Strategy Note /

Fixed Income Strategy: Top picks for 2023

  • Our Top 5 picks for 2023 are Buys on hard currency sovereign bonds in Ghana, Mozambique, Nigeria, Pakistan, Tajikistan

  • Seven other trades to watch, or themes, for the year ahead: Argentina, Ukraine, Venezuela, Rwanda, and themes…

  • …sovereign default risks, restructuring plays in Sri Lanka and Zambia, and local debt plays in Uganda and Zambia

Fixed Income Strategy: Top picks for 2023
Stuart Culverhouse
Stuart Culverhouse

Chief Economist & Head of Fixed Income Research

Tellimer Research
12 December 2022
Published byTellimer Research

This is the third and final report in our series covering our traditional end-of-year review for emerging and frontier fixed income markets, the outlook for the year ahead and top picks for 2023 that have been published separately in recent days.

For our top picks for 2022, published last year, see here, and, for our mid-year update, with our top picks for the second half of this year, see here.

Our top picks for 2023

We present our top picks for 2023. Our Top 5 comprises Buys on hard currency sovereign bonds in Ghana, Mozambique, Nigeria, Pakistan and Tajikistan.

This represents just one change from our mid-year update. In comes Tajikistan. Out goes Uzbekistan. We still really like the name, but, with UZBEK '31s up 14pts since we included them in our Top 5 in July (rising from US$69 to US$83), in line with our call (which we reiterated in October), we think the bulk of the outsized move has happened. Yields are now a more realistic 6.5% (z-spread 328bps as of 7 December on a mid-price basis on Bloomberg), falling by 250bps since this year's high of 9%, although we expect more gains are likely for investors that want to take advantage of further spread compression.

Our Top 5 picks

We also highlight seven other trades to watch, or themes, for the year ahead, namely Argentina, Ukraine, Venezuela, Rwanda, sovereign default risks, restructuring plays in Sri Lanka and Zambia, and local debt plays in Uganda and Zambia.

Our Top 5 picks

We summarise our top picks below.

1. Buy Ghana 8.125% 2032

We retain Ghana in our Top 5, with a Buy on GHANA '32s at a price of US$32.6 (yield 31.3%) as of cob 7 December on Bloomberg (mid-price basis). This follows our upgrade to Buy from Hold on 9 June (at a price of US$52), after prices fell in line with even our more pessimistic estimates of recovery values, although the bonds fell much further in the sharp EM sell-off (reaching a low of US$29 on 25 October). Indeed, while Ghana is now one of the countries most likely to default in 2023, having already announced its intention to restructure (although investors may hope it is not a fait accompli), we still expect recoveries to be much better than is implied by current prices.

Ghana announced that it will seek to restructure both its domestic debt and foreign bonds on 24 November, as the price for IMF support, although details are still vague and it remains current on its international bonds (it launched its domestic debt exchange on 5 December). However, with most eurobonds (excluding near maturities and the guaranteed 2030s) trading at the US$30s price level, the risk of default is already more than priced in. We think recoveries could be much better.

We estimate recovery values for Ghana's dollar bonds based on the terms outlined by the deputy finance minister (30% haircuts on principal and possibly coupons too) – for illustrative purposes only, although the Ministry of Finance later rowed back on his comments – in the low 40s, rising to the mid-50s in plausible worst and base cases and exit yields. Moreover, if the deputy finance minister's comments are the opening salvo of a negotiation, we presume the final terms shouldn't be any worse, while we expect a robust and well-coordinated bondholder committee will be able to push back and extract better recoveries.

However, it may not be a quick process, based on the experiences of Zambia and Sri Lanka, and in light of reports of some domestic resistance to the domestic debt exchange. In the meantime, we await agreement on the new IMF programme and its modalities and conditions (which could be imminent, according to recent media reports).

Ghana 8.125% 2032 - price (US$)

2. Buy Mozambique 5% 2031

We retain Mozambique in our Top 5, with a Buy on the MOZAM 5% 2031 at a yield of 13.8% (price US$76.0) as of cob 7 December on Bloomberg (mid-price basis). Mozambique has been an ever-present in our top picks for this year, and, while we recognise the bonds did fall 23pts from peak (April) to trough (July), they have also shown some degree of resilience – the net decline this year is only 14pts, making for a total return ytd of -5% (outperforming the index by far).

Our positive view is based on the onset of LNG production and strong ability to pay (debt service on the bond is very low), together with the government's prudent approach to macro-management. The IMF programme, which was approved in May, improves the outlook for donor funding and is the icing on the cake.

We reiterated our positive view on Mozambique following the IMF/World Bank Annual Meetings in October. Since then, the IMF Board has approved the first review of the extended credit facility (ECF) as expected (and we welcome publication of the staff report). It has been a good start to the programme and there are no real major changes to the outlook. In addition, the first exports from ENI's FLNG offshore platform also began in November, as expected, and, while the volumes are low (and little revenue accrues to the government at this early stage), it is nonetheless an important milestone. Meanwhile, TotalEnergies is evaluating the security situation with a view to determining when it might resume activity at its project.

Nonetheless, there are risks, primarily the fragile security situation (mainly in the north), possible social pressures (including arising from higher food and fuel prices), risks from higher inflation (11.8% yoy in October) and currency devaluation (with concomitant risks to the debt burden given some four-fifths is external), the timing of the ramp-up in LNG production, governance and capacity, and climate vulnerabilities.

Mozambique 5% 2031 - price (US$)

3. Buy Nigeria 7.875% 2032

Nigeria is a carryover from our H2 22 top picks. Since then, it has comfortably outperformed the market, with the Bloomberg Nigeria Sovereign Index returning 15.3% in total return terms through 7 December versus 4.5% for the Bloomberg EM Sovereign Aggregate and 10.1% for the Bloomberg EM Sovereign High Yield (HY) Index (bringing the cumulative return to 10.9% since the inception of our Buy recommendation on 21 June versus 3.4% for the EM Aggregate and 5% for the HY Index).

