The Big Idea
Colombia | Opposition momentum
This material is a Marketing Communication and does not constitute Independent Investment Research.
The surprise results from Colombia’s latest round of elections have triggered an average 30 bp of spread tightening along the sovereign curve and stronger Eurobond valuations. It’s too soon to take profits with more potential for a further drop in political risk premium. This would then suggest a gradual tightening to ‘BB’ peers such as Brazil or the Dominican Republic with most of the value on the inverted intermediate sector of the curve.
The emergence of Abelardo De la Espriella as frontrunner for Colombia’s presidency caught most of the market off guard. The prospects for political transition now look much stronger. Things looked neutral heading into the first round of Colombia’s elections with Eurobond valuations reflecting roughly 65% odds of political transition against the 50% odds from the recent polls. The first-round results not only validate this optimism but increases conviction. The 80% Polymarket odds seem reasonable under the premise that the frontrunner should win at least 50% of the other votes—most political pundits assign a higher 70%—and a higher margin of blank or null votes. The brief three weeks of the runoff campaign probably won’t alter the underlying trends, especially if voter sentiment prefers an outsider candidate with pragmatic flexibility. The incumbent candidate is constrained by the rigidity of radicalism with a notable 40% ceiling on the first round.
The next phase suggests a slow grind tighter on credit spreads as political risk premium unwinds into the second round. There is still significant premium, with Colombia an outlier to ‘BB’ credits. The technicals are also favorable. There is ‘positive interpretation bias’ of events considering few if any other outliers at an advanced phase of asset spread compression. There is also a structural underweight according to latest mutual fund data after repeated buybacks and caution ahead of the binary election risks. This points to one-sided demand with buying into strength (or weakness) after the first-round results as investors add exposure. This would also explain the gapping price action, with bond prices two to four points higher on the headline announcement.
Then there’s a more nuanced debate about best relative value. The liquid benchmark ‘BB’ credits in the region are Brazil and the Dominican Republic. Both are viewed as stable and mostly neutral comparisons. There is still considerable upside from a political transition that would realign Colombia to ‘BB’ peers. There is also supportive external risk that would suggest tighter alignment of credits within the same ‘BB’ rating category. The first observation is the flat curve for Dominican Republic, the steep curve for Brazil and the inverted Colombia curve from intermediate to longer tenors. This intermediate sector of the curve offers the most value on the convergence trade with 50 bp to 70 bp pickup to the duration-adjusted Brazil curve. There should also be appetite for higher yielding proxies to the US dollar sovereign for either quasi-sovereigns (EcoPetrol) or EUR-denominated bonds.
The tighter the valuations then the louder the debate about the relative fundamentals at a later stage of the convergence trade. The rating agencies should provide some breathing room with S&P in probably no rush to downgrade after the recent move to ’BB-‘ and Fitch next to assess the ‘BB’ rating, probably after a few months to assess post-electoral policy management. This should motivate proactive policy management soon after the political transition to defend against negative rating action. The initial euphoria on the political transition should eventually meet the reality of the more difficult policy transition and a slower phase of asset spread compression. This would then represent a ‘hard stop’ within the ‘BB’ valuation metrics with optimism for a honeymoon of fiscal activism but a harder reality on tackling a structurally high fiscal deficit necessary to stabilize the debt dynamics.
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