100% Yields on Ecuador Bonds: A Sign of the Times

Nobody should be surprised that rating agencies are again trying to close the barn doors after the horses have fled. But as yields on Ecuador sovereigns reached 100% on Friday, even credit default swap traders and political risk insurance principals were left wondering whether they should simply be deleting probability-driven emerging market risk pricing models from their computers.

Emerging market mutual funds manager have been deeming this year’s collapse in junior equity exchanges as an undervalued opportunity. But, after the exceptionally dramatic degradation in bond default risk spreads on Ukraine, Hungary, Russia, Argentina and Ecuador in recent weeks, the question investors must ask is this: Do their asset managers really understand what formative impact the global recession will have on highly-favoured countries like China, India, Turkey, Brazil, Russia and South Africa?

On Friday, Ecuador’s credit rating was cut from “B-” to “CCC-” by S&P, and from “B3” to “Caa1” by Moody’s. Both rating agencies now place the recovery potential for Ecuador sovereigns due in 2012 and 2013 at zero, implying that bondholders can expect no more than 10 cents on the dollar. Both rating agencies acknowledge that Ecuador’s decision to skip the coupon payment (on the 2012 bonds) due next week is more a consequence of “unwillingness” than inability to service debt; oil-exporting Ecuador has about US$2 billion cash on hand today.

What the rating agencies are belatedly recognizing is that well-argued, if not acceptable, political considerations are supporting Ecuador’s default decision. On the one hand, President Rafael Correa has been stating publicly for months that he considers foreign loans secured by military dictatorships and corrupt politicians as “illegitimate” and that Ecuador has no moral or contractual obligations to comply with loan terms. On the other hand, President Correa’s cabinet colleagues reiterate, almost daily, that any international commitment, made by previous administrations, which conflicts with the anti-poverty (Bolivarian) social agenda will be not be met.

Shades of Fidel Castro and Hugo Chavez? Quite clearly, yes. However, emerging market investors still need to address two questions before they heed Wall Street analysts who are continuing to issue “buy” signals. Firstly, as far as Latin America is concerned, will Nicaragua, Bolivia, Guatemala and Peru follow Ecuador’s lead and encourage revisions to their sovereign bond obligations? Argentina already has its own default-to-restructure history. Secondly, will deteriorating economic and consumer conditions force non-Latin American political leaders to enact legislative changes (e.g. currency controls, food subsidies, taxation, leverage caps and protectionist measures) which will lay the foundations for a comprehensive revaluation (down) of emerging market assets?

While it is indeed critical that investors not embroil themselves in any type of ideological debate, one cannot ignore the populist nature of the thesis that the failure to diminish or eradicate poverty amongst huge proportions of third-world populations, despite IMF and World Bank interventions, is now threatening to bring real growth (not GDP numbers) in dozens of emerging economies to a grinding halt in the first half of 2009.

For that matter, why are these developing country governments being asked to implement stimulus packages if their growth rates are between 5 and 10 percent? Or, are these growth rates bogus? Remember, if a truckload of toxic chemicals spills somewhere, the money spent cleaning it up counts towards GDP. When near-famine conditions exhaust all natural sources of water, the money spent on bottled water is added to GDP. When the lack of basic preventive health care leads to serious illnesses, medical costs also contribute to GDP.

In brief, GDP, by its very nature, has the ability to convert harm and waste into positive gains, and independent, verifiable data (not government-generated statistics) shows just that; this conversion process has been rampant right across the emerging market spectrum for the better part of two decades.

Recommendation: Stay out of emerging market ETFs, or sell on rallies for healthy profits as deleveraging gathers momentum.

Disclosure: none

Comments

[investor88:]

An insightful and revealing article. More evidence that the world economy is not well and far from recovering.

2008 Nov 16 07:18 AM

[tragicomix:]

And $2.8 trillion (official estimate) of sub-prime home loans plus another $1 trillion of credit card debt, a lot of it sub-prime and possibly other sub-prime loans masquerading as conforming loans backed by Fannie Mae and Freddie Mac --- all created plenty of GDP growth in the US. As did and does the expenditure on the Iraq war and salaries paid to government officials. To the best of my knowledge the public sector is largest in the EU, not in Lat America. So what is the new thing, if any, that are you trying to say?

2008 Nov 16 08:38 AM

[jepittman:]

The situation in Ecuador sadly reflects the inevitable results of poor economic policies. The same political policies are being practiced in Venezuala and Argentina. Contrast these basket cases with Columbia and Brazil. Open markets, low taxation, sound banking practices, democraticly elected governments and committments to honoring all obligations contribute powerfully to a lasting prosperity. Brazil and Columbia 'get it'. Sadly Ecuador does not.

2008 Nov 16 10:08 AM

[notsosmart:]

can anybody trust ratings on anything? has anybody figured out the default rate of russia since ww1? the scams in this country are bad enough without putting your money off shore specially south america.well, its your money. brazil & columbia may get "it" at this moment but things can & have turned quickly in those places.

2008 Nov 16 10:31 AM

[Hank/Hawkeye:]

Why settle for "only" 100% yield on Ecuadorian bonds when up here in Canada you can get Quebecor Pref. C's yielding 1,112.9032 %, or better still the D's at 2,197.1428!!!

2008 Nov 16 01:11 PM

[Rob Viglione:]

And yet populism continues to drive power to defunct ideologically-driven policymakers. You'd think humanity has sufficient data at this stage to pass judgment on collectivist politics.

2008 Nov 16 01:50 PM

[Urbane Gori...:]

This says it better than anything i could come up with:

As Mr. Kirkpatrick notes in referring to David Dreman's research which studied 78,695 earnings forecasts by analysts over a 20 year period from 1973 to 1993 only 1 in 170 forecasts were within 5% of any four consecutive quarter's actual earnings. Why do we continue to rely on such speculation?


jegan ;-)

2008 Nov 16 05:11 PM

[dr.doolittle:]

great piece, keep up the good work. to the clown who says "what's new here" trying living through a hyperinflation in an industrialized economy instead of some backward ass agrarian based shit-hole called "Ecuador." His name was Hilter and he was responsible for the death of 10's of millions and the only "new" thing he and his cohorts created was stuff like jet planes, electronic communication, high output turbo-diesel engines and very nearly a nuclear bomb with the means to deliver it on a rocket. And don't think the name is not spoken in terms of admiration today both at home and abroad. Thank God for clowns like Hugo Chavez who will never be anything other than a meathead. Iran? Putin? Maybe someone in the good old USA? The word here is not "intervention" but fascism. Watch your freedoms closely here.

2008 Nov 17 03:53 PM

[Dividend Gr...:]

Interesting article. I see a great profit opportunity for emerging market countries, if they learn how to play smart with their debts. First emerging market countries like Ecuador manage to sell as much debt as possible when times are good, by locking in low long-term interest rates. Then they just wait for the next global crisis and then they default on investors, sending the bonds to super low levels..

If they have 2 billion on hand, why can't they ( at least theoretically) simply purchase these bonds.. And reduce their debts forever?

2008 Nov 18 11:30 AM