar high probability of default. However, the post-2021 restructuring debt relief translates into a much smaller part of the budget—debt service at less than 4% of current revenues—and low overall gross financing needs with $700 million annual Eurobond payments in 2024. It would require a disproportionate unwillingness to pay or equally significant domestic shock to interrupt the low annual debt service. That stands at $400 million in 2023 and $700 million in 2024 and in 2025 relative to $10 billion for the sovereign. The high current yields of 19% far exceed the sovereign with a sinking fund schedule in 2024 that translates into attractive breakeven returns, especially after adjusting for default probability.