That said, yields are still high and prices low, with the NGERIA 7 ⅞ 02/16/2032s trading at a US$76.6 (12.17% YTM, 893bps z-spread) as of 7 December. Nigeria’s index OAS of 840bps is 143bps wide of the HY Index, which compares with an average of -119bps in 2019 and -21bps in 2021, pointing to room for spread compression relative to its peers.

At its core, the investment thesis in Nigeria is the same as it was in July when we published our H2 22 top picks. In short, Nigeria’s external financing needs (GEFR) are relatively low, with a projected current account deficit of just US$3.2bn on average from 2023-25 (IMF WEO) and public external amortisations of US$1.7bn over that period (World Bank IDS). Eurobond maturities over that period are even more limited, totaling just US$500m in 2023 and US$1.1bn in 2025.

With annual GEFR of cUS$5bn from 2023-25 versus international reserves of cUS$37bn currently, Nigeria is not subject to the same severe external liquidity constraints as some other countries that are locked out of the market. As such, we think the risk of default is low in the near to medium term and that it is already baked into Nigeria’s eurobond prices.

That said, the risks we outlined in July are all still relevant as well. Nigeria continues to suffer from endemic stagflation (with growth of 3.1% over the first three quarters of 2022 and inflation at 21.1% in October), the monetary policy framework is broken despite the recent hawkish shift, a costly fuel subsidy has completely eroded the fiscal gains of higher oil prices, chronic FX mismanagement has pushed the naira to a c70% premium on the parallel market, and chronic insecurity and underinvestment has halved oil production over the past five years to just c1mn barrels per day (although there is some preliminary evidence that increased security efforts have begun to lift production, constituting a possible upside risk).

From the debt sustainability perspective, despite low public debt (the WEO projects a rise from c37% of GDP in 2022 to c44% by 2027), Nigeria’s meagre revenue collection (with aggregate federal revenue of 3.1% of pro-rata full-year GDP through August 2022 and federally retained revenue of 2.7% of GDP) has led to an alarmingly high debt service burden (83% of aggregate federal revenue and 96% of federally retained revenue over that period), pointing to a dire need to boost revenue collection if the government is to continue servicing its debt and build up enough fiscal space for badly needed pro-growth investments.

That said, the debt service problem is largely domestic, with foreign interest comprising just 22% of the interest bill through August 2022. Further, the February 2023 election could herald a positive policy shift, with presidential frontrunner Peter Obi promising to re-establish the independence of the CBN, liberalise the exchange rate in a single unified market, remove import restrictions and fuel subsidies, reduce the fiscal deficit and boost investment, and tackle Nigeria’s insecurity problems.

It is too early to say whether Obi will be able to convert his lead in the opinion polls into a victory at the ballot box and whether he will be able to convert his policy rhetoric into action if he takes office, especially given how deep-rooted Nigeria’s structural problems are. Remember, Buhari was heralded as the man to solve Nigeria’s insecurity and anti-corruption problems after his victory in 2015, but there has been stagnation, if not backsliding, on both these fronts since.

However, for the first time in years, there is finally some real hope that Nigeria may be able to shift away from at least some of its more harmful macro missteps, including its mismanaged monetary and FX policy regimes, which could unlock some of the latent upside for Nigeria’s eurobonds in early 2023 and trigger a convergence in spreads towards some of its HY and African peers.  

As such, while we remain negative on Nigeria’s longer-term fundamental story, we reiterate our Buy recommendation at US$76.6 (12.17% YTM, 894bps z-spread) as of cob on 7 December on Bloomberg and retain Nigeria as one of our Top 5 picks for 2023.


4. Buy Pakistan 7.375% 2031

Pakistan, too, was one of our top picks for H2. The rationale at the time was that default was fully priced in, with the PKSTAN 7 ⅜ 04/08/2031s trading at US$47.5 versus our estimated recovery value of US$59 (US$53-71 range at a 12% exit yield), and that, while default was inevitable without an IMF programme, its imminent resumption would offer some breathing room and potentially allow Pakistan to avoid a balance of payments (BOP) and debt crisis altogether.

However, even after IMF Board approval was secured, political uncertainty led to doubts over the government’s ability to deliver on its reform promises, with Pakistan’s bonds continuing to plummet amid broader market malaise. Then, to make matters worse, catastrophic flooding derailed Pakistan’s economic recovery plans, leading to US$46.4bn of damages (per the latest planning ministry estimate) and making default a certainty without flexibility from the IMF and generous outlays from Pakistan’s external partners.

As such, the ‘31s continued to plummet to a low of US$30.7 at the beginning of November, even further below our estimated recovery value. However, Pakistan’s government has continued to insist that it will meet its external debt obligations and says that discussions with the IMF on the ninth programme review have commenced with the understanding that the underlying macro assumptions and targets will need to be changed to accommodate the impact of the floods.

Bonds have responded positively, with the ‘31s rallying to US$40.7bn on 2 December before softening to US$36 on 7 December. While we had previously worried that the IMF may deem debt as unsustainable and require it to be restructured to continue disbursing funds, Pakistan successfully retired a US$1bn sukuk bond on 2 December amid the ongoing IMF discussions, drawing on its limited reserves and supported by a US$500m disbursement by the AIIB.

This would be a strange decision if the Fund seemed likely to require a restructuring and may imply that it still sees a way out of the current crisis that doesn’t end in default. However, it could also be that the Fund and government didn’t want to act pre-emptively before the details of the reworked programme are hashed out, and that it was simply cleaner to pay off the sukuk in the meantime (not least because there has not yet been a restructuring of a sovereign sukuk, to our knowledge). 

