Emerging market debt continues firm; Ecuador seen facing second-round vote

By Reshmi Basu

New York, Oct. 13 - Emerging market debt had another firm session Friday, but there were spots of unevenness as Argentina and Venezuela posted gains while Brazil recorded losses on the longer end of its curve.

Both Argentina and Venezuela plowed ahead as U.S. stocks extended their rally.

Higher oil prices also helped lift Venezuela. During the session, its bond due 2027 gained 0.35 to 121.20 bid, 121.60 offered.

The Argentinean discount bond due 2033 added 0.35 to 98.90 bid, 99.15 offered.

Meanwhile Brazil saw some profit-taking as the bellwether bond due 2040 gave up 0.15 to 130.70 bid, 130.75 offered, according to a trader.

Nonetheless, the tone in the market is bullish as cash is being put back to work. This week saw the biggest inflow into the asset class since March 22, according to EmergingPortfolio.com Fund Research.

Dedicated funds saw a $315 million enter the market for the week ending Oct. 11.

However, more than half of the inflows were due to a single local currency emerging market bond fund - Ashmore Local Currency Debt Fund.

So far this year, the funds have taken in $3.4 billion.

Ecuador second vote likely

The past week saw an important development ahead of Sunday's presidential election in Ecuador. Rafael Correa, who has scared Wall Street with his hard-line rhetoric regarding debt default, was losing momentum in the most recent poll results.

Two weeks ago, the radical leftist presidential hopeful looked to become the outright winner in the first round election, which would have been the first time ever that a second round vote was not needed in the Andean nation.

But by Friday the market was pricing in a second-round run-off, in which Correa will most likely be pitted against Alvaro Noboa, the owner of the country's largest banana exporter.

In trading Friday, Ecuador saw a mixed session. Its bond due 2012 eased 0.15 to 98.25 bid, 98.75 offered while the bond due 2030 gained 0.65 to 91.75 bid, 92.25 offered.

Debt default rhetoric

The question is whether or not Correa's advocacy of debt default is an empty threat, just another means for him to garner populist support. Nonetheless, since no one knows the answer to that million-dollar question, Ecuador's bonds have come under pressure as it has distinguished itself as one of the asset class' underperformers.

But there are some misconceptions that need to be cleared up, according to Alberto Bernal, fixed income analyst for Bear Stearns & Co. Inc.

For instance, Correa has said that 7% of the nation's gross domestic product is spent on debt servicing, an intentionally misleading and inaccurate number, pointed out Bernal.

"The actual number that counts is how much interest Ecuador pays on existing debt - and that number is only 2.9% of GDP," which is manageable, especially when one makes a cross-country comparison of debt loads, he observed.

That number is lower than many of Ecuador's Latin American peers. As evidence, the debt load for Colombia is 4.5%. Depending on the intervention rate in Brazil, that figure is 6% to 7% and around 5% for Uruguay.

"Only Argentina and Chile have a lower debt load than Ecuador," Bernal said.

Bernal noted that this means that Correa's case for insolvency or incapacity to pay down the debt is not there. But that does not mean that Correa will leave the debt alone or that his comments are pure rhetoric

Underscoring the risk is that Correa is a staunch idealogue, who believes that the external debts of a country go against human rights and are also a way for the international community to exploit poor nations.

But there was some good news out in the past week in that the election will likely go to a second round vote, a positive occurrence for the market.

"The reason why Correa is not winning in the first round is because apparently there has been some stabilization in his momentum," explained Bernal.

"This has been a fortunate occurrence, because it implies that there are still some voters in Ecuador who really do understand that the way Mr. Correa is portraying the salvation of his country is too radical and too dangerous."

"The question of whether or not Correa is going to default is an open question with a very difficult answer.

"We know for a fact that people that will be working with him had a very strong ideological view on the issues and they would like for Ecuador to stop paying the debt, if the current terms remain in place (i.e. if coupon rates remain high)," remarked Bernal.

Suspension of congress

There is a lack of clarity on whether default is a politically logical move to be implemented right from the beginning of his administration. The timing of such a decision has been keeping analysts awake.

Additionally, Bernal warned that Correa would not work with the existing congress since members do not share his view, and because his party did not field any candidates he will not have any representation in the future congress.

This means that if Correa is president, he will most likely close congress by calling a national assembly to change the constitution, a terrible negative for the market.

Bears Stearns is recommending an underweight on the country's debt

"In my view, the risk that negative things will happen is much higher than the risk of the market seeing positive surprises. We do see a possibility that if Correa wins and he decides not to talk about default, there might be some short-lived rally in the bonds, because that part of the risk will be going away," remarked Bernal.

But after that adjustment, there will continue to be downward pressure because of Correa's radical position. Correa is strongly against dollarization and international investment in the country. Months after Correa takes office, Bernal said he expects the level of investment to collapse, because under a dollarized system, the only tool available to make the economy grow is to attract new capital. Otherwise, the monetary base will not expand.

Even if there is not an initial decision to stop payments on debt, the economic policies that come out of the country may force the economy into a slowdown or a recession, resulting in a self-fulfilling prophecy or the inevitable outcome of non-payment of debt, Bernal cautioned.

Two Russian issuers price

In the primary market, two Russian issuers placed deals.

Promsvyazbank sold $125 million in five-year fixed-rate senior bonds (Ba3/B/B+) at par to yield 8¾% via Citigroup.

The issue came in line with price guidance for a yield in the 8¾% area.

And the City of Moscow (Baa2/BBB+/BBB+) sold a €407 million offering of 10-year loan participation notes at mid-swaps plus 102 basis points.

The deal priced inside of price guidance, which was set at 105 to 110 basis points over mid-swaps.

Citigroup, Deutsche Bank, Dresdner Kleinwort and JP Morgan were joint bookrunners for the Regulation S issue of senior notes.

Set to price in the coming next week include deals from Mexico's Papeles Industriales de Michoacan SA de CV, Petrol AD (Bulgaria), Chile's Codelco, Malaysia's Ranhill Ltd. and Hungaria's Invitel Holdings NV.

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