LATIN AMERICAN DEBT: Backed by popular demand

23/03/2010 | Sid Verma

After a big rally last year, investors are taking stock of LatAm’s relative value. But this time it’s a blip, not a correction, they say

By early this year, the torrent of Latin American corporate and sovereign debt issued in recent months had slowed to a trickle.

The spectre of sovereign debt crisis – notably in the eurozone – returned to haunt markets around the world, taking the shine off one of the past year’s most buoyant regions as global risk aversion once again reared its head.

Says Katia Bouazza, head of debt capital markets for Latin America at HSBC: “Investors became more selective in February – even though there was ample liquidity – because of concerns over Greece’s debt burden, the outlook of the global economy and the direction of US Treasury rates.”

Just $2.44 billion of new Latin corporate deals was launched between February and March 6, compared to $6.86 billion in January. By contrast, a record $45 billion of corporate paper was printed last year, compared with $30 billion in the 2007 bull run.

Bankers had pencilled in a front-loaded issuance calendar this year, thanks to cheap liquidity and stable secondary market spreads. “We’d expected a far more active primary market out of Latin America, as pricing levels are very attractive,” says Augusto Urmeneta, head of Latin America capital markets at Bank of America Merrill Lynch.

Global asset prices reflated rapidly last year, thanks to massive monetary and fiscal measures, principally in G-7 economies. The result was that investors started once again in earnest to search for yield. But falling credit spreads and expanding regional economies have also triggered a hunt for yield further down the credit curve.

From last spring, Latin American issuers prized open the doors to single-B, perpetual, and even covenant-lite deals with ever-tighter yields.

But after the massive rally in 2009, investors are once again taking stock of the relative value of Latin credits, contributing to the recent primary market slowdown, says Claudia Calich, a senior emerging markets portfolio manager at Invesco. “Markets have been taking a bit of a breather in recent weeks.”

Has the exuberance for emerging markets in a sea of liquidity – against the threat of a global market slump and anaemic western growth – stretched valuations?

According to Anne Milne, head of Latin American corporate bond research at Deutsche Bank, the bull market has left high-grade investors with little compensation for interest rate risk. A US rate hike of 0.5% will cause returns on high-grade Latin corporate paper to drop to 0–5% in 2010, whereas a 1% hike would cause investor returns to fall to zero, or in some cases negative territory, she notes.

But we are not in bubble territory – yet, say investors. “Emerging market corporate bonds are still trading at wider valuations than 2003,” says Polina Kurdyavko, portfolio manager at BlueBay Asset Management. Emerging market corporates on average still offer a 150bp to 300bp pick-up to similarly rated firms in the US high-yield market, according to ING.

Market technicals also suggest the rally still has legs. ING estimates $19 billion of coupon and amortization payments were paid to emerging market portfolio managers in February. Re-investment flows will soak up new supply without pressuring secondary market credit spreads.

CASH SEEKS HOME

Meanwhile, investor inflows into emerging market funds have maintained their frenzied pace, in contrast to the outflows out of US high-yield funds in recent weeks. In the week ended March 10, investors ploughed $1.05 billion into emerging market bond funds – the biggest weekly inflow in more than a decade – bringing the year-to-date allocation to $5 billion, according to Emerging Portfolio Fund Research.

The lower levels of international new issuance are due to the reduced financing needs of Latin American borrowers rather than investors becoming reluctant to invest, say bankers.

Pent-up borrowing needs, after the crunch shut the door on emerging market issues in 2008, set off the debt binge in 2009. As a result, “Latin firms don’t have large funding needs this year, as many firms have already prefinanced or refinanced their funding needs,” says Urmeneta.

The relative resilience of the asset class in the February global market sell-off suggests the recent primary market slowdown is a cyclical blip in a structural bull market for Latin credit.

Emerging market hard currency sovereign bonds have, to date, outperformed US high-yield and developed high-grade bonds. The benchmark, known as JPMorgan’s EMBI index, has returned to pre-Lehman Brothers levels of 250–270bp.

Meanwhile, nearly all of the 22 Latin corporate deals priced this year are trading at or above their issue price, says Bevan Rosenbloom, corporate debt analyst at RBS. “This provides a supportive environment for issuers to come to the market, as they will price off new deals whether tighter or flat to existing yield curves.”

Nevertheless, Richard McNeil, head of Latin America debt capital markets at Goldman Sachs, foresees lighter primary market activity in the coming months due to low corporate financing needs in the near-term. He says financial issuers, especially in Brazil, buoyed by strong credit demand, will dominate the corporate market along with industrial companies with large capex programmes.

