Local currency drive picks up pace
The sovereign dollar and euro bond market in Latin America has shrunk to a shadow of its former self, with some spreads trading at half 2005's levels, as governments have paid down dollar debt and exchanged it for local debt. But as the global search for yield intensifies, the Latin high yield corporate bond market has never had so much potential. Danielle Robinson reports.
It was a case of the incredible shrinking Latin sovereign dollar global bond market.
What was once a thriving underwriting business of about $30bn of Latin sovereign dollar and euro bond issuance five years ago had dwindled to a little over $15bn in 2006. And planned sovereign global dollar bond issuance in Latin America for 2007 is less than $3bn, given that issuers like Colombia have pre-financed their dollar needs and Brazil has no planned dollar issuance for the year.
Moreover, Latin sovereigns' relentless pursuit of paying down dollar debt reached zealous proportions in 2006. By the end of the year $28bn of external dollar and euro denominated bonds had been bought back, called or exchanged for local debt by Latin American sovereigns.
At the same time, all the big Latin sovereigns increased local currency issuance and extended the duration of their domestic yield curves at home and abroad. Brazil issued over $1bn of 15 year Brazilian real global bonds, Uruguay issued the equivalent of $400m 12 year peso globals, Colombia added more than $800m of peso bonds to its outstanding 2015 peso global and Mexico made history by becoming the first Latin American sovereign to raise 30 year bonds in pesos, locally.
The result has been an almost complete transformation in the Latin American global dollar bond business.
With sovereign spreads having halved in some cases last year, their dollar bonds have lost their use as portfolio return boosters for global investors.
In 2006, for the first time in five years, emerging market sovereign bonds failed to provide double-digit returns.
"Emerging markets returns are now more or less in line with returns from other asset classes, reflecting a reduction in diversification benefits from owning EM," said Joyce Chang, global head of emerging market research at JP Morgan, in an emerging markets outlook report issued in December.
The declining Latin sovereign dollar float has transformed the way in which investors and bankers alike approach the Latin bond business.
"[The reduction in sovereign issuance in dollars] has changed the business dramatically," says Laurence Schreiber, managing director and head of Merrill Lynch's Latin American client solutions group in New York.
"We have structured our business to go after opportunities that are very different than they were five years ago."
Those opportunities include liability management operations and local market oriented deals for the sovereigns, although most of the obvious liability management deals — to buy back short-dated debt in exchange for new longer bonds and cleaning up sovereign's yield curves — were done in 2006. Those bonds left in the global market are becoming increasingly difficult to prise loose from investors.
Another source of business for underwriters is bringing frequent borrowers in the global high grade corporate bond market to the local Latin bond markets, in particular the peso market, where there is an abundance of pension fund liquidity and a long and liquid swap market to bring the proceeds back into dollars at globally competitive funding costs.
But it is the large Latin American company that now holds the purse strings.
With sovereign issuance almost gone and the remainder of their bonds trading at spreads that have halved in some cases over the last year, investors need yield and underwriters need better fees, profitable derivatives and other ancillary business.
Now, rather than buying up sovereigns in dollars, investors are going into the local markets and getting yields in dollars from corporate deals in the US.
"We are increasingly seeing investors going into the local currency debt markets for their core sovereign exposure and keeping the corporate dollar issues as their main play in the external dollar market," says Cynthia Powell, managing director and head of emerging market syndicate at JP Morgan in New York.
Inflows into local emerging markets topped 30% of new strategic inflows into the asset class in 2006. Although local market investment can be extremely volatile, those that took their chances in local currency bonds outperformed external debt in Latin America last year.
The transformation couldn't come at a better time for corporate Latin America. Like their governments, Latin companies have spent the last several years using commodity windfalls to clean up their balance sheets and prepare their own plans to expand locally and abroad through acquisition.
Corporates on the rise
The rise in corporate issuance as sovereigns take a back seat is also not unrelated.
"The fact that many of the sovereigns are more or less out of the market is somewhat to do with why we have seen such success with corporate issuance in the past year," says Michael Schoen, managing director and head of Latin American debt capital markets at Credit Suisse in New York. "When you are doing a deal the size of CVRD's it doesn't hurt that the market has not seen a lot of sovereign supply."
