Death of a debt salesman
The emerging debt market has been knocked back several years by the financial crisis. Latin borrowers and investors are struggling to adjust to the new reality
A new reality is being forced upon Latin America as the region’s cross-border debt markets remain all but seized up.
In recent months the market’s key variables – pricing levels, deal structures, as well as borrower and investor profiles – have changed beyond recognition. And the region’s most prolific borrowers are finding it nigh on impossible to issue long-dated debt while at the same time being forced to pay punishing premiums on what they can push through.
The speed and scale of the collapse – even relative to the ongoing rout in developed markets – is staggering. For the first time since spring 2005, spreads on Latin sovereign bonds have widened well above non-investment grade US corporate debt. Latin spreads in JPMorgan’s emerging markets bond index global (EMBIG) rose from 209bp in January 2008 to a staggering 693bp a year later; their emerging market corporate index (CEMBI) shot up to 965bp from 320bp in January last year.
“The bull years have ended dramatically,” says Luis Costa, EM debt strategist at Commerzbank. “The marketplace has now forced the asset class into completely new territory in terms of risk premiums, liquidity as well as bid/offer spreads.”
At the onset of the credit crisis in August 2007, sell-side analysts for months persuaded their clients that markets once again would become hospitable to high-rated private-sector borrowers willing to pay the premium. Debt bankers meanwhile argued that the new issue market would bounce back before too long, and that higher premiums would be manageable for low-leveraged investment-grade borrowers.
“They were living in a different world before Lehman Brothers collapsed,” claims Costa.
The new reality since September 2008 is a far cry from the preceding era of abundant liquidity: between 2002 and 2007, investors ventured down Latin credit curves, and emerging market issuers were able to demand aggressive pricing terms; even conservative investors were snapping up corporate paper and local currency assets.
But as Wall Street imploded following Lehman’s demise, emerging market cross-border debt issuance ground to a halt. Markets remained closed until the end of December when Mexico surprised investors with a $2 billion, 10-year global bond, priced to yield 5.98% or 390bp over US Treasuries, representing a premium of around 40bp. A year earlier, Mexico priced a $1.5 billion issue due 2040 with a 170bp spread in January 2008, with an impressive 9bp–10bp premium.
The first full trading week of this year saw a flurry of new issuance as Latin borrowers sought to fulfil their funding needs for the year, taking advantage of what they saw as a moderate recovery in risk appetite.
Brazil launched a $1 billion, 10-year bond to yield 6.127%, 370bp over US Treasuries, paying around a 50bp premium. The same day, Colombia priced $1 billion, 10-year notes with a 40bp concession to yield 7.50%, or 502.9bp over US Treasuries. Quasi-sovereign companies Petrobras, Codelco and Pemex also took the opportunity to issue $4.1 billion in total – an amount that compares favourably with the $9.5 billion issued in 34 corporate deals in 2008.
Some saw the dealflow as evidence of a resurgence in risk appetite for high-rated borrowers. “These large deals show there is an impressive amount of cash on the sidelines for high-quality credits,” said one US investor who snapped up Mexican, Brazilian, Colombian and Petrobras paper.
But Brazil’s January deal was far from ideal, dogged as it was by a dispute over pricing. Bankers were forced to widen their pricing guidance from 330bp to 375bp. And a tussle between the lead banks and investors over the size of the premium meant the deal took a whole day to execute – compared with two or three hours under normal market conditions for typical Latin sovereign transactions.
The deal’s fraught execution underscores the perils of determining market clearing levels for new benchmarks in the wake of Latin primary markets’ closure late last year.
A month later Mexico, having successfully opened the door to Latin issuers in December, came to the market again. This time the sovereign sought to issue between $1.5 billion and $2 billion through a five-year tranche and a new 21-year benchmark. But the latter idea failed: there was only $600 million of interest in the long-dated paper, even with a proposed new issue premium of around 65bp. Instead Mexico was forced to price a large $1.5 billion 2014 bond – bucking its six-year trend of issuing benchmarks with strategic extensions in the long-end of its yield curve.
In contrast, that same week Cisco Systems, the investment-grade US communications company, printed $4 billion of new paper, showing up the divide between prolific US high-grade borrowers and emerging sovereigns deprived of market access for new long-dated paper. Cisco’s 10-year, $2 billion notes paid 4.95% with just a 200bp spread, and its other $2 billion bond was priced with a 30-year tenor and a spread of 225bp.
“The primary culprit [for Mexico’s cancelled long-dated bond] was supply indigestion,” says Siobhan Morden, Latin American debt strategist at RBS Greenwich Capital. She argues that an oversupply of Mexican risk was deterring fresh cash following its $2 billion deal in December and the $2 billion offer from Pemex, the quasi-sovereign oil company, at the end of January.
