Saturday, 21 July 2018

Mexican standoff

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The credit crunch emanating from its continental neighbour to the north is sucking the life out of the corporate bond market in Latin America. At the same time it has found itself a victim of its own success, as investors look to countries paying higher yields to compensate their credit risk. Paul Kilby reports.

Over the last few years bankers have pinned their hopes on – and funnelled resources into – what had been expected to be a burgeoning high-yield market in Latin America. But with investors retreating from all but the best credits and blue chip names reluctant to pay new issue premiums, DCM officials are expecting a slow year ahead.

As of early March, Latin America had seen just three corporate issues worth US$1.25bn in total, mostly comprising deals from investment-grade names such as Petrobras and Usiminas. That compares to corporate issuance that reached close to US$7bn over the same period last year, when new names or lower-grade credits were the dominant drivers.

The region probably hasn't seen a new year so troubling since 2002, just after the Argentine default and during the build up to President Lula's victory in Brazil's presidential elections, which eventually pushed EMBI+ spreads out to around 978bp.

Even then, between January and early March, total issuance hit US$8.3bn, mostly propped up by sovereigns and the odd blue chip, such as Pemex. It is similar story this year, with sovereign issues accounting for US$2.5bn of the US$4bn issued in January and February.

This is a reversal of a trend that has seen LatAm – and indeed EM – corporate volumes leave sovereigns behind as governments focused on debt buybacks and issuing in their own local markets.

"Banks have been focusing their resources on corporate credit, which more and more represented the lion's share of the issuance pie," said one syndicate official. "This year we expected the same, but year-to-date something like sixty percent was sovereign."

Over the last few years, banks have been spending less time on the diminishing and less profitable sovereign business, concentrating efforts instead on the higher margin corporate sector. Hopes were that this would become a true credit market, available not only to traditional blue-chip names but also lower-tier credits looking to make their debuts.

For now the market for Double and Single B companies has dried up, leaving only room for a small universe of blue chips. Bankers are hoping to see a lower-tier name break the stalemate and reopen the high-yield market, but few expect this to happen in the short-term.

Top tier names can still tap the market, but such issuers are often reluctant to pay the widening new issue premiums, arguing their credit quality has not deteriorated. They feel they are being somewhat unjustly punished for global turmoil emanating from north of the border.

"Good strong stories will always find a home if they are priced well. It is a matter of adjusting the issuers' financing expectations to the market environment," said Alfredo Chang, senior vice-president at Lehman Brothers Asset Management.

No longer at the centre of the financial storm as in times past, Latin American borrowers have in some ways been a victim of their own success. Corporate Latin America has outperformed against its US markets, and even its EM peers, most recently helped by solid earnings reports, decent fundamentals and – in Brazil's case – a strong bid among locals, who remain doggedly optimistic despite the fallout from the US.

According to JPMorgan, as of February 21, the shop's LEI Latin corporate index, which has an average rating of BB+, saw month and year-to-date returns of 0.42% and -0.16%, respectively. That compares to -2.05% and -1.26% on the JACI Asian corporate high yield index and -2.35% and -7.82% on the Euro high yield index.

While that may show how far the region has come since the last crisis, it also puts it at a disadvantage: investors with a global view see more compelling yields elsewhere among similarly or better rated credits.

"With the spread of the Global High Yield Index currently above 720bp it has become harder to make a compelling case for Latin American High Yield bonds," JPMorgan said in a recent report.

The relative value argument has been a thorn in Latin American issuers' side as investors, who now have the upper hand, are demanding more, in light of the heightened risk aversion globally.

"I think LatAm will be underrepresented which is good for spreads, but relative value will push spreads wider," said one banker.

The relative tightness of the region's markets either means some unwinding is on the horizon or that there truly has been a decoupling from the troubled US market. Looking at the region's improving ratings landscape and strong economic indicators, some investors still see long-term upside.