Before the six-week primary market slowdown, Latin credit markets had been hit by a flurry of high-yield issuance. Most recently, Brasil Foods made its debut in January by doubling its original borrowing target to $750 million with a 10-year bond, priced to yield 7.375%. Grupo Posadas Hotel, Cemex and Peru’s Coperinica have also issued high-yield bonds in recent months.

The enthusiasm for high-yield borrowers, many of whom have little room for manoeuvre with tight liquidity conditions, contrasts with market hostility, in the grip of the downturn, for companies with large near-term debt maturities.

Investors hope that growing domestic consumption and production will beef up the creditworthiness of Latin firms. Kurdyavko says well-governed corporates, with strong growth outlooks from non-cyclical sectors such as telecommunications, offer the best value in the high-yield sector. Urmeneta at BoAML says that high-yield corporates will issue opportunistically this year whenever “market conditions offer them access to long-term financing at a reasonable cost relative to shorter-term domestic alternatives”.

But the jury is out on the value of external bond markets relative to local bank finance or local capital markets.

It is not clear if liquidity in regional banking systems and local capital markets has returned to pre-crisis levels, say bankers. Local market bulls cite the watershed transaction from Mexican telecom giant América Móvil in early March. This marked the reopening of the Mexican local market to corporate issuers – as the 6.5% contraction in 2009 triggered a liquidity crunch.

It was the first time a private company had achieved a tighter spread than a quasi-sovereign. The borrower, rated A-/BBB+, priced a landmark deal in the local peso market with three tranches for a total Ps15 billion ($1.17 billion). The Ps7 billion, 10-year fixed-rate tranche was priced to yield at a slender 8.6%, just 92bp over the equivalent sovereign paper and 46bp tighter to Pemex, the government-owned oil company. Local banks and international investors snapped up the deal.

However, this may be the exception rather than the norm.

McNeil at Goldman Sachs says balance sheet pressures among global banks that dominate the Mexican financial system will restrict local funding for corporate borrowers. “There’s still a lot of residual uncertainty overshadowing banks globally, with the result that those markets within Latin America that are most reliant on foreign banks may take a bit longer to normalize fully.”

But Urmeneta says Mexican banks still have a stable funding base and large balance sheets, and so financial institutions “will intermediate deposits to corporate borrowers”, once demand picks up. However, he warns that in the near term, international portfolio managers are unlikely to dive into local capital markets since “investors don’t currently have the appetite for foreign exchange risks”.

TIGHTER AND LONGER

The availability of longer-dated paper may also support cross-border primary market issuance in dollars. In the grip of the crisis many Latin firms, especially smaller to medium-sized companies such as Brazilian food producers, faced a liquidity crunch, says McNeil. This inhibited working capital while the ability to roll debt over for long tenors was constrained.

As a result, Latin corporate treasurers view external debt markets more favourably, due to the availability of longer tenors. “Despite the foreign exchange risk and the higher cost of moving out along the yield curve, dollar markets help to reduce roll-over risk,” says McNeil.

Mexico’s latest international debt issue proves the point. The sovereign achieved its lowest ever 10-year funding costs at 139bp for a $1 billion retap and a slender 5% coupon. Yet over the past year, Mexico, rated BBB, has been Latin America’s whipping boy, due to fears over its large debts and close links to the US.

By comparison, Greece was forced to pay 300bp over mid-swaps for a 10-year, E5 billion benchmark.

“Investors are recognizing that Latin American economies have more robust growth prospects than the developed world, which is struggling with big consumer debt and fiscal hangovers,” says Chris Gilfond, head of Latin America debt at Citigroup.

Despite the emerging market government paper trading at tight levels, Gilfond says there is still room for spread compression as investors strategically allocate capital to growing, underlevered economies. He cites the rise of GDP-weighted fixed income indices. “This means real money portfolios are becoming ever more global, gravitating toward centres of economic growth,” he says.

Calich at Invesco says there has been a jump in investor allocations into emerging markets, triggered by outflows from southern European sovereign paper. “The European investor base is so huge that just a minimal re-allocation into emerging markets will drive high-grade sovereign spreads lower,” he says.

Rather than the collapse of confidence in emerging market debt, sparked by the global financial crisis, the opposite has happened: sovereign debt spreads now trade inside BB-rated European corporates and, in some cases, flat to BBB-rated US corporates. Meanwhile, corporate borrowers are demanding ever-aggressive pricing terms to investors.

But such market moves can overshoot. Kurdyavko at BlueBay says: “We have to be careful. We are in a good place right now, but we have to be very selective and prepare ourselves for the next explosion.”

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