Despite a strong start to the year the prospects for the Brazilian bond market aren’t as rosy as they seem, and there is a real risk momentum carried over from 2007 could falter, as Anthony Dovkants explains.
Reality and opinion are hurtling in two very different directions when it comes to sizing up the prospects of Brazil's debt capital markets. On paper, the market is on course for a banner year, with more than US$50bn of issuance expected. The bulk will come from debentures and the rest from ABS, if the market keeps up its present pace. Against a backdrop of Brazilian inflation and GDP expectations of 4.5% for both categories in 2008, it hardly seems surprising that the local market is projected to do so well. Debt issuance has already seen US$20bn worth of deals with just the first two months of the year gone, making the estimated US$50bn issuance target look easy.
And yet dig a little deeper and all is not well. Despite record issuance in what was supposed to be a seasonally quiet first quarter, the market has stalled. Issuers are holding back and deals that are usually expected to be sold in the market are instead being distributed internally as investors, with little liquidity at hand and frayed nerves aplenty, are shunning all but the top quality credits. The market is trying to find its footing, following a repricing in late 2007, when issuers and banks were caught out by investors’ demands for a new structure to pricings, and at least 50bp more on top of previous all-time tights. In short, tenors have dropped to up to five years – from up to eight – and volumes have fallen to a mere US$175m-US$88m range – from US$294m-US$88m.
If anything, the market is enjoying momentum that spilled over from 2007. Of the US$20bn worth of issuance seen to date, US$18.45bn came from bought transactions issued by leasing companies, and absorbed by their banking parents, to help finance client operations. This represents more than 92% of all transactions approved so far this year. Plain vanilla issuance is at a low as leasing deals issue jumbos in the order of US$555m, US$2.95bn or even US$ 5.88bn at a time.
But that is about to end too. The central bank is clamping down on local leasing issuance in Brazil to try to curb aggressive lending growth, in a nation where banks have expanded credit portfolios at a rate of 20%-40% annually over the last five years.
In short, Brazilian leasing company issuance is set to slow – possibly even grind to a halt – over the next few months. There is little prospect of activity until the end of the year now that the central bank is demanding issuers to adhere to a new reserve requirement.
Effective from May, the reserve requirement begins at 5% of the equivalent total value of the debenture issue. By January 2009, however, the rate increases to 25%, said bankers. The central bank expects deposits to come to R$40bn.
"I do not know of any leasing companies planning any issues at this point," confirmed a senior DCM banker, who has worked on more than R$30bn worth of leasing company issuance over the last two years.
Consequently, the near-term prospects for plain vanillas and bought deals are at best grim, as banks tell clients they need to exercise the equivalent of market flexes and reset internal expectations. The market is looking uneasily toward establishing new floors and guidelines for where BBB to AAA rated issuers should price. Issuers are being forced to engage in market flexes of 50bp-75bp wider than what they expected in 2007, when they awarded their transaction mandates, and for CPI-linked tranches, the spread increases by 100bp or more.
For now, there is too little issuance to provide accurate data on just how yields are expected to perform across the credit quality spectrum. Only one company – steel giant Usiminas – has managed to come to market with flair and price its R$500m (US$294m) five-year tighter than already aggressive guidance at DI Plus 0.42% – or 3bp tighter than original guidance. DI is running at 11.09%-11.11% annually.
On the ABS side, petrochemicals giant Braskem managed to price its R$324m (US$183m) three-year ABS fund in line with its aggressive ceiling guidance rate of DI plus 0.50% with R$300m in senior notes and R$24m in mezzanine notes, which were set at DI plus 308bp. The tranches were rated Aa2.br and Ba2.br respectively by Moody's.
These plain vanilla transactions are increasingly rare, as many are being structured as credit operations. Some are being fast-tracked so as to gain regulatory approval within a matter of two weeks versus three or more.
Take constructor Even Construtora, which quickly raised R$100m via a five-year at CPI plus 8.75%: the deal was bought in February and turned around fast just weeks after Even had tapped the market for R$150m at DI plus 1.30% in January. But banks can afford to offer to buy transactions as their cost of capital is relatively cheap.
Those with retail branches can fund at a cost of DI plus 0.50%, while investment banks without retail can fund at a rate closer to DI plus 0.80%. Investors want to buy into transactions at DI plus 0.80% at the tight end, though may prefer levels closer to DI plus 1.30%. For this reason, transactions coming sub DI plus 0.50% are unlikely to be bought.
The ride is rough, too, for the ABS market, though some are hopeful there may be a pick-up in issuance. Firstly and above all, ABS suffers from a pricing mismatch versus debentures and transactions are slow to put together and can be expensive.
For example, Bankers say a three-year guaranteed AAA rated ABS structure will usually involve paying a coupon of CDI plus 1.00%-2.00%. This is not good considering non-guaranteed debentures of the same quality come at CDI plus 0.42%-0.80%.
There was always a mismatch between the two products, a peculiarity to Brazil. However, until volatility set in last year, the coupon rate differential between ABS and debentures was at its smallest when three and five-year debentures were coming at 104%-105% of CDI and ABS was at 106%-107% of CDI for a three year. DI and CDI run at a difference of a few basis points of each other.
In 2005, the difference between the two instruments would have been closer to 105%-107% on a debenture and 109%-110% on a three-year ABS fund. The differential is only expected to narrow again once the local rates tighten, correcting to pre-volatility levels, but this is expected to take time as uncertainty overseas keeps international investors – and their pool of liquidity – largely at bay. Optimists can, however, point to some signs of improvement in March.
At the outset of the year Brazilian ABS was projected to struggle during the first half, as AAA rated securitised issuers are seen staying away. But there is some cause for cheer. The central bank has created new rules on credit sold to third parties whether it be subordinated notes via ABS or via the sale of loan portfolios to other banks.
The authority has told bank issuers that credit-linked asset-backed funds do not constitute a sale of the credit itself. It said the gains from these funds, in terms of returns, can only be booked as the interest comes in on a daily basis. Previously the gains were booked upfront. This is expected to drive banking returns down and financial institutions will be required to bolster their capital. It will eventually translate – bankers hope – into a pick-up in ABS issuance after it failed to meet expectations in 2006 and 2007 when potential candidates instead increased their financial reserves and boosted independence by listing their equity onto the Bovespa.
"A wave of bank IPOs led to a decline in ABS issuance in 2007, when some mid-sized banks, which were particularly strong issuers of FIDCs, needed less money and had improved their capacity to retain more loans on their books, in a market where there is frequent credit portfolio selling,” said Ceres Lisboa, senior analyst at Moody’s in Brazil. "But now that liquidity is restrictive abroad, banks are going to be more reliant on local funding by borrowing in CDI and diversifying into instruments such as CDBs, CCBs, ABS and equity follow-ons too if there is a market," she added.
Any pick-up in ABS issuance will be much welcomed in this market. The CVM has just R$1.8bn worth of 14 yet-to-be approved transactions in its pipeline, after giving the regulatory green light to nine deals so far this year, totaling a mere R$723m. Deal sizes have dropped to a range of R$10m to R$150m for the majority of deals. This is a far cry from the market's heyday in 2005 and 2006, when transactions of up to R$1bn were starting to become common.
It is going to become increasingly difficult for local banks to shrug off the local DCM's image of being a bond loan market, as many take their pedals off the accelerator and bid less aggressively.