Tuesday, 17 July 2018

IFR Top 250 2007: Brazil's ambitious overhaul

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Under a relatively new Treasury team, Brazil is restoring its former glory as it looks to purge itself of previous sins and further extend into a relatively new world of Global Real-denominated issuance. Anthony Dovkants reports.

When it comes to its sovereign debt, Brazil has ambitious goals. The sovereign is adopting a twin approach to taking out and converting US$52.2bn worth of dollar and euro-denominated paper into local currency and a few hard currency benchmarks.

On the way, investors can expect a number of strategic moves from the BB+ sovereign. These include the creation of a new 10-year euro benchmark, a new 20-year dollar-denominated benchmark, a new 30-year Reais-denominated benchmark, more unpopular buybacks and greater distribution to Asian investors.

The strategy also includes more buying back of dollar-denominated debt in secondary – a tactic that is a double-edged sword, as the sovereign not only reduces expensive and illiquid bonds in circulation but also props up its own curve. That in turn allows it to raise money at cheaper and cheaper rates, consequently excluding hedge fund investors from its aggressively tight transactions.

In terms of euro-denominated bonds, the sovereign could easily engage in a new 10-year to help finance formal buybacks and secondary market purchases of more than US$5.6bn worth of such paper. Such a total excludes the buyback of Brazil's current €1.08bn 2015 benchmark.

The 2015s cost relatively little, at 7.375%, like the 7% DM 2008s. But the rest of the curve is expensive to maintain as well as being highly illiquid. The 2009s and 2010s and Eurolira 2017s are the most expensive, at 11%. The 2007s are high, at 9.5%, but will in any case be taken out this year. The 2011s are also high, at 9.5%, while the 2012s are at a more modest 8.5%.

Such euro-denominated buybacks and a new benchmark are a natural progression for a sovereign committed to buying back most of its dollar-denominated debt and putting an emphasis on creating more liquidity in its benchmarks.

On the dollar-denominated front, one or more new benchmarks beyond the 10 and 30-year points on the curve can be expected. For now, Brasilia is closely examining the possibility of creating a 20-year as opposed to a 15 and 25-year – although these may be chosen in the future should they prove to be advantageous in terms of pricing.

And they probably will prove to be so. In first half of May, before volatility started to hit the markets on the back of a rising 10-year US Treasury yield and equity jitters in the US and China, Brazil's 2017 and 2037 were trading at a differential of around 50bp between 5.65% and 6.10%. The levels were tight and would allow Brazil to issue a new 2027 through the 2017's 6.00% coupon.

For the Reais-denominated curve, it would be more of the same in terms of pricing dynamics, amid growing expectations that the nation will issue a long and much-awaited 30-year Global. Before volatility hit the markets, Brazil could easily have priced a new fixed-rate 30-year flat to 9% after reopening its 10.25% 2028 Real Global at 8.938% yield.

That said, the sovereign is expected to wait before it can price a 30-year below that level – a move reflecting the nation's inverted curve and expectations of better things to come, as the country could reach an investment grade rating of BBB– before Christmas.

This would be quite a feat, since Brazil was heavily criticised for aggressively pricing its debut 2016 US$1.5bn equivalent Real Global with a 12.50% coupon and 12.75% yield some two years earlier.

Brazil, which tends to offer issues between US$500m–US$1bn in volume, has earned the right to join Mexico in the exclusive 30-year local currency club. But a new standalone or reopening is unlikely to come the market's way until spreads settle again, as the benchmark 2040 trades more than three points below its highs of this year.

In the current scenario, the sovereign will probably want to make the most of lower prices to buy back debt in secondary and examine the possibility of formal buybacks before issuing new paper. Should there be a formal buyback, the sovereign would do well to come with more generous rates, as investors have demonstrated they are uninterested in exchanging paper for a pick-up of less than 5bp.

Given that the country will hit investment grade, investors would be ill-advised to sell bonds paying more than 10%, such as the 12.75% 2020s, 10.125% 2027s and 12.25% 2030s, despite their lack of liquidity.

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