(Bloomberg) -- The sense of relief among Colombia’s bondholders this year as congress stymies President Gustavo Petro’s radical proposals looks to be turning into one of outright optimism.

After slumping to the lowest levels since the 2008 global financial crisis late last year, the nation’s dollar bonds have rebounded in 2023 in line with its closest emerging market peers, as lawmakers blocked Petro’s plans to overhaul the nation’s economic model. The notes due in 2027 are now trading at 93.2 cents on the dollar, up from a low of 80.8 cents in October of last year, according to indicative pricing data compiled by Bloomberg.

That rally is likely to extend into 2024 and surpass that of similarly-rated nations such as Brazil, narrowing the risk premium investors demand to hold Colombian debt, according to Armando Armenta, an emerging-market strategist at AllianceBernstein. A smaller-than-expected fiscal deficit, a narrowing current account gap and Petro’s falling popularity should all combine to fuel gains in the dollar bonds.

“Even though the bonds have rallied a lot, they’re still cheap,” said Armenta, who’s been positive on the credit for the whole year. “As fiscal risks decrease and external accounts adjust, we see room for outperformance.”

The extra yield investors demand to hold Colombia’s dollar bonds rather than US Treasuries has fallen almost 70 basis points this year, while the peso has rallied about 20%, the most in emerging markets, according to data compiled by Bloomberg. 

Yet the spread over similar US Treasuries remains more than 50 basis points wider than Colombia’s BB-rated peers, according to JPMorgan indices. It’s that difference that many now expect to narrow.

Fading Risk

Risk perception has been improving since Petro’s political coalition in congress started to shatter earlier this year, making it harder for the president to pass controversial reforms of the health-care, labor and pension systems. His government — mired in political scandals involving top aides — also saw its allies lose control of major cities in elections in October. 

“It looks like the markets are increasingly viewing Petro as a lame duck president,” said Zulfi Ali, a portfolio manager focusing on Latin American hard currency sovereign and quasi sovereign debt at PGIM Fixed Income in Newark. 

Even as Petro and some of his ministers continue to invite confrontation with calls to overturn a fiscal rule that limits government spending, the lack of concrete action and the overall improvement of the fiscal outlook has helped turn investor sentiment.

“We think spreads still don’t fully reflect the reduction in imbalances and continued evidence that Colombia’s institutions are conducive toward policy moderation,” Bank of America economist Alexander Muller and strategists including Christian Gonzalez Rojas and Lucas Martin wrote in a November note. 

Public Credit Director Jose Roberto Acosta said in October that this year’s fiscal deficit will likely be narrower than the official forecast of 4.3% of gross domestic product. Private estimates agree. Bank of America sees the overall shortfall for 2023 at about 3.7% of GDP.

The Proof

The market is now waiting for the official numbers to confirm the improved fiscal outlook, said Sarah Glendon, senior analyst at Columbia Threadneedle Investments in New York.

If investors can “see that the fiscal dynamics have improved, that would be a clear catalyst” for a rally, Glendon said. 

Still, not everyone is convinced that Petro’s failures will lead to a more consensual approach.

“If you thought these reforms had certain probability of passing, now that probability is lower, and that gives room for some correction,” said Andrés Pardo, chief macro strategist for Latin America at XP Investments. “But I’m skeptical about the signs of moderation and it’s likely the government will radicalize.”

One concern is that Petro will use increased tax revenue to boost his popularity via subsidies and handouts. 

All the same, Morgan Stanley picked Colombia’s dollar bonds due in 2035 as one of its top high-yield choices for next year, while liking Colombia as a credit overall. Economists at the bank expect the country’s current account deficit to narrow further next year, and see the market turning more positive on the credit.

“Colombia is still by far the cheapest BB credit by pricing in 2.5 downgrades” by rating companies, wrote strategists Simon Waever, Neville Mandimika, Pascal Bode and Emma Cerda in a report. “We don’t see any significant reforms passing, which is another key reason for the bullish view.” 

--With assistance from Oscar Medina.

©2023 Bloomberg L.P.