Strategy Note /

Seven trades to watch in 2023

  • Our recently published Top 5 picks for 2023 featured a number of other trades to watch, or themes

  • These involve Argentina, Ukraine, Venezuela, Rwanda, Sri Lanka/Zambia, Uganda/Zambia, sovereign default risks generally

  • Most are high yield/distressed, representing idiosyncratic risks – positive news could be a catalyst for strong gains

Seven trades to watch in 2023
Stuart Culverhouse
Stuart Culverhouse

Chief Economist & Head of Fixed Income Research

Tellimer Research
23 December 2022
Published byTellimer Research

In light of the publication of our Top 5 picks for 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

  2. Ukraine

  3. Venezuela

  4. Rwanda

  5. Sovereign default risks

  6. Restructuring plays in Sri Lanka and Zambia

  7. Local debt plays in Uganda and Zambia

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 an 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 Venezuelan 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 c15,000 barrels per day (bpd) before sanctions forced it to half operations, according to media reports). Venezuelan oil production was 690,000bpd in November, according to Bloomberg data, and has averaged 765,000bpd this year compared with 530,000bpd 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 c30% over the past month (based on Bloomberg prices) – to cUS$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 – remain 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 the 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, Rwanda just reached a staff-level agreement (SLA) on a new 36-month PCI and resilience and sustainability facility (RSF) worth US$310mn, 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 will be considered by the IMF Executive Board on 12 December, and if it is approved (which we think is likely) it will ensure reform continuity by finalising a new programme ahead of the current PCI’s expiration in June 2023 and 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.

This report is extracted from our publication Top picks for 2023, dated 12 December.

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