So, while we think Pakistan is one of the most likely countries in our coverage universe to default in 2023, it may still be able to maneuver its way through the crisis if it is able to rework its IMF programme and mobilise enough new external financing to offset the impact of the floods, with State Bank of Pakistan (SBP) Governor Jameel Ahmad reiterating in a podcast yesterday that Pakistan would continue to meet its debt obligations.

Recent current account developments have also been encouraging, with the current account deficit narrowing to US$2.82bn over the first four months of FY 23 from US$5.31bn in the same period of FY 22 on the back of a 12% yoy fall in imports and 3% rise in exports. However, the drop in imports was driven by import controls, which is not a sustainable way to reduce external imbalances. Further, remittances, which have been a key tailwind for the BOP over the past year, have tailed off so far this year (albeit from historically high levels), falling 8.5% yoy so far in FY 23.

Further, the SBP’s net reserves continue to plummet, falling to US$6.7bn as of 2 December in the wake of the sukuk repayment. This is enough to cover just one month of trailing goods and services imports and <30% of the external debt payments due over the next 12 months. While Pakistan has made no headway on its goal to boost reserves above US$16bn by the end of FY 23 (eg June 2023), Governor Ahmad said in a December podcast that delayed funding disbursements will start to materialise in the second half of the year, including a US$3bn deposit rollover and US$1.2bn oil facility from Saudi Arabia.

That said, Pakistan’s BOP imbalances will be exacerbated not only by the floods, but also by Finance Minister Dar’s preference for currency stability. This has led to growing FX shortages and the emergence of a c10% premium for PKR on the parallel market and, alongside import controls, is causing shortages of basic goods and raw materials (with >1,000 containers of food items reportedly stuck at the Karachi port due to the refusal of commercial banks to provide clearing documents to importers).

Overall, it is too early to say whether Pakistan will be able to set its IMF programme back on track and boost reserves to more sustainable levels without restructuring. The recent rate hike by the SBP was viewed by many as a capitulation to IMF demands, but an overvalued currency could make negotiations more difficult and Pakistan still needs to figure out how to fill a PKR300bn-350bn fiscal hole created by the resumption of fuel subsidies. The current political backdrop will also make it extremely difficult for the government to deliver on its reform promises.

If Pakistan does default, it will shape up to be a difficult restructuring. Like the ongoing cases of Sri Lanka, Suriname and Zambia, China is a major credit to Pakistan, which has created difficulties in recent restructurings. Further, Pakistan still has US$6.8bn of sukuks (including a US$1bn maturity in April 2024), and there could be some uncertainty over how they will be treated given the lack of precedent for restructuring a sovereign sukuk.

Even more problematic are the 'funky' clauses in Pakistan’s 2024 eurobond, whose collective action clause (CAC) specifies a voting threshold of “90% of votes cast” to approve any changes to the payment terms rather than the more typical “75% of aggregate principal amount”, potentially making it easier for holdouts while also amplifying the voting power of smaller holders. Indeed, markets have picked up on this oddity, with the ‘24s trading at par with the ‘25s at the beginning of the year but rising to a c25% premium in late November (although it has since moderated to c10%).

Pakistan 24-25 spread

Overall, we maintain Pakistan in our Top 5 for 2023 with a Buy recommendation on the PKSTAN 7 ⅜ 04/08/2031s at US$36 as of cob on 7 December on Bloomberg. While we have included it in our Top 5 heading into 2022 and again in H2 22, with admittedly poor results, we stand by our thesis that the bonds are trading well below recovery value and that there is significant upside (even more so now), even if default now seems increasingly likely (with odds well above 50% in the next 12 months, in our view).

Indeed, at US$36, the ‘31s trade just above similar maturities in Ghana (cUS$33 on the ‘32s), which just announced its plans to restructure, plus Sri Lanka (cUS$30 on the ‘30s) and Zambia (cUS$47 on the ‘27s), both of which are restructuring with much higher debt levels. And this for a country that is still servicing its debt, potentially offering investors the opportunity to clip a coupon or two before any potential default.

Pakistan vs peers

5. Buy Tajikistan 7.125% 2027

We add Tajikistan to our Top 5, with a Buy on the TAJIKI '27s at a yield of 18.9% (price US$71.0) as of cob 7 December on Bloomberg (mid price basis). We upgraded Tajikistan to Buy from Hold after the IMF/World Bank Spring Meetings in April and reiterated the Buy after the Annual Meetings in October. The bonds are up 8pts since October, in line with our call, and have risen by c10pts since this year's low in July/August, although we recognise they are down 5pts from April and -19pts this year.

Economic fundamentals have remained solid as spillovers from Russia and the war in Ukraine have been minimal, confounding initial expectations. Remittances appear to have been resilient, supporting strong GDP growth, while inflation has remained under control due to tight monetary policy. Fiscal policy has also remained disciplined. Stronger remittances have also helped boost FX reserves, which stood at US$3.4bn in August (including gold, IMF IFS definition), c34% of projected 2022 GDP. But there is little to add on the Roghun dam, where slow progress seems to be being made.

The authorities have recently renewed their interest in an IMF programme, under the ECF, although we think the investment needs of the Roghun dam is driving the programme interest rather than a balance of payments need. Bondholders may welcome an IMF programme, although it does potentially raise some thorny issues for the Fund.

Moreover, we think its strong reserves coverage, and gold endowment, can mitigate payment risks to bondholders in the near term, as we've previously noted. Debt service (interest only) is just US$36mn a year over 2022-24, ahead of the bond's amortisation commencing in 2025. That said, bondholders remain concerned about the external environment, sanctions risk related to Russia (investors worry Tajikistan might get caught up somehow), and the bond's poor liquidity.

