Brazil opened a new funding avenue in the international bond market last week when it priced its long-awaited global bond in reais.
The R$3.4bn ($1.5bn) 10 year deal, led by Goldman Sachs and JP Morgan with co-manager Banco Itaú, attracted more than 200 investors and $7bn of orders, enabling the country to achieve aggressive pricing of 12.75% and a size of $1.5bn.
The deal is now the biggest global ever issued by an emerging market sovereign in its own currency.
Although it is not the first global bond in a Latin American local currency, it is the first to offer international investors the prospect of substantial liquidity, and fulfils Brazil's long-held ambition of extending its fixed rate yield curve in reais.
"This is a very important transaction from the point of view of debt management," said Jerome Booth, head of research at Ashmore Investment Management in London. "It is the first of its type and I expect there to be more deals as Brazil attempts to push out its local currency yield curve. I think other countries will also do the same."
Brazil is following a trend among Latin sovereigns to reduce their vulnerability to crises by cutting the amount of foreign currency debt in their total public stock of debt, at the same time as reducing their dependence on short term, floating rate domestic borrowing. The goal is to build a liquid, fixed rate yield curve in the domestic market.
Like those in many other countries, Brazil's local investors are wary of longer dated bonds, having lived through a long period of hyperinflation.
Until this week, Brazil's longest dated fixed rate bond in reais was an illiquid R$880m ($390m) seven year domestic instrument, sold to a handful of mostly foreign investors on a reverse inquiry basis.
In their quest for longer-dated funding, sovereigns like Mexico and Peru have opened their domestic markets to international investors.
Brazil has grappled with how to follow suit, without attracting a wave of unwanted hot money accounts desperate to buy local bonds in reais for their double digit yields.
Issuing a local currency deal offshore is a first step.
"For Brazil it was an extremely important transaction," said Moctar Fall, head of Latin American debt capital markets at JP Morgan. "In the last year local markets has been a very big theme for both issuers and investors. Brazil has one of the biggest local markets out there but access was not always easy for international investors."
Liquidity premium
The leads argued when pricing the deal that the value of the bond's liquidity should also be taken into account. Until Brazil's deal this week, the real and peso Eurobond market was stagnant because none of the Latin currency deals offered liquidity.
"The increased liquidity this bond offers to investors is striking," said Cynthia Powell, head of emerging market debt syndicate at JP Morgan.
"Up until now, investors who wanted to buy longer duration exposure to reais had to purchase structured notes or smaller Euro-real deals issued by corporates or banks. Those deals are extremely illiquid — often, the bid/offer spread implies a yield differential of over 200bp. By comparison, this bond is trading with a bid/offer yield differential of just 2bp."
Some rival firms thought the deal too aggressive by around 50bp, while others considered the pricing appropriate but thought there should not have been so much confusion on how to price the deal.
"This was a fantastic deal for Brazil and the leads did a good job of getting Brazil the best possible price, but they should have provided the market with a stronger lead on how to trade the bond," said a syndicate manager at a rival firm.
Ambushed in secondary
Despite its significance, the bond has traded down in the secondary market and come under attack from rival bond houses which missed out on the highly sought-after mandate.
"This was the most anticipated and wanted deal of the year," said one head of Latin DCM at a rival bond house. "It defines the whole trend of issuers going into local currencies and moving away from dollars and euro financing, and it has traded down."
In reais the deal was priced at R$98.636 to yield 12.75%, which in dollar terms was equivalent to a $42.90 cash price.
It sold off almost immediately as the market struggled to find the best possible way of trading the deal — in reais or in dollars — while the leads fought off dealers shorting the transaction.
By yesterday (Thursday) it had fallen about two points to R$96.50 in reais to yield 13.12%, partly due to a 30bp back-up in local rates. The damage was less in dollar terms, however, because of a rally in the real during the week. Yesterday it was quoted at $42.50.
Goldman and JP Morgan had decided before launch that the best way to trade the deal was in reais, because it was essentially a Brazilian real instrument that, for the sake of convenience, is settled and cleared in dollars.
But although they tried to lead the market in that direction, rival banks almost immediately began trading the bond on a dollar price basis, arguing that many accounts interested in getting into the deal did not want the added complexity of having it quoted in reais and then negotiating the foreign exchange portion of the trade with a counterparty.
By the end of its first trading day the bond was being quoted and traded in dollars on one screen and reais on another.
"It did create confusion in the market," said one syndicate manager not involved in the offering. "The bond by its nature is complicated and the situation was complicated further by the market not immediately settling on a standard way to trade it."
A further problem came from the deal's tax status. Since the bond is not covered by the 15% Brazilian withholding tax, the leads launched it with a lower coupon than is available on Brazil's domestic bonds, to bring the yield back in line with their after-tax yield.
However, some local firms have worked out ways to avoid the tax on domestic bonds — so they spotted an opportunity to short the new globals and go long the local instruments, profiting from the carry between them.
"There are market participants out there that have a vested interest in seeing the bond go down," said one banker.
The talk of shorts led to suggestions that the global bond could trade back up again if the leads and investors with large positions try to squeeze the shorts by bidding up the bonds.
"Huge step forward"
Despite the instrument's teething problems, there is no ignoring the huge ongoing demand among investors worldwide for exposure to Brazil's high yielding bonds at a time when global interest rates are expected to stay low.
"The fact that this deal is up or down is a tad irrelevant, given it is Thursday and the deal was placed on Monday," said a hedge fund portfolio manager in São Paulo. "No deal lives or dies by the first three days of trading.
"It has had a few teething problems because people had to work out how to trade it and some people don't understand what they have bought, and I think that's the main reason why it has traded down. Clearly there was a lot of demand for it."
"The deal has traded off but you have to keep in mind that this is new territory for the market," added a senior analyst at an investment firm in the US. "It would have been the case, regardless of who led the deal. This is a huge step forward for the market and the development of the Brazilian market and the emerging markets in general."
Brazil's landmark was followed this week by a rash of announcements of other local currency offerings from Latin America.
Colombia said yesterday that it planned to return to the global bond market with another peso TES bond. Felipe Sardi, Colombia's director of public credit, said the deal would either be a reopening of its 2015 peso bond or a new deal in a shorter maturity.
Telefónica del Peru (TDP) went on the road with a $200m issue denominated in soles, the first such issue in the Eurobond market, led by Citigroup.
Bradesco is in the market with a five year real deal, but has been forced to raise its original 14% talk to 15% because of the poor performance of Brazil's global.
Citigroup has also put on hold plans to reopen its $150m 15% 2010s for another $100m at 13.2% until the dust settles on the Brazilian deal.
The TDP issue is, however, said to be roaring ahead and given the rarity of the Peruvian telephone company's issuance in any currency, should be a blowout.
The deal will begin roadshows in Europe and the US next week and be priced the week thereafter.
TDP's bond follows the Peruvian sovereign's $1.5bn prepayment of Paris Club debt in July, led by JP Morgan and UBS, which involved issuing local fixed rate sol bonds, sold largely to foreign investors.
The July deal comprised Sol 1.5bn ($460m) of 12 year fixed rate bonds and Sol 700m ($215m) in a 15 year fixed rate transaction, along with a $750m 20 year global bond led by JP Morgan and UBS.