The emerging markets plunged along with the rest of the world’s capital markets at the beginning of March, once again catching investors off guard and leaving many lamenting their pursuit of over-valued Latin American bonds in recent months.
Latin capital markets became one of the worst hit during the rout. Argentina’s Province of Buenos Aires pulled a $425 million bond issue while more aggressively priced deals were pummelled in the secondary markets as hedge fund managers moved to avoid the losses they suffered when the market sold off last May. Digicel Debacle Although Latin markets regained their footing by the second week of March, like many other market corrections, there were signs ahead of time that a repricing was looming.
In this case it was late February’s $1.4 billion record-breaking junk bond issue by Digicel Group, the majority owner of Jamaican-based cellular phone company Digicel. It was the biggest ever Latin American junk bond issue from the first CCC-rated issuer to come to market, bulging at the seams with an 8.5 times debt to Ebitda level compared with usually no more than three times leverage on previous high-yield Latin American corporate bonds. “Why not?” was the resounding response from many investors at the time, particularly US high-yield crossover accounts looking for extra juice at a time when their own market’s yields had hit record lows.
More than $7 billion of orders from US high-yield and dedicated emerging market accounts swamped bookrunners Citigroup and JP Morgan, despite very aggressive guidance levels of 9.0-9.125%. It was also in spite of the proceeds being used to provide Digicel chairman Denis O’Brien with enough money to buy the remaining shares in the company that he didn’t already own and to pay himself, as 78% shareholder, a $700 million dividend. O’Brien then turned the crank on the rack just one more time and pushed the yield at pricing below 9%, to 8.875% on the $1 billion cash pay tranche, a level that bankers freely admit would have normally needed a double digit yield if O’Brien didn’t enjoy almost cult status among US high-yield bond buyers.
But as O’Brien rode off into the sunset with $700 million in cash tucked under his arm, investors in the Digicel deal barely saw the $1 billion, eight non-call three and $400 million, eight non-call three PIK toggle tranche trade over their offer price of par before languishing in the 98.00-99.00 level. Two weeks later, it was the first deal to get hammered amid the downturn. On Monday, March 5 it had slumped to a dollar price as low as 94.00 before clawing its way back to around 95.5. “It’s been a pig of a deal,” said one head of Latin American bond origination in New York. “Investors who bought this are now sitting there asking themselves why on earth they did it.” To veterans in the Latin American bond buying business, it’s a perpetual theme ahead of a downturn.
“I’ve seen this before,” remarks John Sullivan, a senior bond portfolio manager for Darby Overseas Investments, who has traded Latin debt since 1988. “Bond managers get desperate for yield and become more and more like equity fund managers – they don’t do the credit work and just follow the flow of cash,” adds Violet Osterberg, managing director in charge of private placements and a long-time buyer of Latin American corporates for Pacific Life. “In general, there’s been a dramatic change from a year ago in the Latin corporate bond market,” she said in February, just before the correction. “Spreads are obviously tighter, and there is a dislocation between pricing and ratings. I don’t think it is because ratings are wrong. Really, many of these companies are not so much stronger as to justify the pricing they are getting.” Which index now?
Yet many investors have had little choice but to buy up corporates. With a declining stock of sovereign bonds and 40% of the Embig index now investment grade, investors who benchmark their performance against the Embi family simply can’t get enough sovereign bonds to fill their needs and have by necessity moved into corporate deals. “Given that the vast majority of benchmarked portfolios out there can’t find enough sovereign paper to meet their needs, investors are diversifying and going into corporate paper and local bonds,” says Cynthia Powell, managing director and head of emerging market debt syndicate at JP Morgan in New York. “People are looking more at corporates as a core part of their portfolio going forward, and that’s a big change from even a year ago when many of these investors would never have considered buying corporates,” she adds.
With the emerging market corporate bond market on schedule to double the size of the external emerging sovereign market by year’s end, investors who benchmark their performance against indices like the Embig are urging banks to develop an emerging corporate index. Because of the decline in sovereign issuance abroad, the last year has seen about a third of all strategic investor inflows into the emerging markets directed at the local markets. According to JP Morgan’s head quantitative emerging market analyst, Will Oswald, forward allocations are more of a 50/50 local/international mix. Crossing over Those issuers who simply used to buy external sovereign bonds and benchmark their performance against the Embi are now benchmarking performance against a combination of the Embi index and the local emerging market bond index, the GBI-EM. With the emerging markets now clearly a three-pronged affair, a corporate index is now needed.
Meanwhile, “special opportunity” funds have sprouted up for those emerging corporate bond investors uninspired by the low yields now on offer. Those funds offer pieces of structured private credit facilities, deals that offer investors a mix of bond and equity upside and mezzanine financing to boost their returns. It’s not just an increase in dedicated money directed at corporates. “One of the biggest changes I’ve seen this year is not only how much money dedicated accounts have for corporate issues, but the number of crossover accounts showing up in trades,” adds Michael Schoen, managing director and head of Latin American debt capital markets at Credit Suisse.
Those crossover accounts will probably not be as eager, following the Digicel experience. Blessing in disguise But in general, the March correction is expected to be short-lived and ultimately seen as an opportunity for savvier investors to pick up cheap product. “Within our constructive secular view of the EM asset class, we try to view days when all assets trade down in response to an external event as if our local grocery store hung out a sign reading ‘10% off all items!’” says Curtis Mewbourne, co-head of emerging market portfolio management at Pimco.
“On such days, you don’t need to buy everything, but it’s certainly a good time to stock up on things that you want to have in the coming weeks and months.” In the first week of March, investors were sitting on the sidelines, waiting for prices to bottom. “There are no substantial sellers, and many people feel that the beginning of this sell-off was mostly due to dealers and hedge funds taking risk off the table,” says Powell. “What’s going on in our market is entirely in line with the downturn in others, and in some cases we are witnessing a more managed decline compared to other asset classes like high yield. Investors are trying to pick the right time to come in and buy, but as with any sell-off, people want to buy at the bottom rather than buying when the market still has more room to fall.”
Technicals remain strong, and at least in the first two weeks of March there were no alarming reversals of allocations earmarked by new strategic investors planning a long-term exposure to the Latin American region. Economic fundamentals also remain in place, although any change in global liquidity conditions or a prominent decline in Chinese and American economic growth would have significant impact on the region. “We obviously have to keep a sharp eye on anything the correction uncovers that could become a substantial problem,” says Schoen. Latin deals, he says, will stay on hold during the worst bout of volatility but will soon come back to the market. “I am hopeful this has been a bit of a correction where people say ‘things got expensive; now they are more attractive’, and the game is back on again,” says Schoen.
New issue concessions will be larger, of course, like any market, but comparing the fate of Digicel’s deal with other Latin corporate bonds done this year gives hope that challenging credit stories can still access the US dollar market. Looking at Mexican glassmaker Vitro’s trading levels in early March versus Digicel’s suggests that it’s aggressive pricing that investors are baulking at, and not an aggressive credit story.