Sovereign Analysis /
Ethiopia

Ethiopian bonds fall to fair value; Upgrade to Hold

  • Eurobond has fallen by over 26% since we downgraded to sell in mid-August amid the worsening conflict

  • Little prospect for end to conflict, but bonds now trade at or below recovery value based on “normal” exit yields

  • Risks are broadly balance and bonds now trade in line with fair value; we upgrade to Hold from Sell

Ethiopian bonds fall to fair value; Upgrade to Hold
Tellimer Research
7 December 2021
Published byTellimer Research

Since we downgraded ETHOPI 6 ⅝ 12/11/2024s to Sell on 19 August amid a worsening conflict and economic outlook, they have fallen by over 26% to US$65.68 (with the yield rising from 10.61% to 23.07% on a mid-basis). Bonds now trade well into distressed territory, despite a lack of clarity over whether or not private creditors will be asked to participate in the ongoing Common Framework debt restructuring.  

Bonds

Even if the bonds are restructured, current prices are likely below recovery value based on a “normal” exit yield assumption of 8-12%. However, with the conflict continuing to worsen and threatening to tear apart the very fabric of the country, yields are likely to hover well above these levels even if private sector involvement (PSI) is ultimately avoided.

It is difficult to disentangle the impact of the conflict from the impact of the restructuring in Ethiopia’s bond prices. Further, there is limited information on the current state of Ethiopia’s economy, which will, in turn, dictate the terms of the debt restructuring and the yields that prevail on the debt after the restructuring and conflict come to an end. This note will try to disentangle the various forces at play to answer whether the precipitous drop in prices has made Ethiopia’s eurobond attractive, or if the selloff is likely to continue.

While there is certainly scope for further underperformance given limited prospects for an end to the conflict and a broader risk-off environment for EM assets, there is also material upside if Ethiopia’s eurobonds are excluded from the restructuring and if the conflict is brought under control. We think bonds are now trading in line with fair value with risks broadly balanced, and upgrade to Hold from Sell on the ETHOPI 6 ⅝ 12/11/2024s at a mid-price of US$65.7 (mid-yield of 23.1%) as of cob on 6 December on Bloomberg.

Restructuring

Our conversations with the Ministry of Finance and IMF during IMF/World Bank Annual Meetings in October left us with the impression that the government is still keen to keep bondholders from having to participate in the restructuring, while the IMF would likely be content to allow this so long as the official sector restructuring brings Ethiopia’s debt within the relevant sustainability thresholds.

If the government does decide to include bondholders, we think it hopes to do so in an NPV-neutral way (ie more like a liability management exercise), but uncertainty remains over whether this will be acceptable to the Paris Club and/or China. But with the second phase of the official sector restructuring still unfinished, and no engagement with private creditors at this point, much remains up in the air.

For illustrative purposes, we see what a reasonable recovery value could be for Ethiopia’s eurobond if it is included in the restructuring on the same terms as the two official sector restructurings. The completed restructuring (scenario 1) included a 2-year maturity extension and 5-year grace period, while the ongoing restructuring (scenario 2) included a 10-year maturity extension and 6-year grace period.

In scenario 1, the bonds break even with a 14.5% exit yield and the recovery value is estimated to be US$74.6-91.2 based on 8-12% exit yields. In scenario 2, the bonds break even at a 9.9% exit yield and the recovery value is estimated to be US$53-81.9 based on 8-12% exit yields. On this basis, we think bonds are currently trading in line with or below recovery value based on normal exit yield assumptions.

Restructuring scenarios

The next major signal about Ethiopia’s restructuring intentions will come on 11 December, when it is due to make its next US$33mn eurobond coupon payment. State finance minister Eyob Tekalign has assured investors that the government “will pay the value,” and with no eurobond principal due until the bond matures in December 2024, we think Ethiopia will continue to service the bond for now.

Conflict

While bonds appear to be trading at or below recovery value based on “normal” exit yields, with serious upside if Ethiopia is excluded from the restructuring, the ongoing conflict is likely to keep yields elevated even once the restructuring is in the rearview.

