IMF World Bank 2006: Do as the
Banks have little choice but to do as the Brazilians do and come up with ways of bringing foreign investors to the country's shores as Latin America's biggest economy rapidly and aggressively opens up its US$470bn local debt market. Anthony Dovkants reports.
Global investment banks have so far been reluctant or slow to take advantage of the goldmine that is Brazil local debt market but they are likely to start moving more quickly after it became clear in late August that they can no longer rely on Brazil to issue US$4.5bn-$6bn overseas anymore.
The standard 30 cents fees per Brazilian international bond offer are as good as gone after the Republic scrapped its external debt programme, saying it would finance US$14.19bn worth of 2007-2008 net foreign currency needs locally.
The few opportunities to be had overseas are in liability management as the sovereign aggressively shrinks the size of its external global debt, which totals US$50.3bn versus US$61.5bn at the end of 2005. But even then the pickings stemming from liability management transactions are small as Brazil has only issued US$500m of new paper since February as part of an early August swap of five old bonds for new 2037 paper. Since February, Brazil has engaged in more than US$12bn worth of buybacks.
Brazil has not completely exited the external debt market. The nation still wants to maintain its benchmarks in dollars and build up a curve in global Reais, starting from the 10-year point and extending beyond. But bankers are going to be lucky if Brazil does US$2bn worth of new issuance a year.
Simply put, the nation no longer needs foreign currency money and it is likely before long that its external debt will shrink to less than US$30bn within the next two years after it has taken out off-the-runs, built up its external curve in Reais and just about extinguished its curve in euros.
Opportunities knock now
Banks are going to have to be quick to see opportunities in local government debt issuance and it is clear that some have been better at this than others. JPMorgan is among a few that has spearheaded the entry of foreign money into Brazilian public debt since the sovereign withdrew a 15% withholding tax on its local bills mid-February – a move that has been key to helping Brazil create a fixed-rate curve for the first time after spending years trying to get out of a floating-rate issuance rut. JPMorgan has brought to Brazil US$3bn worth of foreign investor money and expects to keep increasing this as funds look to make the most of yields ranging between 9%-15%.
As part of this, the shop's research team has been quick to exploit such opportunities, frequently recommending the cheapest points on the NTN-B fixed yet inflation-linked curves and fixed-rate LTN curves. There is much to be had here and not just for the sovereign, which has been able to reduce carry of more than 17% at the start of the year.
For example, in the last half of August, Brazil managed to place – with ease – 15, 20 and 30-year fixed rate NTN-B debt with the 2035 priced at 7.98% yield. This is considerably less than what investors can get if they buy into floating-rate paper, whether it be government LFT bonds or corporate debt. FRNs are based on the reference DI curve, which is currently moving at 14.57% annual.
But buying such paper is tricky. The government has just about stopped offering LFT bonds altogether and on top of that, private sector debt, which is all floating rate, comes with a 15% withholding tax – a huge impediment for most investors.
Investors still want NTN-Bs, largely because Brazil is seen turning investment grade as soon as the end of next year. So much so, that the idea of buying a 30-year bond at 7.98% locally is attractive given that the Selic reference base rate – which serves as a point of reference for the DI curve – is seen dropping to single digits within three years from its late August level of 14.75%. Few believe that Brazil will see inflation at 8% in 30 years from now, especially as it is seen closing this year below 4.5%.
Like JPMorgan, Credit Suisse too has done much to latch onto this area of business. But this is a natural progression for the two banks, which have a history of being significant issuers of Reais-denominated credit-linked notes.
The two will likely try to bring more offshore money to Brazil but there are challenges ahead if Brazil is to succeed in ridding itself of LFT floaters, which are expected to total less than 40% of the US$470bn debt pile end 2006.
Opening the process
Brazil has to improve legislation, streamlining bureaucracy. While it has managed to reduce investor registrations to a period of about a day from a previous month to three months, Brazil still needs to ease up on legislation involving the opening of a 2.689 account.
Foreign investors coming to Brazil need to open such an account so as to be able to bring money into the country. To be able to have this account, however, investors must have a fund administrator based locally. Finding out who is reliable or good at this is another hurdle if investors do not go with their locally-based bulge bracket bank. Another issue is the foreign exchange. While the 15% withholding tax has been removed, investors still have to pay a CPMF financial transactions tax of 0.38% on each transaction.
Aside from these hurdles, investors would like to see government public-sector debt transformed into euroclearable paper. The benefits are clear to foreign investors – greater security and less 2.689 foreign account hassle. This last point seems far off. As does the idea of Brazil finally getting rid of the CPMF tax, which was brought in as a temporary measure to help boost the coffers. The CPMF has been so good at making money for the government that it looks like Brasilia will never let go of it – despite constant criticism from the public. It has been key to helping Brazil meet its annual primary budget surplus target. Something Brazil did with much success in 2005 when it reached a high of 4.8% of GDP versus a target of 4.25%.
Until such factors are eliminated, Brazil may have trouble in luring significant sums of foreign investor money, totalling tens of billions of dollars. In the meantime, global investment banks will have the opportunity to teach investors how to get used to Brazil's way of issuing debt. Such quirks include a 252-working day coupon as opposed to the more traditional 30/360 overseas. Banks should make a point of this because these same investors will end up becoming the same buyers of higher-yielding and shorter-term floating-rate private-sector debt.
In fact, this is already happening but only on a much smaller level as investors study the local market and start to understand its rhythms. For example, some of the big banks are already beginning to set up funds for foreign investors to buy into corporate debt. Credit Suisse, Deutsche Bank and Standard Bank are among those looking to lead the way - a move that is likely to prompt others to follow suit.
Though, there are risks and the sea-change is expected to be gradual as secondary debt liquidity will be held up as private-sector debt continues to be penalised by a 15% withholding tax. Plus, there are no market makers and local investors - as well as banks coordinating such offerings - snap up the paper on a buy and hold basis.
Chasing lucrative yields
That said, there are opportunities to be had. Funds will likely chase paper offering yields of at least 108% or more of CDI, which is at 14.64% on an annual basis. Investors should not try to buy more tightly priced paper because of the foreign exchange risk as the Real is trading at tights not seen in more than four years. Transactions providing such returns are low risk guaranteed ABS funds, which are made up of senior notes.
This is important as the government is seen withdrawing its withholding tax as soon as next year. When that happens, investors familiar with private and public-sector debt will move into this market en masse.
As part of this process, foreign investment banks should take the opportunity to delve deeper into underwriting in the local market. Some are already doing this such as Citigroup, HSBC, and Standard Bank by looking to participate in debenture or ABS fund transactions.
For example, such banks are either working alongside Brazilian banks or starting to take a lead on local transactions. Citigroup and ABN AMRO are working with Banco do Brasil on petrochemicals giant Braskem's R$500m (US$233m) five-year debenture. ING is also coordinating with lead Banco do Brasil on technology group Cobra's R$250m five-year ABS fund. And HSBC is leading an R$250m five-year issue by construction group Gafisa.
Banks would also do well to hire local talent from banks such as Unibanco, Bradesco and Itau BBA to gain overnight expertise. Standard Bank did this in June and already has four mandates.
Ultimately, the opening of the public-sector market will play hand in hand with the opportunities in the fast-growing private-sector debt market. Opportunities abound and first-mover advantage is critical in a market that will offer mandates of more than US$33bn this year, or more than double 2005's US$15.9bn.