The Big Idea
Ecuador | External bounce
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There is no specific fundamental catalyst for the recent outperformance of Ecuador’s sovereign debt. This looks almost purely technical, with Ecuador a liquid credit at distressed prices anchored for now by an International Monetary Fund program. But bond prices have started struggling after breaking through January 2023 price highs and looking increasingly vulnerable to any surprises. Ecuador has looked promising since early July after cuts in certain subsidies. But recent gains may be vulnerable to the approaching fiscal and financing challenges of the IMF program next year
Ecuador has been the main beneficiary of the risk-on trade. Perhaps Ecuador benefits from relative “neutral” liquidity stress near-term under the anchor of a fully funded and front-loaded fiscal adjustment of the IMF program through 2024. This contrasts against the low and lower foreign exchange reserves in Argentina with the liquidity risks perhaps explaining the relative underperformance. The distressed prices are also difficult to quantify on absolute valuations. There is no exact methodology on quantifying the probability and timing for default risk, especially against the track record of repayment this year, subsidy cuts, tax reform and the support from an IMF program. The breakeven return analysis doesn’t provide much insight with the bonds trading far above 30 recovery value even after the sinking-fund payments in 2026. The implied default risk remains high; however, bond yields are no longer overly distressed with yields dipping below 14% on the 2040s.
There has been no shift on fundamentals to greatly lower default risk, especially against recently lower oil prices. The credit backdrop remains fairly neutral into the election cycle with no serious challenge to the frontrunner status for re-election of President Noboa. However, challenges remain. Will President Noboa deliver on additional tax reform and spending cutbacks next year? The execution risks are high on the IMF program with ambitious fiscal targets and optimistic market re-entry next year. Arguably, the liquidity risks should resurface next year on the assumption of $1.5bn in Eurobond issuance within the 2025 financing program and still distressed bond yields.
The markets also seem overly optimistic on the blue bond transaction. The first transaction last year delivered only a small 2-3 point bounce on bond prices at much lower levels in the 30s to 40s. The impact should be much less impactful at much higher bond prices in the 50s, especially on the weaker technicals of tighter valuations. There is typically a buyback price premium but any cashflow savings from the buyback shifts to higher budget obligations for marine conservation. The debt burden would be smaller; however, the budget constraints would remain unchanged with still the same chronic liquidity risks. This is the fundamental constraint for debt repayment. The 2020 debt restructuring allowed for a smooth repayment cycle that doesn’t exceed 1.5%-of-GDP in total annual payments but these compete with a budget deficit and senior multilateral and bilateral debt payments with few sources of financing.
It is difficult to assume still higher bond prices heading into the election cycle against still latent policy risks post elections. There is yet no fundamental trajectory for normalization on credit risk with a serious challenge on budget management ahead of the 2026 sinking fund amortization payments. This suggests a slightly more defensive strategy with ECUA’2030 now underperforming ECUA’2035 after some profit taking this week with a higher sensitivity to external risk after the impressive performance from early August. The credit spread normalization will first require the re-election of President Noboa and sufficient political capital to deliver another phase of fiscal austerity to lower gross financing needs while broadening access to external financing.
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