The Pemex deal was the largest dollar-denominated Latin corporate bond since the first half of 2006. But even here the market cheer was muted: the deal was supported by local funds that helped in wangling a 13% all-in yield in pesos through a cross-currency swap.
As Anne Milne, head of Latin American corporate bond research at Deutsche Bank, explains, the deal’s high spread – at 570bp over US Treasuries – reflects the “less-than-supportive environment for corporate borrowers”.
Sam Finkelstein, emerging markets portfolio manager at Goldman Sachs Asset Management, notes that investors were disappointed by Mexico’s perceived lack of transparency about its funding plans as the sovereign unexpectedly flooded the market with new paper as well as Pemex risk. “It is important to know what your funding needs are before you come to the market,” he says.
Emerging sovereigns are likely to raise more international cash this year to fund fiscal stimulus programmes and provide dollar liquidity for corporates deprived of capital market access. HSBC estimates that borrowing requirements for Latin sovereigns will rise from an average of 1.1% of GDP to 2.8% over the next year. A glut of sovereign issuance could curb the investor capital available for corporate paper. Finkelstein allows worries that the anticipation of new supply could cause volatility in secondary market allocations to outstanding sovereign debt.
If supposedly safe Latin sovereigns are facing a struggle on both execution and pricing of their debt, it’s hardly a surprise that prospects for the corporate bond market are ever more dim.
In the fourth quarter of 2008, investors redeemed $8.3 billion from dedicated EM debt funds, according to ING. This savaged Latin corporate debt trading volumes and sucked the liquidity from the marketplace. Practically every yield curve repriced higher, and so reduced the appetite to place new paper, notes Costa at Commerzbank. After the tumult, there has been a moderate improvement in market tone and some hard trading in cash bonds in the first few months of the year. After exploding to over 1000bp in November, JPMorgan’s EMBIG is now around 660bp.
But questions remain over whether investor enthusiasm for credit risk is back, or whether – as seems more likely – improved technicals are simply causing a bear market rally. Joyce Chang, head of emerging markets strategy at JPMorgan, argues: “More supportive technicals, including oversold positions, high cash flows, and a cessation of outflows, have contributed to allow EM sovereigns to tap the international capital markets [in January]”.
Kieran Curtis, fund manager of around $750 million in two emerging market debt Sicavs for Morley, notes that “the slowing pace of redemption requests” and “cheapness of some cash bonds” has led to spread compression but the primary market is essentially in cardiac arrest.
Despite global monetary and fiscal action, negative feedback loops from the financial world to the real economy are intensifying, and markets are day by day stunned by the flurry of negative data.
The market is awaiting an avalanche of rating downgrades and debt defaults over the next 18 months that will affect pricing and risk appetite for corporate credits. As a result, investors are now underweight Latin debt and are “reluctant to add new risk for corporates”, says Blaise Antin, head of research for the $1.9 billion TCW Emerging Market Fixed Income Fund in Los Angeles.
In fact, the recent supply of sovereign paper may not pave the way for high-quality companies to launch new deals anytime soon since recent issues are trading below their fixed reoffer prices. “Getting any significant traction out of the non-investment grade corporate market is highly unlikely,” says Victoria Miles, co-head of EM corporate research at JPMorgan.
She says there is a possibility that cash-strapped lower tier credits might issue if there were big reverse enquiry offers and the deal was small – between three to five years in maturity – and provided extremely tight debt covenants.
The emerging market investor base has shrunk dramatically as cross-over investors retreat and as smaller EM bank franchises and institutional funds beef up redemptions and plough into defensive credits.
The high-yield issue in March from Jamaican phone company Digicel is a case in point. The single-B rated issuer issued $335 million from an initially proposed $435 million to yield 15% on a conservative five-year maturity that can be redeemed by the issuer in three years.
Bankers estimate the new issue premiums range between 200bp to 300bp for high-yield emerging corporates. Even the perennially optimistic sell-side admits prospects are dire for primary market access for debut issuers or lower-rated borrowers.
“I would be totally irresponsible if I told these guys to come to the bond markets, given the persistently high yields,” says one Latin debt syndicate banker from a US bulge-bracket firm in New York. “The political consequences of entering the external debt markets would be difficult for any funding official trying to justify high premiums to their CEO.”
Despite the structural strength of many Latin borrowers with their low leverage and improved risk management, issuers are now being severely punished by the violence of global credit markets. Cross-border debt markets are now seen as an expensive funding source for corporates rather than a lucrative means of raising large amounts of cash to a global investor base.
“The million-dollar question is how many years this crisis has knocked back the emerging debt market,” says Costa. “I think it will take many, many, many years for spreads to normalize and for primary markets to open once again for borrowers.”