Anything but dull

IFR IMF/World Bank Report 2022
11 min read
Ben Edwards

El Salvador’s bond market offers investors an uncertain rollercoaster ride

When El Salvador’s government – led by president Nayib Bukele – sacked five Supreme Court judges in May last year, investors started to get jittery. The following month, Bukele said the country would adopt bitcoin as legal tender, and its bonds started to slide further.

Take the country’s US$800m bond issue maturing in January next year. In May 2021, it was trading above par; by September last year it had fallen to around 80 cents on the dollar.

Then, in November last year, when Bukele announced plans for a bitcoin-backed bond (dubbed the volcano bond), its dollar debt tanked. The 2023 bond, having recovered to close to 90 in October, fell to around 74 cents on the dollar. Another US$800m bond issue maturing in 2025 fell to about 67 cents.

As plans for the volcano bond stalled earlier this year, El Salvador’s debt prices continued to sink. By June, the ‘23s had fallen to 66 while the ‘25s were languishing at just 33.

With its debt prices showing no signs of rebounding and credit rating agencies signalling a risk of non-payment, Bukele took to Twitter in July to announce a buyback of the ’23 and ’25 maturity bonds, pledging to pay whatever price they were trading at at the time of the transaction. The bonds instantly responded. The '23s recovered to about 90 cents on the dollar, while the '25s eventually crept back to around 50 cents. The remainder of the curve, however, continues to trade in distressed territory. Its next maturity in 2027 – another US$800m deal – remains in the mid-30s.

Market watchers were unsure how to assess the bond buyback plan, which was scheduled to be completed in mid-September, after this story went to press. While El Salvador had always said it would buy back only a portion of the bonds, its offer to repurchase up to US$360m of debt is well short of the total US$1.6bn that is outstanding on the ’23 and ’25 bond issues and less than the US$560m it had lined up in July to use for the operation.

“A debt buyback makes sense at distressed prices but the announcement didn’t seem very well thought through – by saying they would buy the bonds at market prices, it just made it more expensive for them,” said Stuart Culverhouse, head of sovereign and fixed-income research at Tellimer Research.

Statement of intent?

Another interpretation of the buyback announcement is that it was a signal of intent to investors and a way to push back against the market’s expectations of a default.

“One way to look at it is that it’s a statement from Bukele saying that we have the money and we plan to service our debt,” said Alexis Roach, an emerging market sovereign analyst at Payden & Rygel Investment Management.

“He’s effectively saying we didn’t have to do it this way – we could have bought them back in a non-public operation while they were cheaper. We didn’t have to pay in the 90s but we wanted to show you that we can pay.”

Roach says it will be hard to gauge signals from participation in the buyback without knowing who owned the bonds, though some market watchers say low participation could be seen as a positive sign.

“It will depend on the risk appetite or whether investors just want to take some profit on the recent rally, but even if there isn’t a sharp take-up, it wouldn’t be seen as a big setback because that would imply that people are relatively more confident that they will actually meet their obligations,” said Steven Palacio, an emerging markets economist at JP Morgan.

While the bond buyback might provide a little short-term respite, some investors suggest there are still more questions than answers about what happens next for El Salvador.

“It probably changes the narrative a bit – which was El Salvador was going to be next in line to default after Sri Lanka,” said Kevin Daly, a portfolio manager of American Beacon’s Frontier Markets Income Fund and investment director for emerging market debt at abrdn.

“What it will lead to, though, is more questions about future resources to service their debt. Given where longer-dated yields and spreads are, external financing is just not available.”

Only a matter of time

Other investors believe it is only a matter of time before El Salvador defaults.

“A default is essentially already priced in, so if they can play games with reserves and do a buyback, then people will probably bite their hand off to get rid of the bonds, but it can’t conceivably change the position, which is that the country has too much debt,” said Paul McNamara, an investment director at GAM Investments.

“This is really just a fairly standard throat-clearing before a full-blown default – it’s just moving the deckchairs on the Titanic.”

Getting debt back on a sustainable path is going to be a significant challenge. The IMF says that, under current policies, public debt is expected to rise to about 96% of GDP in 2026 – an unsustainable trajectory.

“We really need to see stronger fiscal policy, and it’s not clear that we’re going to get that under this leadership,” said Culverhouse. “Even if they postpone the default on principal until 2025 or later, the interest on their debt is still pretty high, so any given month they could decide they can’t afford to keep paying, so that default risk doesn’t go away.”

However, some market watchers say a default is not necessarily imminent or even inevitable, given that the country’s fiscal balance was in better shape during the first six months of the year than many people had expected.

“We believe they can muddle through,” said Alexander Muller, head economist for the Andean region, Central America and the Caribbean at Bank of America. “If you exclude interest payments, El Salvador has more revenues than expenditures. That means they have a primary surplus, and it’s very rare to see a government with a primary surplus defaulting.”

The country still has its work cut out to turn things around. One key issue: El Salvador has persistently low growth – the country’s annual growth rate has averaged less than 3% over the past 30 years. To get its finances back on a sustainable path, the IMF says the country needs to make a fiscal adjustment of around 4% of GDP over three years.

“They have an opportunity of making the debt sustainable. But, obviously, this is a country that has high debt and clearly they need to make hard choices,” said Muller. “If they don’t make the hard choices, there could be big problems.”

Bitcoin undermines IMF deal

El Salvador had previously been seeking a deal with the IMF to bolster its finances, but chances of a programme are now slim, in part because of Bukele’s experiment with bitcoin. The IMF says El Salvador’s adoption of the cryptocurrency as legal tender – which Bukele has been loading up on using taxpayers’ cash even as prices have plummeted this year – entails large risks for financial and market integrity, financial stability and consumer protection while also creating contingent liabilities. It has also damaged investor confidence.

“Bitcoin has clearly been a distraction,” said Anthony Simond, investment director at abrdn. “It’s just a sign that Bukele’s government is definitely more focused on the marketing angles, as you saw with the volcano bond. If they had launched this three years ago when bitcoin was about to shoot up in value, that would have been good, but it’s all come at precisely the wrong time.”

Despite being given the cold shoulder by bond investors, Bukele remains popular domestically, with an approval rating of around 85% and a majority in parliament, potentially giving him ample room for fiscal manoeuvre.

“His governability position is stronger than that of most other Latin American presidents, who face low approval ratings and legislative minorities or fragile coalitions in congress,” said Sarah Glendon, senior analyst of emerging markets fixed-income at Columbia Threadneedle Investments.

“In short, the Bukele administration could easily implement fiscal adjustment and adopt reforms that would lead to an improvement in the country’s fundamentals, but at this time it seems highly unlikely that it will do so.”

While the probability of that fiscal adjustment is low, market watchers believe Bukele will do whatever he can to avoid a credit event prior to the 2024 election. Bukele is only able to stand for re-election because the country’s top judges – which Bukele’s party installed after sacking the previous Supreme Court justices – ruled that a president can now serve two consecutive terms.

“Bukele has a strong political aspiration to get re-elected in 2024 and, on the back of that, we calculate that he can’t afford a default,” said Palacio. “Given what happened in 2017 when there was a selective default, that helped bury the opposition, which did very poorly afterwards in the election. Bukele is aware of that and therefore will avoid any major economic distress ahead of the election.”

After that, however, the outlook for El Salvador’s bonds is bleak.

“They need very substantial haircuts and maturity extensions,” said GAM's McNamara. “From our point of view, it’s got a big stamp saying bust on it.”

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