Thursday, 13 December 2018

Brazil Roundtable 2007: Part 3

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IFR: We have talked about how a drop in interest rates will change everything. Certainly we are getting there. But there also exists a mechanism that I believe can change everything and that is the 15% withholding tax on foreign investors looking to invest in debentures locally. The removal of such a tax truly helped Brazil on its local curve and a level playing field is possible.

Everyone is talking about this change in tax treatment and that it could be extended to the debenture market which today is far too weak. This should have been a better year, but it is half of what it was last year. The ABS market is too weak because of overregulation at the CVM. Is it up to you, the Treasury, or is it up to Inland Revenue Service?

Valle: It is a joint effort. When the Treasury exempted foreign investors from a withholding tax on local public-sector bonds, it was a joint production with the Finance Ministry’s administration, the Treasury, the Supreme Federal Court and the Inland Revenue. At the time, alongside Congress, we committed to the new regime.

Congress also wanted to exempt the withholding tax on the private sector too. An agreement was made between the government and Congress but they decided to exempt the private-sector at a later date. First we are going to see the effect on the sovereign curve before we extend the exemption to the private sector. We are committed to doing that but we have to pick the best timing, a moment when the dollar is depreciating.

You really have to pick the best moment. In my opinion it is extremely important. People have seen the impact on the public-sector paper and it has been very positive. There has been a lot of criticism in the paper because it has pushed the Real to R$1.80 to the dollar. We are able to show that this is not the case and that the benefits to public debt far outweigh anything else.

The impact was very positive but this is all about timing and we have to define this. In theory, this is recognised as a good measure.

Peebles: Would there not be the possibility of going half way on this change? Or rather, a reduction, like, for example, in Mexico – the tax continues to exist but instead of being 15% it is 5%. At 5% you have a bit of oomph for the government but it is not that significant for investors.

Valle: I believe the wear and tear would be just about the same. There is a new issue, I must confess that I am not taking part in it directly, but I am reading it in the press and that is the question of double taxation. The issue of double taxation is something that should be discussed at this debate.

Neto: Today we have double taxation agreement with France and there are three French banks here making up for it but even so that is not enough.

Fadigas: This is because the investor pool is very specific and that is the American pool. For an exporter, there is the impact of FX, and there are many more restrictions when funding in Reais and there is also the impact of the value added tax [ICMS]. These ICMS levies can grow fast. That is another problem. Those three problems can really add up but at least for now exports continue to be strong provided commodities stay where they are. But from a structural point of view, all of Brazilian products are affected by this.

Berlfein: I do not believe that a drop in interest rates will represent the solution to all problems. The reduction is fundamental, however. Today, premium on government secondary paper does not exist. Floating-rate paper? Forget it. No matter the tenor, you will get a flat 100% of CDI rate. So the pick-up is very low and forces any asset to buy private-sector paper in order to get a better return. But what messes up the pricing – for me at least – is the rating and the structure of the market, the system of firm guarantees, the duration of the firm guarantee from mandate to execution, the lack of secondary market liquidity and the reduced presence of foreign investors. And we have already commented about the BIS rules on capital allocation and trading.

Perhaps there should be a web for brokers, as there is overseas, allowing those to enter and help boost secondary liquidity. It would be a group effort.

Everybody knows about these issues. No matter the discussion, we always return to the same points. A combination of a structural change, a reduction in a crowding out effect and a fall in interest rates would take off some of the onus that people are putting on interest rates to solve all market problems.

For now there is no sprit or notion of what a true direct capital market should be. “I am going to do this issue because I want to open up a local curve and afterward I want to extend because I need to create a point on the CPI-linked curve because my revenue is in CPI.” But that sort of bond market sophistication will have to come later. For many Brazilian issuers, their attitude is likely to be one of “I want the money for me and in the best way possible”.

Peebles: You need to create some kind of stimulus. The person who buys the local corporate paper is restricted. There is income tax on top of the gains, for example. Your idea would certainly help. It would provide some gas. But what is the incentive to do it today? There is none.

Achoa: Aside from providing an incentive, you can either decide to not provide an incentive to a foreign investor or you can give the incentive to local and foreign investors. In an hour of stress, who is going to hold their ground? It will not be the foreign investor. It is problematic if you rely too much on a foreign investor. What if there is a crisis? If there is a surprise, the investor is spooked and takes his money out of the country for a reason that has nothing to do with Brazil. It is going to be complicated if there is no development of the investor base.

Fadigas: What Paulo said will probably happen like it did in 2006 when yields shot up because there were no buyers. Foreigners wanted out and ended up with this difficulty.

