When Mexico's state oil company Pemex sold the first of what turned out to be a string of perpetual non-call five year bonds to Asian retail investors in autumn 2004, some bankers saw it as a deal that brought a whole new investor base to emerging market debt. They were right. But the more farsighted among them also realised demand could vanish just as quickly, and in May it happened, after the leap in US Treasury rates. Caren Chesler investigates if the market is likely to reopen any time soon.
Pemex's $1.75bn perpetual bond issue, led by Citigroup, HSBC and Merrill Lynch in September 2004 set off an 18 month trend in which Latin American issuers — mainly high quality Brazilian credits — sold perpetual bonds to Asian retail investors.
Most deals allow the issuer to call the bond after five years, which is likely to happen if its credit quality has risen and it could refinance more cheaply. If, on the other hand, the issuer's credit quality deteriorates or markets tank, investors may be left holding the bonds indefinitely. The attraction for them is yields ranging from 8% to as much as 11%, depending on the credit quality of the issuer.
It was a match made in heaven. Wealthy investors in Hong Kong and Singapore, flush with cash and looking for yield, were happy to put down tens of millions of dollars for securities that were likely to be redeemed in five years, if the returns were more lucrative than they could get anywhere else.
Issuers, for their part, had found investors who were willing to charge very little for the call feature. And being retail investors, the buyers were less likely to compare the yields they were getting for the corporate perpetual with the sovereign curve.
"[Latin perpetuals] were really hot in 2005 because equity markets were relatively flat and global interest rates were extremely low," says Sandy Severino, director in Latin American capital markets at Citigroup in New York. "So when Brazilian perpetuals came out with 9% and then 8% coupons, compared to 30 year US Treasuries at 4.25%-4.5%, these type of returns looked very interesting."
Underwriters were surprised, not just by the amount of money available, but by the speed with which investors snapped up these bonds. When Brazilian steelmaker Companhia Siderúrgica Nacional came to market in July 2005, for instance, through its vehicle CSN Islands X Corp, it planned to sell $150m but found demand for its bonds was a whopping $2.3bn. It ended up issuing $500m in the first week of July and another $250m the following week.
Between September 2004 and May 2006, Latin American banks and companies sold $7bn of perpetual securities.
"Issuers, particularly from Brazil, have historically had a hard time when the markets go bad," says Andrew Schwendiman, head of corporate Latin America global capital markets at Morgan Stanley in New York. "They may not be able to refinance. With these bonds, they were protected. They were paying a small premium for the optionality to refinance in five years, but if they can, it was still good insurance to have."
End of the line — for now
To experienced emerging market debt hands, these deals always looked like a bull market trade, and in May, the first shake-out began.
US Treasury rates rose, global stockmarkets tumbled, especially in emerging markets, and the perp bonanza ground to a halt.
Latin American bonds plunged to one of their lowest levels of the year as crossover investors panicked about inflation and fled to higher quality assets. It did not help that Pimco, the world's largest emerging market bond fund manager, announced it was cutting the emerging market allocation in its broader high grade bond funds from 2% to 1%.
Investment bankers began telling their clients that if they wanted to issue a perpetual, they would have to offer 100bp more than what comparable borrowers were paying earlier this year.
"It's not just rates. It's spreads," said one emerging markets banker in late May. "We had a big sell-off in equities, in currencies, in fixed income. There is no way this will be the one market that outperforms. I wouldn't in any way, shape or form recommend to an issuer that they do a perpetual right now."
Yet right up until the wind changed, this market was accepting issuers of lower and lower credit quality. Pemex, which started it all off, is rated Baa1/BBB/BBB- but in April Brazilian broadcaster Globopar, rated BB-, brought a deal having been through a debt restructuring only last year.
A month earlier, GOL Finance, a subsidiary of the start-up Brazilian airline GOL Linhas Aereas Inteligentes, had issued bonds rated Ba2.
"At first, the Eurasian perpetual market accepted top tier Brazilian credits like Bradesco, Gerdau, CSN and Braskem," says Severino. "Those are top blue chip Brazilian companies. But then banks came out with second tier companies and sold them to a retail market that didn't differentiate between credits.
"These second tier bonds were priced too tightly on a relative value basis and quickly dropped in price. And that, unfortunately, clouded the market for future Brazilian perpetual issues."
Investors who bought bonds that traded at 97.00/98.00 just a few weeks later are unlikely, Severino adds, to buy other Brazilian deals.
