Ecuador's Post-Election Bond Risk

Sources: Bloomberg, Ecuador Bonds Riskiest, Credit-Default Swaps Indicate; BBC News, Ecuador Leftist Correa Leads Vote.

Leftist-candidate Rafeal Correa declared himself the winner of the Ecuadorian presidential election on November 27, garnering sixty-seven percent of the vote with just slightly over fifty percent of the ballots counted. Upon that declaration, Ecuador became the riskiest country in the world for bondholders, surpassing Lebanon (#2) and Argentina (#3). There are many factors that contribute to the risk of a bond, including the bond quality, or the likelihood that the issuer will be able to pay back the bondholder. The greater the likelihood that the bond will be paid on time, the higher the quality of the bond and the less risk involved.

Ecuador’s increased risk stems, in part, from Correa’s recent announcements that he would consider defaulting on much of the country’s $11 billion sovereign debt if elected. See Ecuadorian Presidential Candidate Plans to Cut Ties with World Bank and IMF and Ecuadorian Candidate Creates Unease Over Debt. Additionally, despite the increased risk for bondholders, Correa seems to care very little; “[i]f country risk goes up because of speculators worrying over ability to pay the debt, I don't care . . . The country risk I care about is children suffering.”

Ecuador’s risk is evaluated based on the cost of credit-default swaps. Credit-default swaps are “financial instruments based on bonds and loans that are used to speculate on [an issuer’s] ability to repay debt.” Essentially, they protect bondholders by allowing the holder to buy insurance against the default of the third party, in this case Ecuador. If Ecuador defaults, the bondholder will be able to recover the face-value of the bond because the party providing the insurance will have to buy the bond from the holder. The cost of credit-default swaps increased fifty-five percent from $313,000 to $483,000, the increase in price indicating the perception of the quality of the bond is declining.

Question:

(1) What are the disadvantages for Mr. Correa of not paying attention to the country’s risk rating, if any? Are there problems with measuring risk by the credit-default swaps? Are they accurate measures?