By Sid Verma
New issuance in Latin debt markets has ground to a halt – with corporate credit hardest hit. As the dust settles, Latin borrowers are facing up to a grim new reality
When the mayhem in US financial markets last August took a sharp turn for the worse, it seemed for a moment that it might take other markets with it: Latin American currencies were slammed, the Mexican peso weakened, spreads on external bonds of most sovereigns widened, and regional stock markets took a hefty hit.
In years past, such tumult would have seen the region’s central bankers seeking to ward off speculative attacks on their currencies by ramping up interest rates and bleeding dry foreign exchange reserves, aggravating a cycle of indebtedness.
This time it’s different, commentators are quick to remind us: the historically disaster-prone continent now has solid fundamentals; moreover, Latin America’s quick rebound from turbulence elsewhere is clear evidence, say the optimists, that the fate of the region’s emerging markets is no longer tied to the US.
Yet, if anything, the nose dive in US credit markets is holding Latin America’s debt mart hostage while bringing cross-border new issuance to a grinding halt.
The subprime mortgage disaster has awakened investors and borrowers to the correlation of global credit cycles, and to the shrinking value of the region’s credits relative to US high-yield paper. As a result, investors now foresee an imminent price correction this year as global markets crumble in tandem.“There is less urgency to invest in something if you think prices are going to get cheaper – as many investors do,” says Claudia Calich, senior emerging markets portfolio manager at Invesco in New York.
This market dynamic has yet to play itself out, but the staggering out-performance of LatAm credits in the last two years that cheered cross-border issuers in the region may now be over. “Investors are bracing themselves for further adjustments in credit markets and an up-tick in US corporate default rates,” says Chris Gilfond, Citigroup’s co-head of Latin American debt capital markets.
ING estimates that on average BB credit spreads have widened 50bp and 200bp for B-rated names since October 2007. These are set to deteriorate further this year with the Dutch bank raising its target spreads for investment-grade credits by an additional 25bp, 50bp for BB credits, and 100bp for B-rated borrowers.
In fact, despite the lucrative promise for investors of currency appreciation, all 21 issuers that tapped the international markets last year with local currency bonds which settle in US dollars offshore are now trading below par. This is partly down to the market sell-off but also to volatile exchange rates and risk aversion – factors that will derail deals in such format this year.
Western portfolio managers were expected to step up their allocations to local currency corporate paper this year, but thin liquidity is now a real concern. “This is not the year for the local currency market,” says Polina Kurdyavko, portfolio manager at BlueBay Asset Management. “Investors are not currently adequately compensated for the loss of liquidity that you are getting in the corporate space and the expensive prices against the sovereign.”
With crossover investors in retreat and US high yield remaining under pressure, no near-term rally for the region’s credits is expected. As a result – despite the generally robust fundamentals of credits in the region – there is a chill wind blowing through the international new issuance market.
In response, investors are focusing on safe, liquid and higher rated bonds in the first half of the year that are less susceptible to market volatility, and piling money into these credits during market dips.
High yielders’ scramble
This risk aversion comes after a record year for deals from non-investment names in 2007, with 65% of new issues from such borrowers, up from just 35% in 2004. The average deal size for high-yield credits was $300 million compared with just over $400 million for investment-grade issuers.
But as liquidity becomes scarce, investors are less willing to slide down the credit curve in their search for yield. As a result, high-yield corporates such as Colombian state-owned telecommunications company ETB, Costa Rican retailer Grupo M and Brazilian cable operator Net Servicos, which have been languishing in the deal pipeline since October, have now ditched their plans.
Optimists will point out that a degree of decoupling is nevertheless taking place: just witness the competitive global offerings by some Latin sovereigns since the credit crunch began. Since September, Mexico, Aruba, Colombia and Jamaica have placed international bonds while Uruguay completed a voluntary debt buy-back programme in December.
Most recently, Mexico opportunistically fulfilled its financing plans for the year in January, selling a $1.5 billion, 2040 global bond with a 6.055% yield – achieving the lowest rate for a bond of that maturity in its debt portfolio. On the same day, AAA-rated General Electric Capital sold a 30-year, $6 billion deal, with the second $4 billion tranche yielding 5.976%, a spread of 165bp above US Treasuries versus BBB+ Mexico’s 170bp.
Lower financing needs, enhanced macroeconomic stability and improved local-currency markets have bestowed an expensive scarcity premium on external sovereign paper. Fitch estimates issuance from governments in the region will fall to $9.5 billion this year, down from an already modest $13 billion in 2007. Artificially tight spreads are most acute in Chile, with a lack of international sovereign benchmarks, and in Brazil with ongoing buy-backs of external debt.
“You have seen some decoupling in general for [Latin] sovereigns,” Gerardo Rodriguez, deputy under-secretary for public credit at the Mexican finance ministry, tells Emerging Markets. “But the dynamics of the sovereign credit are totally different from that of corporates, which have been victim to the adjustments in global credit prices.”
Relative value
In fact, an indirect consequence of the aggressive pricing terms for these deals is the destruction of “spread-over-sovereign” benchmark analysis. Now when bankers and investors mull their pricing terms for corporate issuers, they are increasingly compared to other international credits – a fact which brings into sharp relief just how expensive the region has become.
“There is a long way to go before we see value for these credits compared to US high yield, while we should see a significant rise in US corporate defaults at end of this year – increasing spread widening,” says Eric Ollom, head of LatAm corporate debt research at ING Financial Markets.
“The financial, homebuilding and pulp and paper sectors in LatAm look expensive relative to their peers, highlighting how integrated the global trading platform has become,” explains Anne Milne, head of Latin American corporate bond research at Deutsche Bank.
By contrast, credits tipped this year are commodity heavyweights, such as Cemex, Gerdau, CSN and CVRD, which are less dependent on US business cycles. But these are all companies in an acquisition and consolidation phase, so they have higher than average leverage, and can refinance any bond debt with cheaper syndicated loans.
With no clear corporate benchmarks set this year, investors and issuers aren’t taking any risks. “We have to actively diversify our portfolios into different countries and industries because, even if we like a sector very much, there is always the risk that if a new issue comes at a cheap concession then the whole sector will reprice,” says Calich.
Price sensitivity
The investor scramble for LatAm issuers over the last five years has seen borrowers commanding ever-aggressive pricing terms to an obliging investor base. But these demands are now being snubbed.
For example, Brazilian oil giant Petrobras postponed the $500 million re-opening of its global 6.125% 2016 in February after failing to attract enough investors. The issue was shelved after investors blasted the issuer for its unrealistic price guidance via leads Morgan Stanley and BNP Paribas and co-manager Santander. Its existing 2016 notes were trading at 205bp over US Treasuries on the day, but it offered the tap with a mere 5bp concession at 210bp over US Treasuries.
Even market darling Petrobras received a bloody nose, shattering already brittle market confidence and forcing new issuers to retreat even further.
In many ways, the borrower exemplifies the dilemma facing investment and junk names alike: the financial and political repercussions of repricing their curves at this juncture are just too risky. “Issuers are unwilling to pay big concessions because they do not want to accept penalties for the sins of others, and naturally do not want their funding programme to take a step backwards in terms of pricing,” says Gilfond.
For the time being, borrowers now have a large menu of alternative financing options: domestic bonds, structured notes, hybrid securities, syndicated loans and equities. What’s more, fee-hungry bankers anxious to cement their lucrative relationships with good credits are arranging competitive private placements deals. But LatAm corporates with large long-term funding needs seeking international exposure cannot live on these sources alone. Only when global conditions improve will cross-border issuance resume.
Until then, believers in the decoupling myth will continue paying through their noses.