Massenet: It was very interesting to see what happened because foreign investors got out but now they are coming back. It shows that the foreign investor has begun to differentiate and that funds like Brazil. It is something differentiated. Just a few years ago everyone would have bolted if there were any volatility. But today it was organised and the market returned. I believe the investor is going to differentiate more and recognise the strength of the country.

Valle: I used to tell people how we talked about the foreign investor as a distinct class. Today, it is difficult to make this one reference. Our investor base is far more diversified. Today, you have pension funds, you have hedge funds and prop desks.

The Asians are participating a lot in our local market. So today’s investor base represents the right way forward. But when we talk about the private-sector, the government is still deliberating about how to proceed with this because the sovereign debt market is not yet consolidated. We have progressed a lot but it is not yet consolidated.

We are increasing our investor base as the fall in interest rates and a change in the composition of fund portfolios have helped. An increase in hedge funds and a move away from having funds that just buy DI has been instrumental. It is a process and I am optimistic that there will be change.

The private sector in truth is just a step behind the public sector, which has liquidity. As you have mentioned, it is about zero risk and having liquidity. If you look back five years ago, there was no discussion about liquidity. But then we went through a process of consolidating the creation of our benchmarks and today it is possible to see prices daily on screens.

Neto: What we see is a large concentration of investors and while there are a large number of pension funds, unfortunately – and I say unfortunately – a large number of these funds outsourced a large part of the management of their investments. This ends up leading to a concentration in the same investments.

Moura: And the decisions.

Neto: And the decisions. So the argument is between giants. It is this that forces you to open up new frontiers because you know the base is given, it will not change. Today, there is just as much local liquidity in mutual funds and pension funds but it is being hurt by leasing issues and CCBs. Top quality banks issuing CCBs and CDBs are paying attractive rates of return. The very best of banks are paying 103% of CDI. If you compare this with a debenture, there is no premium. Liquidity is dried up. So you need to have new agents, a new packaging, to help increase the investor base and also come with a new culture and ask this of the local banks leading the local market as banks from overseas are already used to this abroad.

The question of being a market maker is very different to us when we are doing a transaction. We see it this way: if I am to be the market maker, I have to have a limit on trading, but this is difficult here because the market is not organised.

So today you have a large number of foreign investors looking for Brazilian assets but with the exception of the government bonds which are tax free, you have to come up with some intricate structures to convince foreign investors to buy high quality private sector paper.

I myself admit that I spend a large part of my time creating a structure that is focused on reducing the tax on those investments so that I can meet the needs of my external investors who seek Brazilian paper.

You get to the absurd point where the foreign investor proposes that the bank shares a portion of the tax credits. So this is how it is today. There is a very large distortion and because of it you have to invest a lot of effort because of the structure created by the government.

When a foreign investor considers purchasing government paper he looks at the components of liquidity and tax exemption. For a private-sector bond, unfortunately, much needs to be done to get an investor to buy such paper.

IFR: We have talked about nearly everything on the roundtable’s agenda but I just wanted to change tack. What would be the necessary conditions for issuers to return to euros? What kind of levels and what would it take?

Peebles: Our bank would be a big winner if this were to happen. So what is the attraction of the euro? For the sovereign, I can understand why because it issues such paper regularly. The sovereign has a second curve. But the problem is this: you have to have a lot of revenue in euros or something else that creates a natural hedge for euro financing; otherwise there is no interest, even if the rate is lower in euros, since the cost of the swap will make the pricing higher than issuing in dollars, due to the lack of liquidity in BRL/EUR swaps.

Today, to issue in euros and convert to dollars by making the round-trip does not make sense. At some point, companies may start to do more transactions in euros. If there is enough volume in these transactions, the need for hedging would be less great, and it would make more economic sense. But remember, another such example is the yen market – you don’t hear as much about Samurai bonds as you did in the 1990s because there is no external trade denominated in yen.

Berlfein: I think that the euro market is a bit more difficult so I believe those accessing it will be more selective. Perhaps Brazil, which is keen on creating a 10-year reference point, should maintain this benchmark by returning to the market once every three years and effectively renewing the 10-year point. For the corporates, the sovereign would be the reference for all. Also a liquid benchmark is important since the euro market could be the solution for Brazil during difficult times as in 1999–2000 when the dollar market was closed to Brazil and instead it issued euros.

