Local bonds could shine post Colombian presidential election

At first glance, things look ominous for the performance of Colombian local assets—especially considering how tumultuous the first half of 2022 was with a mix of political uncertainty, social discontent and deteriorating fundamentals. This made for a veritable breeding ground for radical populism to prosper, especially after disastrous management of the Covid-19 crisis.

Fortunately for active investors, things are seldom as bleak (or as rosy) as they appear at first sight. Colombia has the most vibrant economy of Latin America with a long history of sound macroeconomic policies, leaving the country unscathed from large economic collapses and hyperinflation. Colombia is also the only country in Latin America that never defaulted on its debt. And, of course, it is one of those countries benefitting from high commodity prices, especially oil.

Resolving the economic trinity

There are two candidates vying for the job of El Presidente in the runoff election scheduled for June 19, 2022: Gustavo Petro and Rodolfo Hernández Suárez.

The main economic challenge now, for whomever will run the country, is to resolve a challenging economic trinity:

1. reducing inequalities while
2. achieving a medium-term responsible fiscal framework, and
3. maintaining the sustainability of its external debt.

In this respect, both candidates’ bold electoral promises seem somewhat illusive: Petro wants to fund social policies by taxing the rich more, while Hernández claims he will find all the financial resources he needs by eradicating corruption.

Both pitches sound familiar but leave a feeling of skepticism as to where in the world such promises have ever produced any palpable results. Fighting corruption, for example, is obviously a noble cause but should be treated as an objective, per se, and not as low hanging fruit to attain other objectives. From a market perspective, Hernández would be the best option given his pro-business pragmatic stance, even though his economic program is light and inconclusive.

Beyond economy, the main challenge is about security: consolidating the peace with guerrilla groups and addressing the endemic violence of the Pacific departments, where guerrilla resurgence and drug trafficking show few signs of abating. From that perspective, one can say that the tough approach of counterinsurgency embraced by the right-wing governments (including Duque’s) have seldom proven successful.

What’s in it for investors?

We believe markets have not been complacent to the risk, and that an appropriate risk premium has been built across the different local asset classes. In addition, the institutional framework has enough checks and balances to prevent whoever wins the election from conducting blatantly irresponsible policies. A Petro victory certainly would widen the risk premium further in the short run. However, sooner rather than later, he would have to soften his radical narrative and become pragmatic, as most leftist Latin American leaders always end up doing.

Looking at each Colombian asset class:

• Equities have performed well this year, courtesy of the commodity rally, a wave of takeover bids from local giant conglomerate Grupo Empresarial Antioqueño and a buoyant post-Covid economic recovery.
• The Colombian peso was boosted by the stellar commodity terms of trade and stands as one of the best-performing EM currencies in 2022, delivering a positive total return (spot + interest) of more than 6% year to date. But the volatility has been brutal since the war in Ukraine deterred EM investors’ risk appetite. In this complicated environment, we like the massive divergence between the spot rate, buoyed by the favorable terms of trade and, on the other hand, the forward rates that stayed under pressure due to the extreme risk aversion. This makes the FX forward implied yields attractive as they now stand 350 to 450 basis points wider year to date, reaching 9.5% for the one-year point.
• Local rates were a tale of two stories, with government bond yields rising much more than the interest rate swap rates. The latter curve is mainly driven by monetary policy expectations, while the former factors in an extra premium for the risk of glut in government bond issuance. The widening of the spread between these two curves has reflected fears about the market capacity to absorb more bond supply on the back of larger financing needs from the government. We see a spread of more than 200 basis points as attractive, given that it stands significantly above all its EM peers despite Colombia’s excellent track record in coping with its economic imbalances through faster growth.
• The credit spreads on US dollar-denominated bonds have moderately widened year to date, a lot less than EM sovereigns in general but also less than other Latin American peers. Thus, they might look less attractive than local rates and FX forward implied rates that repriced a lot more. However, they might be the first choice for a foreign investor unwilling to take the currency risk since the FX hedging costs are eating away a lot of the juice of the high local rates.

Susceptible to short-term volatility due to geopolitics and local politics but with a track record of managing its economic imbalances, Colombia holds possibilities for active bond investors. Right now, local bonds look particularly attractive as spreads are wider than their EM peers, and the economy and currency are buoyed by strong commodity prices.