When Brazilian Eike Batista’s oil and gas company OGX defaulted in October, it left $3.6bn of bondholders facing big losses, and created the largest corporate default in Latin American history.
But OGX’s failure to produce oil will be remembered as more than just a terrible misjudgement on the part of the analysts who bought into the story. For if Brazil was the talisman of Latin America’s booming bond markets in recent years, then Batista was the flamboyant face of a reformed Brazil welcoming new investment. The ignominious collapse of his EBX business empire was symbolic of a loss of faith in the rise of Brazil.
One banker described the OGX saga as a “slow-motion bankruptcy”, as it ran on and on in a difficult year for Brazilian bond markets. When EM debt faced a brutal sell-off in May and June on the back of QE tapering talk in the US, Brazil was hit worst than most.
Disappointing growth, mass public protests in June, investor concerns about a meddling government and a negative outlook on the sovereign rating from Standard & Poor’s all added to the concern.
In debt capital markets, the numbers speak for themselves. LatAm beat 2012’s record issuance volumes of $114bn before November. But Brazil was still $12bn behind 2012’s issuance volumes of $51.5bn as of November 25, according to Dealogic. And this despite state oil company Petrobras obliterating its own record for the largest ever EM debt issue, printing six tranches totalling $11bn in April.
Mexico, benefiting from enthusiasm around president Enrique Peña Nieto’s reform programme, had provided 31.9% of Latin American bond issuance as of November 25 — versus 26.5% in 2012. Brazil’s share fell from 45% to just below a third, its lowest portion since 2007.
Moreover, Brazil’s CDS and sovereign spreads are suddenly as much as 100bp wider than Mexico’s, having trading at parity in recent years. Is there a power shift at the top?
Bankers and investors tend to feel talk of Brazil’s downfall is exaggerated. The country is suffering the consequences of “poor market psychology,” says Robert Abad, portfolio manager at Western Asset Management in California.
“The euphoria that built up under Lula’s presidency created a set of expectations that Brazil would be the next China,” he says. “OGX was part of this euphoria: when it raised money it was basically just a PowerPoint presentation brought to life by the Wall Street machinery and media.”
Brazil is the “classic bull market story turned classic bear market story,” says Abad. “Any negative headline today reinforces the notion that Brazil is somehow going down in flames.”
The negativity has been an “overreaction based on misguided and over-hyped expectations of economic growth and policy continuity”. Indeed, Abad says Brazil has only been a positive economic story for 10 years. Given the decades of turbulence that closed the 20th century, the development path was not going to be smooth all the way.
“In the same way there was over-excitement about Brazil’s prospects leading up to the EBX debacle, the June protests and the steep reversal in the overnight rates, now the negative sentiment has probably gone too far the other way,” says David Gould, responsible for DCM, sales and trading at Brazilian lender Banco Pine.
Though the prospect of paying new issue premiums, even more elevated than those faced by other LatAm issuers, has put several Brazilian borrowers off bond markets, some buyers are already spotting the chance of a rally.
“Although issuer ratings downgrades may be on the horizon, a number of fixed income investors seem to think that certain sectors in Brazil have been oversold,” says Clayton Pope, head of bond syndicate for emerging markets at Credit Suisse in New York.
“Whether Brazilian issuers continue to pay greater premiums than the rest of LatAm depends on the country’s economic performance in an election year and whether we finally see the turnaround that we were hoping to see in the second half of 2013.
“If economic performance shows signs of improvement, some of the required new issue bond concessions may begin to recede.”
Fundamentals to drive debuts
Bond bankers therefore hope that OGX will serve as a caution against getting caught up in a herd mentality — whether positive or negative. If so, Latin America is well positioned to withstand the market volatility that struck EM in the second half of 2013.
“We’ve obtained these levels of issuance despite the volatility due to Latin America’s good fundamentals versus the rest of the world,” says Roberto D’Avola, head of Latin American DCM at JP Morgan.