Tajikistan 7.125% 2027 - price (US$)

Performance of our Top 5 in 2022

We estimate a total return of our Top 5 picks over the past year of -6.7% on an unweighted average basis (14 December 2021-7 December 2022). While negative – and with only five index constituents enjoying positive returns this year (Tunisia, Costa Rica, Iraq, Turkey and Ethiopia), it would be difficult for any EM hard currency fund, especially long-only, to have avoided negative returns this year – this represents outperformance versus the index over the same period (-16.7% on the Bloomberg EM Sovereign USD index).

It was, of course, a brutal year, although the second half (+5%) saw a better performance than the first half (-15%). Most assets performed poorly in the first half of our review period, Pakistan being the worst, but performance was salvaged by a strong performance from our Sell on Tunisia. In the second half, Buys on Mozambique, Nigeria and Uzbekistan performed well.

Total return of Top-5 picks in 2022

Seven other trades to watch in 2023

We highlight seven other trades/assets, or themes, to watch for next year. Most of them are high-yield or distressed cases (some are more distressed than others), representing mainly idiosyncratic risks, and therefore positive developments could be a catalyst for strong gains from fairly depressed levels.

1. Argentina

2023 is an election year in Argentina and, as always, it will be a trade to watch as investors hope for regime change (or to put it another way, Argentina is a trade to watch, and always will be). Argentina was one of our trades to watch for 2022 on the basis that progress towards an IMF programme could be a positive catalyst for the bonds (the '30s were trading at cUS$35, on a mid-price basis, a year ago). But, while the IMF approved a new programme in March, it wasn't the catalyst we might have expected – Argentina has suffered a total return of -20% this year (a bit worse than the index) in the Bloomberg EM Sovereign USD index, and that was from its already depressed levels.

Still, the IMF programme remains on track, which is itself some achievement, with the Fund announcing staff-level agreement on the third review of the extended fund facility (EFF) on 2 December (following completion of the second review in October), although the real challenge may still be to come as we move into 2023 and elections (presidential and congressional).

An election year in Argentina could bring opportunity as well as the usual uncertainty. It is too early to call, and it will be a while before we know the runners and riders (some presidential candidates might want to leave it late to see which way the wind is blowing), ahead of the primaries in August (the presidential election first round is in October).

Incumbent president Alberto Fernandez, of the ruling centre-left Frente de Todos (FdT) coalition, could run again under the Peronist umbrella but seems to lack the political capital to win and, while his current vice president Cristina Fernandez de Kirchner (CFK) has said she won't run next year, she is expected to remain influential. Economy Minister Sergio Massa, who is regarded as having done a good job since his appointment in July, could be the preferred choice of the moderate Peronists (and could be received reasonably favourably by investors), but whether he needs and would get CFK's support is unclear (and it might be better if he does not!). She might favour her son Maximo (needless to say, a victory for any CFK-backed candidate, as unlikely as it seems, would be seen as disastrous by investors).

But it is the centre-right opposition alliance, Juntos por el Cambio (JxC), that is leading the polls and in a good place after inflicting a heavy defeat for the government in the 2021 mid-term elections, although who will win its selection is unclear (Rodriguez Larreta, Patricia Bullrich, even former president Mauricio Macri have all been mentioned), while Liberals outsider Javier Milei, who is third in the polls, could present a threat to the main parties (and have influence in any alliance or run-off). That said, with Alberto Fernandez's and CFK's low approval ratings, it seems like JxC's to lose – and victory for the market friendly centre-right party, with a strong mandate, would be welcomed by investors. The opposition's biggest challenge may be complacency.

Still, whoever wins, they will enter the Pink House with an economy in a mess – current policies are unsustainable. We are unlikely to see any substantive improvement between now and then, as the current government seeks to do enough muddling through to get re-elected (and defer tough decisions until its second term, if it tackles them at all) – although if it hits a wall before then, it could be curtains for their chances. Hence, even Massa would confront a greater challenge (although he may enjoy wider Peronist support to do something about it, if left alone by the Kirchnerite faction).

If JxC wins, it may enjoy more international support but could rapidly use up its domestic political capital trying to fix the economy and unwind the imbalances it would inherit (with echoes of the rise and fall of Macri's presidency in 2015-19) and, what it could achieve, and whether it could implement difficult reforms, will depend in large part on how much support it has in Congress (the government lost control of Congress in the mid-terms but remains the biggest party in both houses). Congressional deadlock (a JxC presidency but without Congressional control) could be negative for reform prospects.

Crucially, the next administration will also face a massive up-tick in debt service payments on Argentina's restructured bonds – as the principal that was deferred through maturity extension and grace periods in the 2020 deal starts to come due, in size. This is as well as dealing with inflation heading towards an annual rate of 100%, a dollar shortage and an overvalued currency (the blue chip rate is at a 100% premium over the official rate).

Principal payments on the foreign bonds rises from zero in 2023, to US$0.6bn in 2024, and to US$2.7bn in 2025 and 2026, while interest averages US$2bn a year over 2024-26; that's debt service on the bonds alone of US$2.5bn in the first year of the next term, rising to nearly US$5bn in both 2025 and 2026.

Argentina debt service schedule on foreign bonds (US$ bn)

Without a drastic change to the economic model, it is not clear where the money will come from, hence market concerns about another default and re-restructuring under the next government (one might argue that the government that created them wouldn't default on them while the market-friendly opposition wouldn't want to default either, but we guard against being too sanguine).

We maintain our Hold on Argentina's US$ bonds, with the 2030s priced at US$26.0 (yield of 36.8%) as of cob 7 December on Bloomberg (mid-price basis). We acknowledge that the bonds could be poised for significant upside on regime change under a more market-friendly government (JxC, or even Massa, under the right circumstances), especially if it gains a strong mandate.