On the blue chip front Companhia Vale do Rio Doce (CVRD) stole the limelight last year with its record-breaking $3.75bn 10 and 30 year global bond issue. The deal was led by ABN Amro, Credit Suisse, Santander and UBS, the four that arranged an $18bn bridge loan for the Brazilian mining company to take over Inco, a Canadian nickel miner.
More blue chip companies will be in the market for acquisition-related financing in the year ahead: both Cemex and CSN (Companhia Siderurgia Nacional) announced multi-billion dollar M&A plans in the fourth quarter of last year.
But it is obscure second and third tier credits from the region that really offer the greatest opportunities for investors to add yield and for bankers to reap large fees and profits from ancillary business.
"The newest trend is corporate credit and it is a trend that has moved significantly down the food chain in terms of leveraged credits being able to come to the dollar market," says Chris Gilfond, managing director and head of Citigroup's local Latin American debt capital markets business. "We have been talking about the resurgence of high yield opportunities for Latin American corporates for a few years now, but it wasn't until 2006 that it arrived in full force."
Others agree. "Everyone is starting to target the second and third tier corporate names now," says Gerardo Mato, co-head of global capital markets for HSBC in New York. "That's because they will offer investors high yield and fees are generally higher on these smaller deals, as well as what you can make doing derivatives around the transactions."
Underwriting fees on big M&A-related transactions aren't necessarily that much better than sovereign fees, with CVRD paying its bookrunners 35 cents, and Brazil having paid its bookrunners 30 cents on its $1.5bn issue of 2017s.
Hence the search for smaller family owned companies that can be polished up for international consumption.
"I think we have probably all been surprised at times with the kind of names that have been done," says Powell. "Investors today are far more prepared to dig down into more complicated credits than they were a year or two go."
Fees on a $200m five year deal for Brazilian meatpacker, Friboi, were 1.4% (JP Morgan), Marfrig, another meatpacker, paid 1.5% fees to Merrill Lynch for its $375m 10 year deal, Jamaican resort firm, Cap Cana, paid 1% fees for a $250m seven year amortiser (Bear Stearns) while more speculative issuers like Metrofinanciera paid 2.875% for a $100m 11.25% perpetual non-call 10 year to Dresdner Kleinwort.
Acquisition-related financing opportunities will continue to come mainly out of Brazil and Mexico, while some large refinancing-related bond issues are expected out of Argentina. "Argentina will surprise with some refinancing transactions in the year ahead, but that part of the market will be opening slowly" says Mato. "I think the year for Argentina will be more 2008."
Underwriters are targeting companies that could potentially provide many banking services and multiple fees as they prepare them for the international markets.
"These deals take a tremendous amount of work," says Schreiber. "More highly structured transactions can take as long as five months to bring to market." These kinds of issuers are often private, family-owned companies whose management has now passed down to a new generation of family managers who have received MBAs from the US and are ready to grow the business through acquisition.
Banks and/or financial sponsors will first approach them with loans or equity to pay off loans with restrictive covenants. Their accounts are re-audited several years back, using standard global practices. Then they are brought to the public bond market for capital expenditure, the banks provide them with the derivatives package to swap funds back into local currency and sometimes further down the road the company is taken to the equity markets for an IPO.
"The process of developing a relationship and walking a corporate through every phase of the capital markets, from loans to bonds to hedging to equity issuance — that's the opportunity that we are chasing," says Schreiber.
As is almost every other bank in the business.
Within the emerging market sector, Latin America is also the region which offers the greatest opportunities for corporate bond issuance and all of the related derivatives, investment banking and corporate financing work.
Both Asia and emerging Europe have had greater levels of corporate bond issuance in the last three years than Latin America, but if one excludes bank transactions Latin America is way ahead of the pack for generating true corporate debt business.
Since 1998, 83 banks and 230 non-bank corporates have issued bonds out of Latin America, compared with 166 banks and 119 non-banks in emerging Europe, and 153 banks and 170 non-banks in Asia.
Latin America is also the only region where sub-investment grade issuance still dominates corporate supply. The most rapid growth in new corporate names also comes from Latin America.