We are now over 13 months into the conflict, and it has only continued to worsen. Last month, the rebel TPLF announced the formation of the United Front of Ethiopian Federalist and Confederalist Forces (UFEFCF), a coalition of nine opposition groups (including the Oromo Liberation Army). It also made major territorial gains, capturing several key towns just 220km from Addis Ababa.

This prompted Prime Minister Abiy Ahmed to mount a counteroffensive, urging “citizens of all ages and capabilities” to take up arms against Tigrayan forces. PM Abiy has even supposedly moved to the front lines to lead the counter-offensive, and the government has reportedly recaptured some of the previously lost territories.

With both sides seeming confident of their prospects for military victory, AU-sponsored negotiations between the government and rebels failed to make any progress last month, with former Nigerian president Olusegun Obasanjo warning that the “window of opportunity” to reach a peaceful agreement is limited and the US special envoy to the Horn of Africa saying that negotiations “highly at risk of being outpaced by the military escalation on the two sides.”

The EU has warned that Ethiopia risks disintegrating into “the Yugoslavia of Africa” without a ceasefire, while US Secretary of State Antony Blinken said “I am very concerned about the potential for Ethiopia to implode” and that such an outcome “would be disastrous for the Ethiopian people and also for countries in the region.”

Meanwhile, humanitarian assistance into the region continues to be blocked both directly by the government and indirectly by the fighting, with the UN speaking out against the detaining of its national staff and a joint investigation with Ethiopia’s human rights commission finding that all sides had "committed violations of international human rights, humanitarian and refugee law, some of which may amount to war crimes and crimes against humanity."

Against this backdrop, it is tough to tell what a reasonable exit yield would be in a potential debt restructuring or where Ethiopian debt would trade with restructuring risk stripped out. With no signs that the conflict will end anytime soon, and a risk that it leads to the disintegration of PM Abiy’s government (ie a coup or military defeat) and potentially even the state in its current form (ie seccession), bonds could keep falling even if Ethiopia can avoid restructuring its eurobonds.

It is also not clear if the restructuring can be completed before the conflict is resolved, with both official and private sector creditors (especially commercial creditors with ESG considerations) potentially preferring to wait until there is greater accountability over the humanitarian crisis and/or assurances over who is the legitimate internationally recognised government. If PM Abiy's government is overthrown, there is a risk that the successor government could say the deal was illegitimate and/or accuse creditors of providing debt relief to finance the war.

Further, until the IMF is able to provide clarity on the state of the economy (see below) and publish a complete DSA (which itself is contingent on the second official sector restructuring being completed), it is unlikely that private creditors will agree to anything other than a PV-neutral restructuring (which the official sector could resist). The conflict, therefore, is likely to continue to act as an impediment to the restructuring and could lead to a protracted process that leaves Ethiopia's economy in a weaker position and necessitates a more punitive restructuring once negotiations begin in earnest.

Economy

The final piece of the puzzle is the economy, which is also intimately linked to the conflict. Fighting destroyed much of Ethiopia’s harvest this past season and delayed planting for the next one, which, alongside rising global food prices, pushed up food inflation to a peak of nearly 42% in September and overall inflation to nearly 35% that same month (it moderated slightly to 34.2% in October).

Output, investment and financing are also being impacted, with PVH Corp. (which manufactures for brands including Tommy Hilfiger, Calvin Klein, and Michael Kors) recently closing its local plant, the US International Development Finance Corp. yet to release US$500mn for the Safaricom-led consortium’s mobile infrastructure investments, and a growing threat of sanctions that could deprive Ethiopia of the US$1bn+ of official assistance they have relied on annually in recent years.

High-frequency data is scarce, and the IMF refrained from updating its WEO forecasts in October due to elevated uncertainty, making it difficult to paint a complete picture of Ethiopia’s economy. While the recent release of the NBE’s quarterly bulletin shows a rebound in reserves from US$2.5bn to US$2.9bn in Q2 21 (or from -US$1.2bn to -US$1bn on a net basis), sharp parallel market depreciation in August could point to renewed BOP pressures (parallel market data hasn’t been updated since  19 August).