For instance, even if the yield on the '30s falls to 16%, still c200bps wide of Tellimer's estimated Frontier market yield of 14% (and wider than the HY yield of c10.5% on the Bloomberg index), that implies a price of US$53 (100% upside). However, this might not become clear until the second half of the year.

Argentina US$ bonds – price

2. Ukraine

We noted in our trades to watch for 2022 last year that the outlook for Ukraine bonds may be determined in Moscow as the threat of conflict with Russia weighed on investor sentiment. Sadly, this proved right. The unnecessary war has exerted a huge toll on the Ukrainian people, loss of life and destruction of the country. Our thoughts remain with Ukraine.

We keep Ukraine as a trade to watch for 2023 as it seems next year will be no different. The war has entered its 10th month, as hopes for a quick peace have been repeatedly dashed, and the conflict shows no sign of ending. In fact, the war has intensified in recent weeks as Putin reacts to Ukraine's military gains and its retaking of Kherson in early November with sustained missile strikes and attacks on Ukraine's infrastructure, including its energy grid, perhaps in a last-ditch war of attrition (see here and here). Meanwhile, the crucial winter period (for both sides) is here.

The mainstream international community will hope that its continued support for Ukraine (diplomatically, militarily and financially), along with Russia’s military losses (and its economic collapse), will – absent a military victory for either side (however that is defined) – lead Moscow to a negotiated peace that is acceptable to Kyiv. Putin, meanwhile, may hope, absent a military victory, that a prolonged war will lead to divisions in the western alliance and war fatigue that he can exploit. However, the risk of miscalculation and escalation (and use of tactical nuclear weapons) remains.

The war could end tomorrow. Or it could continue for some time. But we do know that it means Ukraine will continue to require substantial external financing in both the recovery and the reconstruction phase. The IMF's new programme monitoring with board involvement (PMB), seen as a precursor to a fully fledged programme when conditions allow, will help catalyse the tens of billions of dollars in external financing that Ukraine needs. It is expected soon to go to the Board after staff-level agreement was announced on 23 November (approval of Ukraine's new PMB is on the IMF Board schedule for 19 December).

For bondholders, despite the government's efforts to remain current for as long as possible, the war eventually eroded ability to pay – as we had expected – the longer it went on. Investors are now in wait-and-see mode following the debt service freeze that was agreed by consent solicitation in August. When conditions allow, attention will then shift to the debt sustainability analysis and debt service capacity, around which there is currently huge uncertainty, to inform what debt reprofiling or restructuring will look like and what this means for the bonds. The IMF projects public debt to reach 87.8% of GDP by end-2022, and to stabilise around that level under the baseline, although its updated debt sustainability analysis (DSA) shows a wide range of potential outcomes.

We retain our Hold on Ukraine USD bonds, with UKRAIN '34s (was '32s) indicated at US$20.4 (mid-price basis) as of cob 7 December on Bloomberg.

Ukraine bond prices (US$)

3. Venezuela

Venezuelan bonds are subject to OFAC sanctions. Investors should seek advice from their compliance departments. We do not have a recommendation on Venezuelan bonds at this stage.

We highlight Venezuela as a trade to watch next year on increasing hopes of political reconciliation, economic reform and an easing in US sanctions ahead of elections in 2024 and possible regime change. However, despite some recent positive steps, we remain sceptical at this very early stage that this will lead to credible, free and fair elections and a democratic transfer of power, so this may not translate yet into durable gains in bond prices.

Optimism has followed what has been seen as a greater international effort urging the Maduro regime to return to the negotiating table with the opposition and holding out the prospect of easing in US sanctions on Venezuela. This came amid a new diplomatic push by the Biden administration earlier this year in support of the removal of broad sanctions in favour of targeted sanctions after the failure of the "maximum pressure" policy, albeit reports of an easing in US sanctions on Venezuela oil to fill the gap caused by the Russian oil ban attracted criticism due to political expediency.

The new effort has met with some success so far. Mediation talks between President Maduro’s regime and the opposition Unitary Platform, facilitated by Norway, resumed in Mexico on 26 November after Maduro effectively suspended them over a year ago. Maduro had stated his willingness to return to negotiations during a US visit in March 2022, albeit later adding conditions which could have stifled progress. Concurrently, the US Office of Foreign Assets Control (OFAC) authorised Chevron to resume limited oil extraction operations in Venezuela under General Licence (GL41) on 26 November. The licence, for an initial period of six months, allows Chevron to produce and export oil but doesn’t allow new drilling.

But it is not clear the US is willing to go further in relaxing its swathe of sanctions on Venezuela, with those on primary market activity and secondary market bond trading of most importance to investors. Moreover, the license really only allows Chevron to get paid on its outstanding debt and may not result in broader easing or a more substantive boost to Venezuela’s overall oil exports (Chevron produced about 15k bpd before sanctions forced it to half operations, according to media reports). Venezuelan oil production was 690k bpd in November, according to Bloomberg data, and has averaged 765k bpd this year compared to 530k in 2021.

And nor is it clear that the talks between the government and opposition will continue in a straight line. Maduro has stalled the talks before and there are no guarantees that progress is irreversible.

Still, the international carrot-and-stick approach aims to leverage sanctions relief to incentivise Maduro to negotiate a path toward free and fair elections in 2024. It also recognises the fading support on the ground for interim president Juan Guaido, who is still recognised as such by the US administration (if not the EU and others), due to fatigue and some improvement in the domestic economy. Venezuela saw positive real GDP growth last year for the first time since 2013, albeit only at 0.5%, and it is expected to pick up further this year to 6%, according to the IMF WEO. Meanwhile, inflation is expected to fall to a still high 210% this year from its recent hyperinflation.  