It was fitting that one of the lead managers that opened the door to this market, Merrill Lynch, was the firm that saw it close, when it tried to bring a deal in mid-May for Sistema Cataguazes-Leopoldina, a Brazilian electricity company. Cataguazes planned to sell $250m of perp non-call five year bonds, but when the markets slumped, the deal was scuttled.
Brazilian cement company Camargo Correa also had to pull a deal. Even bonds with dated maturities — one for Banco de Chile, one of the best credits in the region, and one for the Brazilian steel company Gerdau — were put on hold. Some, like Camargo Correa, have since issued straight 10 year debt in the US market.
"Things are pretty volatile," says an emerging markets banker at one of the bulge bracket firms. "No one is in the market right now. It is a market that opens and shuts, depending on volatility.
"It is also rate-sensitive. With expectations of higher interest rates, the market faded away — at least temporarily. And with the way the market has sold off recently, retail investors in Asia can now buy US Treasuries at better levels. It has always been a relative play."
A seasonal market
Francisco Pujol, head of marketing and origination for Latin America at Morgan Stanley, calls it a "seasonal market," one that ebbs and flows. Retail investors tend to have a lot of money to spend at the beginning of the year and less as the months go by and that cash gets invested, he says.
"It is closed right now, but that does not mean there are no funding options left," Pujol says. "The Asian retail market should be viewed as a great complementary market to the traditional dated US dollar bond market. It is opportunistic, no different from other markets, like sterling or euros."
Pujol likens the Asian perp deals to the window that opened for Latin American issuers in the late 1990s, when they would issue 'step-up' or 'step-down' bonds — securities whose coupon would either climb or fall over time. European retail investors snapped them up, just as Asian retail investors have lately devoured the perps. In fact, Pujol thinks some of the Asian retail demand was actually European retail investors funnelling capital through Asia for tax purposes.
"That one went on for five to six years — at least — and eventually diminished with the Argentinean default," Pujol says. "That market is dead now."
Whether the Asian perp market is also dead, or just lying low for a while, is the key question for bankers now.
On the face of it, things look bad. In June 2005 chemical company Braskem sold a $150m perpetual bond. Priced at par, it attracted $750m of demand and soared in the aftermarket to a 102.375 bid. Today, perpetual bonds are trading well below par. GOL Finance's $200m deal, issued at par in March, was trading at 94.00/96.00 in late May. Globopar's $325m issue, sold a week after GOL's bonds, was recently trading at 97.00/98.00.
"We're not talking about triple-A securities. We're talking about single-B securities," says one emerging markets banker. "So if you have a retail trade that hasn't found its home, they trade down and no one wants to pick them up."
Cynthia Powell, head of JP Morgan's emerging markets debt syndicate, says the problem is not so much the credit. In general, Brazilian companies are far better credits than they were in the past, she says. The question is whether investors want to own perpetual bonds.
"The bigger risk is not so much the credit," she says. "It is the liquidity in the secondary market when the market really takes a downturn. That is where it can get ugly."
When the secondary market becomes volatile, corporate paper becomes less liquid and perpetual bonds get hit even harder than dated paper. The saving grace may be that the holders are largely retail investors, who tend to buy and hold securities much more than institutional investors.
"They're not jumping around looking for a bid just because the Indian stock exchange was down 10% yesterday," Powell says. "Still, dealers' willingness to bid for the paper may be reduced."
Going into it with eyes open?
Some bankers have been sceptical of the perpetual market from the beginning, saying it was always based on the premise that rates wouldn't rise. And now they have.
One banker said at the height of the market that they were certainly good deals for issuers. Whether they were good for investors — and whether investors even knew what they were buying — was another story, the banker said.
Sceptics say some of the demand may have been an illusion, resulting from the hefty 200bp fees that banks and brokers were paid to sell these bonds.
The most cynical critics claim that Asian private banks bought the bonds on spec in order to pocket the fees and then stuffed the bonds into the accounts of their retail customers, who knew no better.
"Cataguazes is a third tier company that had no business being out there," says a capital markets official involved in emerging markets. "This was a deal pushed out to Asian retail investors who don't know what they are buying. This kind of deal should go to sophisticated institutional investors, not to retail investors in Asia, who can't even spell the company's name."
Still, even the sceptics say the perpetual market could stage a comeback if global interest rates come down.
They say there is still a lot of cash in Asia, and the likely alternatives are volatile and unattractive.
"If global interest rates go back down, people may look at them again," the capital markets official says. "But I think for now, many are still licking their wounds."