Latin America’s sovereign bond market has flourished over the past year. But with developed economies poised to raise rates and taper stimulus spending, the allure may wane. Except if the region’s countries can push through reforms to improve their finances
Investing in Latin American sovereign bonds comes with a fair share of risks. Devaluations, elections, financial crises, policy shifts and social unrest can exert pressure on governments to increase social spending and delay — even reverse — structural reforms, pushing sovereigns deeper into debt and their fiscal accounts into deficit.
These concerns swelled during the COVID-19 pandemic last year as a decline in economic activity, dwindling tax collections and higher public spending pushed up debt levels and widened fiscal deficits in much of the region, raising concerns about the health of public finances and the threat of defaults. Argentina and Ecuador did just that.
Despite the volatility, or maybe because of it, capital flows into the region increased last year and many corporates and sovereigns took advantage to sell more bonds. The issues of Latin American and Caribbean bonds in international markets shot up 23% year-on-year to $145 billion in 2020, the second highest level on record, according to data compiled by the United Nations Economic Commission for Latin America and the Caribbean (ECLAC). The pace continued in the first quarter of this year, as issuers in the region placed a quarterly record of $52 billion worth of bonds in international markets, the data show.
One driver of this growth was a rise in investor demand for higher yields. The pandemic brought a cut in global interest rates and a surge in stimulus spending, boosting liquidity and fueling the search for financial assets paying more than in developed markets. In Latin America, the spread on sovereign bonds was 386 basis points over US Treasury bills in December last year, ranging from 132 points in Peru to the higher end of 1,368 in Argentina and 24,099 in Venezuela, according to ECLAC. While the spread tightened in to 372 basis points April this year, it was still wider than it could have been on concerns of COVID-19 outbreaks and vaccine supply shortages, ECLAC said.
The question for investors today is what will happen in the region’s sovereign bond market now that the world is beginning to emerge from the pandemic.
There are a host of new risks. The coronavirus, in particular the Delta variant, is still a threat to the world’s economic recovery. Inflation is rising, and there is talk that the US Federal Reserve and its global peers may start tapering, the process of pulling back on the massive bond-buying programs they started in 2020 to provide stimulus to their economies. This could slow capital flows into the region or increase outflows.
Officials in the region are already taking note of this concern.
“A possible reduction in the monetary impulse in advanced economies is certainly a risk in the current environment, given the different speeds at which countries are recovering from the 2020 recession,” says Mario Marcel, governor of the central bank of Chile. “Risks are higher for countries that are less synchronized with recovery in the United States and Europe. Other vulnerabilities stem from less policy space due to higher inflation or higher debt levels. Some countries in our region are vulnerable in one or more of these dimensions.”
Marcel’s view is held by many analysts and economists covering the region.
“We have to prepare for a world economy that is no longer receiving quite as much support on the policy side over the next 18 months as it had been in the last couple of years,” Brian Coulton, chief economist at Fitch Ratings, said at a recent conference. “Peak fiscal stimulus is very much behind us.”
China is another concern. Slower construction activity and property sales combined with new regulatory pressure on energy consumption to reduce carbon emissions are limiting growth in the world’s second-largest economy.
“The slowdown in China and less fiscal stimulus doesn’t bode well for emerging markets,” said Tony Singer, Fitch’s managing director of sovereign ratings.
The rise in debt-to-GDP ratios in much of Latin American during the pandemic is leaving many countries the region more vulnerable “to changes in rates in the future,” he added.
According to ECLAC estimates, the general government debt levels in Latin America and the Caribbean increased to 79.3% of GDP in 2020 from 68.9% in 2019, making it one of the most indebted regions in the world.
A RATE HIKE. BUT WHEN?
Zulfi Ali, senior portfolio manager of emerging markets debt at PGIM, a US-based asset management firm, says his team does not expect a US interest rate hike until the third or fourth quarter of next year.
He warns, however, that “a selloff in US rates could adversely affect Latin American sovereign debt, particular long duration higher quality paper of countries such as Chile, Uruguay, Panama, Mexico and Peru.”
Some countries could be in a better position to weather the next challenge, a resilience that stems in part from their management of the pandemic. Mexico, for example, has been very disciplined with spending under debt-averse President Andrés Manuel López Obrador, known as AMLO, whereas Brazil has spent more money. Colombia started out with fiscal restraint, but then began spending more after a tax reform project faltered amid anti-austerity protests.
Which strategy has worked better? In economic terms, Chile is benefiting from having provided among the largest stimulus in the emerging world, while Mexico is less so because it forked out “next to nothing,” says Nikhil Sanghani, a Latin American economist at Capital Economics in London. The result is that Chile’s economy is posting the strongest recovery in the region this year, up to 11.5%, while Mexico is lagging at about 6% and Brazil at 4.6%, according to most estimates.
Regardless of the pace, the economic recovery will help boost government revenues, but spending may still prove hard to cut. Brazil, Chile, Colombia and other countries are “finding it difficult to go back on now on their accommodative fiscal policy,” Sanghani says. “There’s been a lot of public spending in the last year to support incomes during the crisis, and it’s becoming politically difficult to wean away from that. I think one consequence of this is that public debt probably ends up rising even more over the next few years.”