However, it is still uncertain to us whether Maduro is truly willing to accept moves towards free and fair elections in 2024 - which he is likely to lose - let alone holding them, or whether his moves so far are just an attempt to buy time, extract what he can, before stalling later and seeking to divide the opposition again.

As such, an easing of US financial sanctions ahead of 2024, which could extend to allowing US investors to trade Venezuelan bonds, is not assured while the sanctions themselves prevent a restructuring or any negotiations and discussions on the debt with the Maduro government (despite the regime’s reported willingness to sit down with bondholders).

Still, Venezuelan bond prices have responded positively to these developments. The VENZ 27s have risen by about 30% over the last month (based on Bloomberg prices) - to about US$9.0 (mid), although it is not clear on how much volume in an illiquid and distorted market because of the secondary market trading ban on US investors. However, the bonds remain in deeply distressed territory with prices in the single digits across the curve. 

As such, defaulted Venezuelan bonds may still look attractive – for patient and risk tolerant investors – on expectations of regime change. Prices may be seen as being well below recovery values under some plausible restructuring scenarios, especially if oil reserves backstop recoveries, although a huge international and financial effort will be required to rebuild the country and its institutions, while debt carrying capacity will initially be extremely limited and it will take time to ramp up oil production.

In sum, recovery prospects – and the path to restructuring and the time it takes – remains highly uncertain. However, investors have some compensation as the claim continues to accrue PDI (over 40pts by now, on our estimates). That said, we understand the expiry of the six-year prescription period since default under the statute of limitations is closing in next year, presenting another risk to bondholders.

VENZ '27s - price (US$)

4. Rwanda

We’ve had a Buy recommendation on Rwanda since September 2020, first on the RWANDA 6 ⅝ 05/02/2023s (which had US$340mn of the total US$400mn outstanding tendered in July 2021) and then, since August 2021, on the RWANDA 5 ½ 08/09/2031s (with 55% of its proceeds used to tender the ‘23s). We calculate a total return on the ‘23s from when we initiated our recommendation until they were tendered of 9.3%, greater than the 2.3% return on the Bloomberg EM Sovereign Index over that period. However, since we initiated our recommendation on the ‘31s they have performed in line with the market, delivering a -18.1% total return versus -18.9% for the Bloomberg EM Sovereign Index.

At just US$77.9 (9.26% YTM, 605bps z-spread) as of cob on 7 December, we think the ‘31s look attractive on a valuation basis. For context, the bonds traded at a z-spread of 429bps when they were issued and as low as 345bps in September 2021, meaning spreads have widened by 260bps from post-Covid lows versus just 122bps for the Bloomberg EM Sovereign Index and 205bps for the Bloomberg EM Sovereign High Yield Index.

On the one hand, part of the underperformance in spread terms is justified by Rwanda’s fundamentals, with large gross external financing needs (stemming from a current account deficit that is projected to reach 12.6% of GDP this year), a wide budget deficit (estimated at 8.7% of GDP in FY 21/22) and a large debt burden (with gross debt including guarantees expected to exceed 75% of GDP in FY 22/23 and to remain above the 65% of GDP anchor until FY 28/29, after adjusting for changes to Rwanda’s borrowing terms – see below).  

Encouragingly, the IMF classified Rwanda as being at a “moderate” risk of debt distress during its latest DSA in December 2021. However, this classification has also negatively impacted Rwanda’s ability to access concessional financing by prompting the World Bank to switch the balance of new financing from 50% loans/50% grants to 100% loans, which will widen Rwanda’s budget deficit and public debt by a cumulative 6.6% of GDP relative to the previous baseline from FY 22/23 to FY 30/31. Rwanda’s ability to run such consistently large fiscal deficits has hinged in large part on the concessional nature of its borrowing, so a reduction in grants over time makes fiscal consolidation all the more urgent.

Rwanda will also eventually run out of room to continue financing such large current account deficits, with the IMF stressing the need for greater exchange rate flexibility to absorb shocks in the interim. In the 2021 Article IV, the IMF estimated Rwanda’s exchange rate to be 23% overvalued based on a “current account norm” of -7.3% of GDP and 2021 deficit of 12.1% of GDP, which would rise to 25% based on the projected 12.6% of GDP deficit in 2022. Structural reforms are also needed to improve the business climate and boost competitiveness, which will help bring Rwanda’s endemically large current account deficit in line with fundamentals and prevent a BOP crisis.

On the other hand, Rwanda has a number of things in its favour. Performance under its three-year policy coordination instrument (PCI) with the IMF has been commendable, with all targets met through December 2021 (except the one on inflation, and most with delays) and fiscal consolidation projected to exceed the target by a cumulative 1% of GDP in FY 21/22 and FY 22/23. Further, Rwanda still enjoys a robust growth trajectory, with real GDP growth projected to rise from 6% in 2022 to 7.5% by 2025, and public debt is projected to peak at 76% of GDP in 2024 and decline gradually thereafter as Rwanda reins its budget deficit (notwithstanding the shift from grants to loans).

Lastly, on 12 December Rwanda received IMF Board approval on a new 36-month PCI and resilience and sustainability facility (RSF) worth US$319mn, making Rwanda the first African country to reach an SLA to access the IMF’s new resilience and sustainability trust (RST). The new PCI/RSF ensures reform continuity ahead of the previous PCI’s expiration in June 2023 and will help solidify Rwanda’s fiscal consolidation efforts, with an additional focus on strengthening its monetary policy framework and supporting longer-term structural reform and resiliency efforts.

