Itaú BBA - Buy Protection in Colombia 5y CDS – Sovereign Debt Trade Idea

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Buy Protection in Colombia 5y CDS – Sovereign Debt Trade Idea

December 20, 2017

We believe markets will price in higher chances that Colombia will lose its investment grade; buy protection in 5y CDS.

STRATEGY TEAM:

Ciro Matuo, CNPI, ciro.matuo@itaubba.com
Eduardo Marza, eduardo.marza@itaubba.com
Luka Barbosa, lbarbosa@itaubba.com


We believe Colombia’s credit risk will deteriorate going forward, as (1) structural fiscal challenges mount; (2) current account deficit remains wide; (3) global financial conditions become tighter and (4) we forecast lower oil prices ahead. Uncertainty over presidential elections can also contribute to increase the sovereign risk premium.

We recommend buying protection in Colombia’s 5y CDS, currently trading at 107bps, slightly below the average of countries rated BBB- by S&P (see chart). We believe the market will price in higher chances that Colombia will lose its investment grade, so CDS should trade at a level in between countries rated BBB- and BB+ by S&P. In addition, tighter global financial conditions are likely to shift upwards the CDS of all emerging markets.

We believe Argentina will continue to outperform its Latam peers (see here), a view reinforced by the approval of the pension reform in Congress earlier this week.

The fiscal challenge

The considerable decline in terms of trade over recent years led to falling revenues, which in turn pushed the fiscal deficit and debt levels upwards. Meanwhile, fiscal expenditure maintains a rising trend, observed in both the commodity boom years and during the downturn. Central government ex-interest expenditure has increased from 12.2% of GDP back in 2000 to 16.7% in the first half of 2017. This increase of 4.5pp is similar to Brazil’s central government primary spending growth (+5.0pp of GDP over the same period).

Although the government has indicated some effort on the spending side, we are skeptical that the trend will improve much going forward, especially taking into account the spending pressure from the implementation of the peace deal with the FARC, estimated between 0.6%-0.9% of GDP per year over the next 10 years.

Moreover, as we discuss in the section below, the outlook for the oil industry is challenging, so it is unlikely that the government will recover a significant portion of the oil revenues lost in previous years.

Colombia’s fiscal rule stipulates the nominal fiscal deficit narrowing to 1.0% of GDP by 2022 (from 4.0% in 2016), which broadly implies a reduction of 0.5% of GDP per year. These targets seem quite challenging, given the headwinds mentioned above. We expect the nominal fiscal deficit at 3.6% of GDP in 2017 and 3.3% of GDP in 2018, and gross public debt to continue rising, from 46.0% of GDP in 2016 to 47.2% in 2017 and 47.6% in 2018.

A wide current account deficit

Colombia’s current account deficit has been narrowing, but remains at high levels, likely finishing this year at 3.7% of GDP (from 4.3% in 2016). It is not expected to worsen soon, as domestic demand remains weak, but the size of the deficit leaves the country more vulnerable to external conditions than many of its peers.

Reinforcing the problem, oil prices are likely to decline going forward, in our view. Prices above USD 50/bbl over recent months have started to stimulate shale-oil investment in the U.S., which will be translated into production ahead. We estimate that the WTI range of USD 45-50/bbl can stabilize the U.S. rig count and helps balance the market in 2018.

We also see medium-term challenges for the balance of payments. Falling investment in the oil sector amid a low price environment led to a decline in reserves (measured in years of exploitation). Projected oil production has been declining consistently, and no growth is expected for the coming years. Oil reserves are now enough to cover only 5 years of exploitation, down from 8 years in 2009.

Presidential elections

Besides the economic woes, there is also uncertainty surrounding the Presidential elections next year. The race is wide open, amid growing signs of an anti-establishment feeling among voters. A Gallup poll shows that corruption has become the country’s major concern for voters, after years in which security was deemed as the country’s top problem. Candidacies will be defined only in March. First-round of the election will take place on May 27th, while the second round is scheduled for June 17th.



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