May 21, 2021
S&P’s one-notch downgrade of Colombia’s foreign currency debt with a stable outlook has moved it from an investment grade to high yield (BB+) rating. The country’s local currency debt also got a one-notch cut but it remains in the investment-grade bucket (BBB-).
While the probability of a downgrade was widely considered to be high, it’s the timing of it that has taken the market by surprise, coming less than a month after S&P affirmed its rating on the country.
S&P’s decision was motivated by the Colombian government withdrawing its ambitious fiscal reform proposal amid widespread protests in the country.
The proposal focused on increasing tax revenues by broadening the VAT base (introducing the levy on some previously untaxed essentials) and lowering the tax-free personal income tax bracket – much-needed reforms to set the country’s debt on a sustainable path. Although the proposals included plans to increase social programs, its unpopular design and unfortunate timing (just as a severe second wave of COVID ripped through the country) triggered widespread protests which turned violent.
The country’s finance minister has since resigned and his replacement has promised a different package with a greater focus on raising the tax burden on corporates. However, S&P’s assessment of that as likely to fall short of the structural increase in revenues that Colombia needs to fix its finances prompted the pre-emptive downgrade.
The timing was certainly unexpected, particularly as rating agencies typically wait until a clear picture emerges on what Congress-adopted reforms look like. However, we think the impact on the country’s hard currency sovereign debt market will be relatively muted. Before the downgrade, prices already reflected a high chance of a rating cut. Furthermore, international investors’ positioning in the market is relatively light (i.e. less susceptible to sentiment-driven capital outflows), so we expect the market reaction to be relatively contained.
While the country’s local currency debt rating remains investment grade, investors might expect some pressure on the market in coming weeks given the more significant positioning among the international investment community. However, we think that the very steep yield curve coupled with the fact that the currency has already depreciated significantly this year (ranking among the worst performing EM currencies) means that current market prices are already reflective of those risks.
At BBB- and on negative outlook, Fitch is the rating agency most likely to follow with the next downgrade, however we expect it to wait and see what fiscal reform Congress ends up passing. Market prices already reflect a second downgrade to high yield.
We believe the S&P downgrade could prove to be a wake-up call for Colombia’s politicians and spur them into taking more significant – and more carefully considered – action to set the economy on a more sustainable path. We will watch closely for signs of a positive shift of this nature. Given the premium built in to local bond yields and hard currency bond spreads, we think investors will be well rewarded if this shift materialises.
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