If Rwanda continues to perform under its new IMF programme, then spreads could continue their downward trend and make up some of the more recent underperformance relative to Rwanda’s HY peers. Conversely, failure to deliver on Rwanda’s ambitious fiscal consolidation plans and rein in its large current account deficit could lead to an unsustainable rise in vulnerabilities in the coming years, so Rwanda’s margin for error remains quite thin (especially with less access to concessional financing). That said, after the successful tender in 2021, there are no major eurobond maturities until the US$620m payment in 2031, which should limit rollover risks if global financial conditions remain tight.

Overall, we continue to think that Rwanda is an attractive investment opportunity given its strong fundamental outlook, notwithstanding its elevated external vulnerabilities, and maintain our Buy recommendation on the RWANDA 5 ½ 08/09/2031s at US$77.9 (9.26% YTM, 605bps z-spread) as of cob on 7 December.

Rwanda '32s

5. Sovereign default risks

In our 2023 outlook, we identified six countries as being at most risk of default in 2023: Ghana, El Salvador, Ethiopia, the Maldives, Pakistan and Tunisia. We highlight them here as trades to watch for the year ahead (with Ghana and Pakistan also in our Top 5). For each, bond prices could come under pressure if default crystalises, although to varying degrees depending on what is already being discounted and recovery prospects, while those that manage to avoid default could see price gains.

Indeed, Ghana has already announced its intention to restructure, although details are still vague (and investors may hope it is not a fait accompli) while Ethiopia’s fate in the Common Framework remains uncertain. 

Otherwise, El Salvador seems at most imminent risk of default ahead of a bond maturity on 24 January 2023 (now US$604mn outstanding after the recent tender offer) although the government has said it has the funds to repay them (the bonds have a 15-day grace period on interest, but don't appear to have a grace period on principal as far as we can tell). With a price of cUS$95 on the ‘23s, the market is attaching something like an 85-90% probability that they will be repaid, so there is a lot of downside if they are not. Conversely, there may be a relief rally with some limited upside for the rest of the bonds if the ‘23s are paid. Prices are in the high 30s, low 40s for the rest of the curve (excluding near maturities). However, even if the payment is made, we think default concerns will persist given the ongoing concerns over the lack of a credible and coherent financing plan, with limited visibility over financing sources, limited policy options and still-high debt service costs.

We think default risk is also elevated in the Maldives, and this is not fully reflected in current bond prices (cUS$78.5 mid on the MVMOFB 9.875% 2026s). The government plans tax rises and is considering other measures to address fiscal vulnerabilities – with double-digit fiscal deficits and public debt over 120% of GDP – but limited financing options and large financing needs, amid declining reserves, pose significant risks. Moreover, there are implementation risks, with 2023 an election year, which may reduce the government’s appetite to pursue, and stick to, needed reforms. And, as we know from Barbados and Suriname, new governments can choose to default.

6. Restructuring plays in Sri Lanka and Zambia

Sri Lanka and Zambia are both in the middle of complicated debt restructurings that will have major implications for future restructurings. We wrote about this in detail in our Global Themes for 2023, but reiterate some of the key points here, along with the investment implications.

There are several similarities between the two cases, including a similar debt stock, service and composition and presence of China as the main bilateral creditor. There are also several key differences, with Zambia restructuring under the Common Framework and Sri Lanka, as a middle-income country, restructuring outside it.

This has important implications for how debt sustainability is assessed, with Zambia subject to the DSA for low-income countries (LICs) and Sri Lanka subject to the DSA for market access countries (MACs). All else equal, this should mean that less relief is required in Sri Lanka to set debt on a sustainable path, and calls into question the logic of Zambia trading at a >50% premium (with ‘27s trading at US$47 in Zambia and just US$30 in Sri Lanka).

Zambia vs Sri lanka

However, Sri Lanka is the first MAC to restructure under the recently revamped MAC DSA framework, so the more concrete implications of his distinction are still unclear. And, as we recently observed, ongoing restructurings are facing common issues whether or not they are taking place under the Common Framework. The key issues include delays in getting the official sector creditor committee to the table (mainly due to China) and disagreements with private sector creditors (mainly due to a lack of early engagement from the official sector and difficulties with sequencing).

Indeed, a footnote of a G20 statement last month highlighted that one member (understood to be China) "has divergent views on debt issues...and emphasized the importance of debt treatment by multilateral creditors like MDBs [multilateral development banks]". The seniority of MDB debt is a fundamental cornerstone of all Paris Club/IMF-backed restructurings, and China's refusal to accept this principle could derail any restructurings where it is a major creditor.

World Bank President David Malpass also spoke out on the issue last week after discussions with Chinese lenders and Premier Li Keqiang, saying that the IMF and World Bank “discussed the urgency of more rapid progress in the ongoing debt restructuring discussions, including for Zambia" and that “Changes in China’s positions are critical in this effort". Meanwhile, a brief IMF statement at the conclusion of its mission on 8 December provided no new insights, saying that and first ECF review is expected in spring 2023 but that "Achieving timely restructuring agreements with external creditors is essential to secure the expected benefits of the Fund-supported program".

How these issues are ultimately dealt with will set important precedents for future restructurings. The reason we have listed Sri Lanka and Zambia as trades to watch, however, is because of the massive uncertainty that still exists about recovery value for each country’s eurobonds, which have been subject to huge swings in recent years both leading up to the events of default and after the restructuring were well underway.

In Zambia’s case, private creditors have taken issue with the sustainability thresholds in the DSA, which are calibrated for a low-income country with a “weak” debt-carrying capacity. These thresholds are more stringent than they are for a country with a “medium” carrying capacity, which creditors argue Zambia will classified as by the end of the IMF programme and should thus be subject to [Note: Carrying capacity is based on a “Composite Indicator”, which in Zambia’s case is currently 2.59 versus the “medium” threshold of 2.69. See page 14 of the latest DSA for how the score is calculated].