Chile and Peru are in better positions to manage higher debt levels, largely because they entered the pandemic with stronger public finances, including debt-to-GDP levels in constant prices of 30% to 40%. Brazil, in comparison, could see a rise in public spending as right-wing President Jair Bolsonaro seeks to win a second term in the general elections in October next year. “Whenever Bolsonaro’s popularity comes under pressure for one reason or another, there tends to be a shift toward more public spending, which, as we have seen in the past, has helped to bolster his popularity.” Sanghani says. But if Bolsonaro loses to former President Luiz Inácio Lula da Silva, a possible opponent, it could usher in a period of increased public spending, a fate that could also play out in Colombia, which has elections in May next year and has already seen massive protests against austerity.
“In the near term, there’s a justification for keeping fiscal policy fairly loose,” Sanghani says. “The problem you run into is that spending more now doesn’t necessarily mean it can be easily unwound at a later stage. With various elections on the horizon, I think it becomes even more difficult to try and convince the electorate that austerity will be needed.”
This could threaten the reform agenda. In Brazil, for example, reforms are needed to reduce its tax burden and improve productivity so that the country can grow faster in the future, says Wilson Ferrarezi, a São Paulo-based economist at TS Lombard, a London-based economic research firm. Without these reforms, Brazil will emerge from the pandemic in “a much more fragile political situation and much more difficult problem to handle in the coming years,” he says.
WHAT TO BUY?
For investors, picking what to buy and when can prove tricky.
PGIM began the year with a “very cautious” position in Latin American sovereign debt, Ali says. But as spreads in the region widened, PGIM added sovereign debt in the higher-rated credits.
Chile, Peru and Colombia, for example, “are seeing political shifts that threaten to undermine the orthodox macroeconomic framework underpinning their credit,” Ali says. “However, as spreads widened to account for some of these risks, valuations more closely reflect the new fundamental trajectory, accommodating potential additional downside in countries where there is political risk.”
While there have been and will be opportunities to buy on sell-offs, Ali says he pays more attention to the “longer term fiscal and debt trajectories” of countries the region
A number of lower-rated sovereign bonds in the region, for example, have benefited from the disbursement of Special Drawing Rights from the International Monetary Fund (IMF) this year, part of the Washington DC-based multilateral lender’s $650 billion program to help countries contend with the COVID-19 pandemic. But these countries “could have financing challenges going forward in the context of potentially tighter global financial conditions,” Ali says.
Other countries with lower ratings may face even challenges in managing their debt maturities in 2022 and 2023 unless there is a recovery in economic growth, fiscal prudence and “a solid relationship with the IMF to afford more financing flexibility,” he adds.
Despite the challenges, opportunities can be found.
“The region has undergone more volatility than most this year, with credit rating downgrades, political risks increasing in places like Brazil and Central America as well as the more traditionally stable countries like Chile and Peru,” says Nick Eisinger, co-head of emerging markets at Vanguard, a US-based investment management firm. “This volatility has produced a long list of opportunities.”
Ecuador is one. While uncertainty swelled in the run-up to the country’s presidential elections — the first round in February and the runoff in April, Vanguard maintained its exposure there.
The bet has paid off. After years as an outlier in the international markets, Ecuador under the leadership of President Guillermo Lasso, a conservative banker who took office in May, has been rebuilding ties with the IMF and investor community. Lasso has pushed through tax and tariff reforms and rebuilt international reserves, while a restructuring of the country’s external debts last year has reduced its debt servicing for several years.
Keeping abreast of the ins-and-outs of what is happing in the region’s politics helps.
“A major part of our job in running active emerging markets is to assess political risk and establish whether changes in politics and policy are factored into the price of financial instruments or whether they are building to some kind of tail risk,” Eisinger says. “Populist governments do risk undoing some of the reform of recent years but usually this comes with nuances and is not a straight line to deterioration. Where we feel that more populist risks are factored into prices we will not be afraid to take an active position in those markets.”
In this vein, PGIM is finding potential in the Dominican Republic, where the administration of President Luis Abinader appears to be pushing forward on structural reforms to enhance the future growth outlook, while vaccination rates improve and tourism picks up.
“Spreads in the long end appear cheap,” Ali says while warning that reform implementation and the pandemic “must be monitored carefully.”
THE NEED FOR REFORMS
Argentina and El Salvador, on the other hand, are vulnerable, as seen in yields in the mid to high double digits, while Brazilian bonds could come under pressure in the run-up to the election next year, Ali says.
That said, Ali says he is less phased by political shifts to the right or the left, and more focused on the actions that governments take, pointing out that Brazil and Colombia under their ruling right-wing governments have made larger fiscal transfers than previous leaders. “Oftentimes, if there are existing constraints, the leaders, including leftist leaders, can exhibit resilience,” Ali says. “Mexico and AMLO during and post pandemic are a case in point.”
A few keys for improving the health of the economy and public finances is the willingness to lure investment and make reforms, as well as move forward on fiscal consolidation.
“We are not seeing yet a clear focus among governments in the region to either boost investment prospects, attract private investment or to implement reforms that would help boost productivity growth in the region,” said Shelly Shetty, a managing director at Fitch.
Brazil has made some progress on structural reforms this year, while Mexico has been reversing some of the reforms of the previous administration, especially in the energy sector, she said.
A rise in commodity prices over the past year is helping reduce fiscal deficits in natural resource-exporting nations in the region, but this may only last until next year, Shetty warned.
In the medium term, “there is going to be a need for countries to actually pursue more structural reforms to consolidate fiscal accounts faster to put debt on a downward trajectory,” she said. “Some of these countries will need a tax reform to improve their public finances. It’s not that we are calling for new defaults in the region, but there are countries where we remain fairly concerned, including El Salvador and Argentina at this time.” LF