“Latin America not only has a lot of the goods and commodities needed in the rest of the world, but it also has internal demand as an engine for growth that several other emerging markets perhaps lack. We believe issuance can continue in the same volume because the Latin American market continues to be under-invested relative to the rest of the world.”
These fundamentals, he says have allowed LatAm issuance to go further down the credit spectrum, despite base rates and spreads widening. But a focus on fundamentals also leads to more selectivity. “A lot of these new credits may have low ratings but they are on an upward trajectory,” he says. “A couple of years ago some weaker credits were coming to market, now as liquidity is tighter only those with a bright future are successfully issuing.”
OGX, and three defaults from Mexican homebuilding companies last year, have reminded investors of the importance of homework, says Abad, who believes this was forgotten in the QE-driven market ruled by technicals.
However, the investors that live through these troubles will have learnt a lot, he says. Therefore “new credits with a strong story will still get a fair hearing despite tighter monetary conditions”.
He adds: “QE allowed the EM corporate market to grow quickly and we now have a large basket of credits offering healthy premiums over sovereigns.
“It will be difficult for the LatAm sovereign space to rally heavily given the uncertainty over US rates, but the corporate space continues to offer more interesting opportunities.”
There is also a market-related reason to believe that new supply will continue to support volumes.
“Pragmatic companies will see that the 10 year Treasury is still around 2.75%, and overall rates and borrowing costs are only trending higher,” says Carlyle Peake, head of EM syndicate at BBVA.
The ability of new and high yield credits to raise money in tough market conditions is part of what bankers see as a newly sophisticated LatAm market. According to Peake, this includes new structures and currencies, the increasing use by investors of investment grade and high yield sector analysts for EM credits, and more experienced borrowers.
“There are more non-deal roadshows, hosting of investors, and discussing of restructuring laws, which means everyone is more educated,” he says. “This helps to keep the market functioning through volatile distress and restructuring scenarios.”
Indeed, even as tapering concerns returned in the autumn, first time issuers from “frontier industries” — according to Abad — were able to find a good bid.
November’s supply of debuts included a Dominican and Guatemalan bank, a Guatemalan cement company, and two small Peruvian companies, San Miguel Industrias and Andino Investment Holding.
None of these raised more than $350m, while San Miguel and Andino printed only $200m and $115m respectively.
Spread of supply
Further issuance from smaller companies could eat further into Brazil’s market share. As Brazilian issuance has tempered, other markets like Peru and Chile have grown and matured partly thanks to small debut issuers.
But similar companies in Brazil “struggle to issue international bonds because they do not have the same local, institutional support”, according to Pine’s Gould.
“In Brazil, pension funds are restricted by charter agreements and cannot truly support high yield international bond deals,” he says. “This restriction makes it very difficult for a Brazilian company with Ebitda of say $40m to access the market.”
Indeed, Peru — boasting the most consistent growth in LatAm in recent years — drew increasing attention in the first half of 2013, as much of its corporate sector ventured out into cross-border bond markets for the first time. The number of non-financial Peruvian corporates with international bonds outstanding increased from seven at the start of 2012 to 24 by November 2013.
While many, including Gould, believe Brazil will remain the largest source of origin for LatAm bonds, other regions will grow in importance.
Colombia, for example, has only 12 non-financial corporates with international bonds outstanding. And there were only two debut deals from Colombia in 2013: telco ETB and airline Avianca.
“The market would like to see a lot more corporate issuance from Colombia,” says Peake. So far the strength of local banks and the domestic market has prevented Colombian issuers embracing the international market like Peruvians have, though Peake hopes they can follow soon.
But Mexico is the big one. Peake believes “there are arguments for Mexico to be the star of the Latin America”, such is the potential size of the market there. And for Western Asset’s Abad, “the lack of diversification in Mexican high yield is glaringly abnormal”, which could bring more supply.
However, Credit Suisse’s Pope points out that, in many cases in Mexico, local sources of financing continue to be more compelling than external sources.
Pope highlights that bank issuance should grow in 2014, “both in terms of Basel III compliant bank capital transactions in Brazil and Mexico as well as senior unsecured debt in other LatAm countries”. |