So it was the only market that was open during that time. It was the same case with the Samurai bonds – I believe it was in 2000 or in 1999 – when the Republic executed a few good transactions as it sought diversification just as the dollar market was closing its door. Now, in the private-sector’s case, it is a question of making a sale. Given that investors do not have access to Brazil risk in Europe in euros, you have repressed demand. All it takes is for the issuer to go out, tell its credit story and the deal will get done.

Jana: A borrower will only issue in euros because of an investment or because of cashflow stemming in an asset in that currency.

Fadigas: I agree with this point of view, plus there is another aspect too, and again we return to the curve that the company is building. An issue in euros would not help in this respect. I did a euro transaction when I was at the constructor [Construtora Norberto Odebrecht] just because it was not a frequent issuer. It was quite opportunistic to issue in euros given the company’s curve which did not have access to an efficient hedge and the end buyer was a fragmented market made up of private banking.

So we captured the efficiency of this hedge for our company, issued in euros and set up a hedge in dollars. The final result in dollars looked cheaper than an issue in dollars. But for a company geared toward building a curve in dollars it was not possible to just forget dollar issuance, which you can use to build a curve as the euro market does not enjoy the same amount of liquidity, nor is it that visible.

In our case, there would be no match with euros given that we do not have assets in euros of any sort of meaningful flux in euros. Plus there would be no benefit from a swap so in the end you do not have any benefits and there would be quite an onus if we were to place an issue completely outside of our strategy of building a curve. It would be very difficult to do and we do not see this changing in the short term.

Jana: We talk about debt issuance, but there is one thing that is happening and I believe will happen more in Brazil – and that is liability management. But you have to act as a pure adviser to your client. A capital markets transaction may not be the best solution because a borrower can enter a subsequent liability management transaction but it could be less fluid if there are too many investors involved. There are pros and cons in this process. This has to be weighed carefully before going ahead with such a deal.

Morais: Something that we have observed for the last few years was the number of European investors getting into our dollar issues. Some hedge or not into euros. There is a base of investors out there, private banking etc but there is a captive audience out there who only wants to invest in euros.

This is a fact. There exists a number of restrictions for these investors to buy dollar-denominated bonds. Or rather, there is the question of liquidity and the question of cost ends up being somewhat larger.

Should the Republic decide to increase its exposure to euros, it can engage in a swap, set up a derivative from dollars into euros to also have an exposure in euros. In any case, we are always working on all possibilities. We do not have anything defined just yet in terms of the euro-denominated curve.

IFR: A Brazil issue would go a long way toward helping companies and bring new issuers to this market, increasing efficiency all the while.

Morais: It is probable. But there is the question of liquidity too.

Peebles: The dollar market has it all. It is far easier to invest in a dollar bond as a dollar to euro swap is relatively low cost, and there is a liquid market. There are simply more investors in the US dollar market than in any other market, so it’s typically the market that provides the best pricing.

Massenet: Companies do have a problem when it comes to maturity. I think it makes more sense to have a better curve and a strong investor base in dollars than it is to think of issuing in euros. Multinationals though are always going to need to increase their investor base. But there are not regular issues to justify the maintenance of two curves in euros and dollars. I believe this is a gradual process and that will all change with more globalisation, more internationalisation, just look at the Euro zone within Europe. It could create a need in the future. For now, it is better to strengthen the curve in dollars. But with investments growing outside of the dollar zone, the need for a euro-denominated issues could increase. But I think it is still too early for this sort of thing to happen.

Peebles: If you look at this potential goldmine of euro issuance, it is a little different. I don’t see Asia getting involved but when you start to have, for example, a large base of investors in the US starting to buy euro-denominated paper too, then you will have conditions to deal with “buy here, it is cheaper”.

Massenet: Many Asian countries have very large reserves and the tendency is that they will diversify their investments. I believe they will move into euros. It will be important for some countries to rebalance their reserves and buy euros – a move that could create additional demand.

IFR: OK, we are drawing to a close, but I just want to put one last question to the issuers and everyone else before we end. I want to talk about liability management just before we finish and I have to be sincere that the only thing that Brazil is not good at is formal liability management exercises because people just do not want to sell their paper.

Morais: We buy back paper every day. This year alone we have bought back US$5.7bn.

IFR: The secondary market is great for this but when you have coupons on your curve paying 14%, many are locked in and investors are largely unwilling to sell. But you are the masters of buying across the curve and buying back everything save the benchmarks. The direction you are taking is very clear but when we look at companies they tend to tackle one point at time. Clearly there is a difference here but we end up entering the realm of questioning the sophistication of corporate issuers and also end up asking what more can be done to avoid situations where banks pitch to them and regularly use bait and switch tactics.

