Monday, 23 July 2018

Not all plain sailing

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It has been more than three years since poster child Brazil graduated from the IMF in style. Since then it attained investment grade status, reduced its inflation, cleaned out its US$13bn restructured Brady debt, bought back more than US$15bn of its expensive international debt, reduced vulnerabilities in its local debt profile and turned its equity capital market into one of the world’s fastest growing. Yet it is not all good news. Anthony Dovkants reports.

It seems Brazil is going to strength from strength after hitting BBB- in May, when it attained its tightest yield ever of 5.299% overseas on a 2017 US$500m reopening. It finally graduated from BB after a difficult first half to this decade, when it was hit by an energy rationing crisis followed by a much-feared default in 2002. Brazil was forced to turn to the IMF and sign up to the multilateral lender’s then biggest ever standby loan of US$42bn, to help stave off currency speculators. The real had collapsed to more than R$4.00 to the dollar. Compare that to the R$1.56 mark the real achieved in 2008, hitting tights it had not seen in more than seven years.

Yet the government is showing signs of neglecting the country’s debt capital markets. If anything, Brazil’s debenture and subordinated debt markets have collapsed, while ABS is struggling to keep up with last year’s mediocre volume results.

The government is providing negligible support to the nation’s local corporate debt markets, leaving them to fend for themselves. The debenture fund-raising arena continues to be dogged by out-of-date dynamics, giving it the negative sobriquet of LatAm’s top bond loan market. In August 2008, for the first time in recent memory securities regulator CVM found itself without any debenture transactions in its pipe. The contrast with the earlier part of the year could not be starker: debenture volume in the first nine of months of 2008 stood at R$37bn.

Where did it all go wrong?

Who could have predicted this after the country achieved a record 2006, when the debenture market enjoyed R$69.5bn (US$39bn) worth of volume and ABS was in its heyday, hitting R$12.8bn? But this year proved a turning point for the ABS market. The CVM introduced a new accounting norm, stipulating all such securitised transactions must be accounted for on the balance sheet. That year, the market had been forecasted to deliver more than R$16bn worth of volume. And its underachievement continued into 2007, when it saw a decline of 22% to R$9.96bn from 2006. For the first nine months of 2008 it crawled in at R$8.2bn.

The ABS market lost its appeal to big name issuers such as petrochemicals giant Braskem overnight, just as transaction sizes were starting to scratch the R1bn mark, tenors were finally extending to five years (up from three), and spreads were finally starting to inch closer to debenture pricings. Investors were finally starting to show enthusiasm for the market – not just because more funds were becoming specialised, but because of the appeal of the corporate debt market in a country that had been drip fed for years on government paper.

In 2008, the problems afflicting the ABS and debenture markets originate from the same underlying factor: a dearth of primary market liquidity.

Today, only top quality names with simple credit stories can get their transactions done in ABS. Even then, it is tough going in a market where sizes tend to be below the R$250m mark, with mostly tenors of three years. Heading into the fourth quarter, bankers said the market could start to perk up, but few are willing to count their chickens just yet.

The debenture market’s problems are more acute: many believed in 2007 that it would at least reach the R$70bn mark – equaling, or possibly surpassing the 2006 performance. But an increase in dollar-denominated issuance, coupled with the onset of liquidity woes in July of 2007, drove issuers away from the market. Constructors, which were tapping debentures en masse for the first time in 2007, ended up selling many of their deals to their leads. Investors were becoming increasingly picky on the back of external market jitters, brought on by the US sub-prime crisis.

Back then, corporates were able to raise paper below the reference rate of DI plus 1.00% spread. But by the fourth quarter of 2007, companies were having to offer above that level: constructors could have offered a debenture at DI plus 0.60% in June 2007 but were forced to come with coupons of DI plus 1.20% or more by October that year if they were to succeed in placing the transaction with funds.

By 2008, yields had deteriorated further. The central bank had decided to implement a reserve requirement on leasing company debenture issuance, and introduced more stringent rules on capital structures, forcing banks to scramble for funds. This created a primary liquidity crisis of a magnitude not seen since 2002, when the nation threatened to default and went running to the IMF for its US$42bn standby loan.

By the start of the second quarter of 2008, the debenture market was already moribund. By August more than R$21bn worth of transactions had been cancelled, as issuers found it impossible to place paper at acceptable levels. Noticeably, constructors are absent from this market.

Today any top quality corporate would be lucky to get a deal done at DI plus 1.70%. Deal sizes have compressed to R$300m, from up to R$2bn in 2006 and early 2007. Tenors have shortened to three years – from up to eight in 2007. Big names to put deals on hold include Brazil’s BNDES, or national development bank, which wanted to set a new R$1.5bn benchmark but ended up delaying.

For now, yields have widened out to DI plus 1.85%-2.75%. Such levels will probably remain until 2009. By then, bankers hope, the nation’s banks will have finally found a way to shore up their capital structures. Then primary liquidity can start to flow back into the markets. “Issuers are just going to have to readjust to these yields because they are here to stay for at least this year but we believe that we can place deals of up to R$300m with tenors of up to three years,” said a senior DCM banker.

Take Duke Energy’s Brazilian unit Geracao Paranapanema: it issued a smaller-than- expected R$300m debenture, after initially wanting to raise R$750m via DI+100bp 2014s and NTN-B+145bp 2016s in the first quarter of this year. By the third quarter the company was offering investors guidance of DI plus 2.15%, and a CPI tranche plus 215bp over government NTN-B 2013s.

What now?

The dire state of this market begs an important question: what is the government doing to improve the situation? The answer: nothing, beyond the usual monitoring of the market’s state.

Brasilia could help but it is unwilling to allow foreign investors to enter this market by removing a 15% withholding tax. This would be the ideal solution to the market’s woes, given locals are reluctant to get involved. Foreign investors – typical holders of local government debt – would likely buy into such paper en masse, as yields for AAA rated corporates are coming at a significant premium to public-sector bonds. Government paper tends to price around the DI mark. If the floodgate opened, corporate spreads would tighten in again, tenors would extend up to 10 years and volumes could easily double overnight, once external markets are back into shape again.

There are two rubs to this conundrum: the government is still trying to build a liquid fixed-rate curve up to 10-15 years locally and it needs foreign investors, as locals prefer short-term paper. Opening the corporate debenture market would create unwanted competition.

In addition, there could be a significant impact on the foreign exchange rate if an additional US$2bn or more were to enter the market every month. Such a trend would put unnecessary pressure on the real and the nation’s economic engine – exporters. The government would not want to jeopardise that.

So it seems the only plausible solution will be an easing of the latest central bank regulation. But the monetary authority, which is raising interest rates on the back of a jump in commodity prices and is trying to slow down a lending boom, is unlikely to let up anytime soon.

For now, the best the market can hope for is a long-lasting rate-cutting cycle that ultimately sends interest rates – currently at 13.75% - down to single digits. When that happens, foreign banks will get increasingly involved. Only then is the secondary market expected to become more liquid, attracting overseas investors en masse for the first time.

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