"If you think about the ratings trajectory for Latin American sovereigns relative to US issuers, there is a divergence there," said Chang at Lehman Brothers. "US credits continue to come under ratings pressure on the downside, but at the same there is a strong path for ratings upgrades in LatAm."

Despite those views LatAm corporates, even the best blue chips, now have to pay new issue premiums that reflect the changing environment in the US. Hence borrowers either have to bite the bullet to lure investors back into the fold or wait until the market settles down.

Bankers have been doing their best to encourage borrowers to move forward, arguing that sentiment could deteriorate further and base rates are still attractive by historical standards, thanks to rallying US Treasuries.

"People are more concerned that subprime will take longer to work itself out. And there are elections in the US, which will bring more uncertainty," said one syndicate official. For good corporates, levels can be attractive on an all in basis, but they are more expensive than they would like them to be. It is not a market that if you wait three months it is going to get better."

But borrowers largely remain defiant, refusing to pay premiums caused by a financial crises sparked outside of their borders. This attitude has been particularly prevalent in market favourite Brazil, where the sovereign has made it clear it would only issue with smaller premiums than those paid by its EM peers.

Brazilian public credit officials argue that the country is no longer a frequent issuer of US dollar debt and has smaller needs in the external market, hence scarcity value should bring in premiums. Arguably, some corporates could say the same, given they have access to alternative financing sources.

In February, Brazilian oil giant Petrobras pulled a retap of its 2016s after deciding that it was unwilling to pay the 20bp-25bp new issue premium that investors were demanding at the time.

Like many top-quality LatAm names, Petrobras may not have seen deterioration in its credit quality, but nevertheless has been faced with higher funding costs as the global credit crisis takes its toll and accounts make comparisons with prices in the US high-grade market.

"This is a very difficult situation because we are paying for something that we are not responsible for, but that is the reality," said Petrobras CFO Almir Guilherme Barbassa said earlier this year. "What we have to do is work hard to show [investors] we are a very good risk. We are trying not to pay up and this is the main reason we stalled the transaction."

Until borrowers and issuers can meet half way, bankers hold out little hope of resurgence in issuance, particularly given that most LatAm issuers do not have their backs to the wall, at least not yet. Unless, they have refinancing needs or require the money for acquisitions, LatAm borrowers are likely to remain sidelined for now. "It is like a Mexican stand-off," said one DCM official. "Someone is going to blink [eventually]."

The region's borrowers are also lucky in that they perhaps have a broader array of financing options open to them. Not only has Latin America worked hard to develop what are now relatively deep local markets, but the loan markets have remained active.

"In Brazil there is still plenty of domestic funding. It is short-term but ample. So unless they are doing an external acquisition or refinancing, Brazilian companies don't need to tap the external markets," said one hedge fund manager.

Blue chip names such as Votorantim and Usiminas were recently able to successfully tap the loan market, partly helped by the momentum provided by relationship banks. Mining giant Vale also quickly put together a US$50bn funding package for its possible up to US$90bn acquisition of Xstrata.

If the Xstrata purchase goes through the ripple effects from the take outs should in theory provide some positive momentum, though mostly in the high-grade space. Bankers are expecting US dollar bonds as well as a euro-denominated issues of between €3bn-€5bn in size, which would mark the first LatAm deal in that currency in a number of years.

For now the lower tier credits can mostly ride out the credit storm, partly thanks to some smart liability management operations conducted at the height of the liquidity wave. Mexican corporates such as Vitro and Durango as well as Argentine names all tapped the market last year, lengthening tenors and/or eliminating restrictive covenants on restructured debt.

Some banks have continued to soldier on with under-the-radar-screen private placements that may involve a bi-lateral loan that is then either sold off or hedged through CDS. This may provide some breathing space for now, though they come at a higher cost for the borrower.

For now bankers are fiercely competing in the public arena for whatever mandates are out there as seen by the eight banking groups that pitched for the City of Buenos Aires request for proposals, and the razor thin fees offered to win the bid.

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