Reserves

While official data shows Ethiopia’s budget deficit declining slightly to 2.6% of GDP in FY 20/21 from 2.8% in FY 19/20, much of Ethiopia’s public spending and debt is off balance sheet with SOEs, so this paints an incomplete picture. Further, a lack of recourse to external financing sources and a shallow domestic market could pose financing challenges. Low cutoff yields (c10-10.5% for 12-month T-bills versus inflation of c35%) have led to undersubscribed T-bill auctions in recent months.

Large external financing needs also pose a particular challenge, with the external debt service set to rise from US$2.4bn in 2021 to US$3.4bn by 2024, more than the gross stock of reserves. A recent MoF report puts public external debt at US$29.5bn in mid-2021 (51% multilateral, 29% bilateral, and 20% private, with 30% held by China), which is equivalent to 242% of exports versus a target of 180%, putting Ethiopia’s debt “distress level at high risk,” according to the report.

Debt service

Failure to reach an agreement on the phase two restructuring with Ethiopia’s official creditors, get its IMF programme back on track, and restore access to external markets and official financing, could result in the depletion of Ethiopia’s reserves, necessitating a more punitive restructuring even if one wasn’t initially needed before the outbreak of the conflict.

Putting the puzzle together

Taking these factors into account, it is difficult to assign a “fair value” to Ethiopia’s eurobond. With the conflict likely to simmer for the foreseeable future, it is clear that Ethiopia won’t return to pre-conflict yields of c6% even once the restructuring is completed. With yields over 23% versus c9% earlier this year after its participation in the Common Framework was announced, we think the bulk of the risk premium now being priced into bonds is a result of the conflict and its impact on the economy.

We run a new scenario analysis using the two restructuring scenarios above. We also include a scenario where bonds are excluded from the restructuring and the conflict is resolved, one where bonds are excluded from the restructuring but the conflict continues, and one where deteriorating economic conditions lead to a more punitive restructuring (ie restructuring 1 plus a 20% haircut).

Scenario analysis

As before, we remain agnostic on whether or not Ethiopia’s eurobonds will be included in the restructuring (ie 50% probability of default). We assume a 10% chance that the conflict is resolved and default is avoided, with an exit yield of 8% versus 6% earlier this year. The other scenarios assume the conflict continues to simmer, with exit yields of 14-16% post-restructuring to reflect the risk premium from the conflict. The resulting target price of cUS$65 is just 1.5% below the current price of US$65.7.

Of course, it is still difficult to parse out what the yield would be without the restructuring risk but with the conflict ongoing. And in practice, most countries that face a prolonged civil war are likely to default eventually as a result. Taking a neutral stance on exit yields, combining the “no default” scenarios into one, and weighting by probability, we find that the bonds “break even” at an exit yield of c14%.

Scenario analysis

We think the bulk of the rise in yields has been driven by the conflict, and see no end to the fighting anytime soon, so yields are likely to stay above 14% over the next 6-12 months even after the restructuring is completed. Further, with the broader risk-off backdrop for EM assets disproportionately impacting higher-yielding credits, Ethiopia’s eurobond could remain on the back foot.

That said, with material upside if Ethiopia’s eurobonds are excluded from the restructuring and if the conflict is brought under control, bonds trading at or below recovery value based on “normal” exit yield assumptions, and its eurobond now sitting just above our new target price of US$65, we think eurobonds are close to bottoming out and upgrade to Hold from Sell on the ETHOPI 6 ⅝ 12/11/2024s at a mid-price of US$65.7 (mid-yield of 23.1%) as of cob on 6 December on Bloomberg.

Related reading

IMF/WB Annual Meetings, October 2021 – country notes, October 2021

Ethiopia: Downgrade to Sell as conflict and economy worsen, August 2021

Ethiopia: Election passes as conflict worsens, July 2021

Ethiopia: Debt restructuring statement still ambiguous, July 2021

Ethiopia: Eurobond coupon remain current amid election uncertainty, June 2021

Ethiopia: Coupon payment first major sign of restructuring intentions, June 2021

Ethiopia: Sanctions exacerbate financing constraints, May 2021

Ethiopia: IMF statement implies private sector involvement can still be avoided, February 2021

Ethiopia: Debt sustainability analysis paints mixed picture, February 2021

Ethiopia’s restructuring plans – initial thoughts and implications, February 2021