Diniz: I would say it varies from company to company. The market is imperfect. Naturally, you have bonds priced at adequate levels and others that are not. You always get this schism where you either end up creating opportunities or not. As soon as you figure out what these opportunities are, you have to go ahead and do it. We are taking out of the market today something that represents our first lesson – a five-year issued in 2004 with a coupon of 9%. Today, for us, it is extremely expensive. We have a US$400m 10-year paying 7.25% and an 8.25% perp NC5 and both were far cheaper. But tomorrow it is possible that I will have a discrepancy, principally in the way the country is heading. It makes sense, yes. We are always checking up on this.

Fadigas: To complement another matter you mentioned, in my point of view, I have no discomfort whatsoever in reading the market to see what a bank is offering. Just like we did with the ratings agency where we tried to play a more proactive role. Yes, there was a discussion with Moody’s and there was some debate as you can compare its point of view and question the difference in rating – we know there is a difference. With a bank, it is the same thing, especially when we are talking about the capital markets. The bank largely has no commitment to the rate it is offering but it does have a commitment to the reading it takes of the market.

In this sense, I feel no discomfort when hearing something from a bank and later hearing it changed. The other point of your question, that is the main point, the question of tackling one bond at a time, is that, and basing this view on other experiences, there are a number of inefficiencies.

Aside from the difficulty of buying back the paper, there is the initial cost of the bank fee and additional costs that pop up later on.

And there is inefficiency, when you talk about buying back, the point migrates to a new level, for example, investors can seek 60bp–70bp of pick-up to get out of a bond at 100bp–150bp. There is inefficiency in this process unless there is much volume behind the transaction.

For a company, when you put it down on paper it is difficult to make a NPV saving but if you are a sovereign engaged in a large transaction it can make a lot more sense.

Morais: I would like to add that it is hard to have an efficient auction process in any liability management transaction. Usually there are many rigidities in the process, such as the fact that holders of the eligible old bonds have to submit their orders to custodians 24 hours prior to the expiring time and, if market moves during this period, there is no way to update their proposal. In the way liability management transactions are structured, you have to deal with topics like Bond Instructions and Letter of Transmittal, which usually make the transaction quite inefficient. That is why most of the issuers prefer to do it on a fixed spread basis, instead of on an auction basis.

Valle: Just to add to this, last year we bought back US$6bn worth of debt right up to 2012 and this year we took out a face value of US$4.3bn. From our point of view, we are being super-efficient because we are not paying any premium. In a way you support the curve because you are in the market on a daily basis. This is helping create more expertise for us.

IFR: I agree this is the case when buying back in secondary, but normally when you try to buy US$22bn of assets and only buy back US$1bn it is much harder because you fall below original expectations.

Morais: Hang on, let’s define what was expected. When we do an operation, we put out a limit. The maximum is the maximum. It is not the expectation. Another thing, which is a disadvantage, is that the transaction has to stay out there in the market for at least four or five years, or even more. So you end up being subject to market risk during this period. When buying back in the secondary, you can make the most of weak moments or buy back later when you can take a reading of the market and buy back without falling prey to risky movements.

IFR: But with a transaction of that size, what would be the threshold? What would be the minimum level for a liability management transaction to be a success? People talk of around 20% or more.

Morais: I don’t believe there is a yardstick anymore. We did two such transactions last year, the maximum size was US$4bn and we did more than US$1bn. That was when we were offering to replace the assets. Obviously, the issuer does not want to leave anything on the table.

Berlfein: Such exchanges or tender offers can arrive at a 35%–40% hit ratio.

Morais: Buying more than US$1bn was in my view a success. But it can create expectations especially when you have a maximum target of US$4bn. But it is like what Carlos said about the cost – so you want US$4bn, well the pick-up is going to have to be different.

Achoa: I agree with you. This market is going to migrate to special situations such as the C-Bond exchange when you need to monetise the value of a call or any other embedded derivative, or when you need to change a covenant, issuer or other situations along these lines. When a large issuer such as the Republic wants to adjust its international curve it will probably end up happening in an OMR [Open Market Repurchase] fashion.

Berlfein: I believe you raised a good point because many are yet to latch onto the idea of changing covenants. Various bonds were done with some financial covenants. You can propose to the market that you are going to remove a covenant so as to force them to participate in the tender offer. Various transactions are done this way in mature markets.

Achoa: CNO, for instance, did a tender with right to consent about two months ago, where the clients were taken out of their positions but the issuer had the right to change a covenant just before buying back the debt. These kinds of transactions are the ones where underwriters are able to add value.

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