An investor presentation by Zambia has clarified that the government is asking for net-present value (NPV) relief of 49% versus the 35-45% range we initially cited, calculated at a 5% discount rate with the face value of debt in the denominator. This would imply a recovery value cUS$39 at a more reasonable 12% discount rate (or NPV relief closer to c69.5%) versus the current price of cUS$47. However, we still think this should be seen as the starting point, with bondholders fighting hard for the reclassification of Zambia as a “medium carrying capacity” country and likely to seek some sort of other recompense if the IMF does not acquiesce (like inclusion of domestic debt in the restructuring, for example).

With the benefit of hindsight, the Buy recommendation we initiated at a price of US$57 no longer looks appropriate given the clarifications that we have since received on the DSA. However, at the current price of US$47 our recommendation stands, with a downside scenario of US$39 (-17% relative to the current price) and upside scenario of US$57.5 (+22%) if a PV of external debt to exports ratio of a 108% is adopted instead of 84% as currently specified (consistent with a “medium carrying capacity” and “sufficient space” to absorb shocks). This would lower the amount of required NPV relief to 24% at 5% discount rate, which is equal to 54.5% at a 12% discount rate and a cash price of US$57.5.

In Sri Lanka’s case, the restructuring is likely to be even messier given the additional complications at play. However, as an MAC, Sri Lanka should presumably have a higher debt-carrying capacity than Zambia (again, all else equal), so logic should follow that its recovery value should be higher. While this may not hold in practice (indeed, our estimated recovery range of US$25-40 in Sri Lanka is lower than our new worst-case US$39 recovery in Zambia), it would mean there is more upside for Sri Lanka’s eurobonds (or, conversely, downside for Zambia’s) given the existing premium of c55% on Zambia’s bonds.

As such, investors will be keenly watching how the restructurings unfold in Sri Lanka and Zambia. After several volatile years for their eurobonds, it is possible that more volatility is in store, with major implications for current and perspective bondholders.

7. Local debt plays in Uganda and Zambia

With the US Fed projected to pivot in 2023, many are predicting the end of the strong dollar cycle. This has been the consensus for the past two years and has proved spectacularly wrong. However, if it turns out to be true this time around, then local currency EM government debt should be set for a strong year. While we are reluctant to call time on the dollar – see here for a thorough explanation why – it may still be an attractive time to go selectively long on local currency debt in countries where real rates are high enough to provide a comfortable cushion against the risk of persistent dollar strength.

Uganda and Zambia are two such countries, and we have Buy recommendations on both (although, in this note, we downgrade Zambia to Hold - see below). In Uganda, the local ‘26s trade at a yield of 15.8% (+5.2% real) while, in Zambia, the ‘26s trade at a yield of 27% (+17.2% real). This is higher than the yields of 13.2% and 25.1%, respectively, at which we initiated our Buy recommendations in October and September 2021, but high-running yields and relative currency stability (-3.7% in Uganda and -6.2% in Zambia vs the US dollar) have led to total US$ returns of +4.1% for the Uganda ‘26s (+4.7% for the ‘31s) and +3.9% for the Zambia ‘26s since we initiated our recommendations versus -9% and -10.8%, respectively, for the Bloomberg EM Local Currency Index over the same period.

Uganda vs Zambia

Yields are relatively less attractive on both a nominal and real basis in Uganda and there is a risk that the currency is overvalued, but we think Uganda has one of the more positive fundamental stories in sub-Saharan Africa and its local currency debt is an attractive way to gain exposure (as it doesn't have any foreign bonds). With nominal yields of c16%, there is ample space to absorb currency depreciation, and, with inflation projected by the IMF to fall to 6.8% by the end of 2023, there is also scope for duration gains if the central bank loosens its policy stance. Further, the trade is far less crowded in Uganda relative to Zambia (with non-residents holding c7-8% of domestic debt in Uganda versus c25% in Zambia).

In Zambia, nominal and real yields are much higher and provide significant cushion against further currency depreciation. However, Zambia’s current account has swung from a 7.9% of GDP surplus in Q1 and 2.6% surplus in Q2 to a 4.9% deficit in Q3 2022 (based on official data, which varies widely from the IMF’s estimates), meaning that ZMW will likely remain under pressure, after falling 11% since the beginning of September. Further, while the government and IMF maintain that domestic debt will not be restructured (indeed, this was the basis for our Buy recommendation), there is a risk that it gets dragged in if the gap cannot be bridged between the IMF’s and bondholders’ views of the appropriate DSA thresholds (see above).

In this case, bondholders may require the inclusion of domestic debt in the restructuring to reduce the amount of NPV relief required by external creditors, given what many now view as an excessively high 49% NPV haircut stemming from the DSA (assuming there is not a lot of overlap between eurobond holders and non-resident holders of domestic debt). Overall, our confidence that it will be excluded from the restructuring has diminished in recent months, and our ZMW outlook has also softened due to the erosion of Zambia’s large current account surplus.

We think the risks are now more finely balanced for Zambia’s domestic debt, with high nominal and real yields making for an attractive trade opportunity and providing a significant cushion against the risk of continued ZMW weakness but the growing risk of its inclusion in the debt restructuring and of BOP weakness triggering further ZMW depreciation creating large downside risks. As such, we downgrade our recommendation on the ZAMGB 11 01/25/2026s from Buy to Hold at US$67.5 (27% YTM) as of cob on 7 December on Bloomberg.

Conversely, we maintain our Buy recommendation on the UGANGB 16 ⅝ 08/27/2026s at US$102.2 (15.8% YTM) and UGANGB 17 04/03/2031s at US$103.8 (16.1% YTM) as of 7 December, which we think are the more attractive – if somewhat idiosyncratic and illiquid – way to play a weak dollar view in the frontier market space.