Thursday, 21 March 2019

The Real fad fades

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Bankers are known for always being in fashion. So it is no wonder that most debt desks in Latin America spent a good deal of 2011 pitching for offshore Reg S/144a deals denominated in Brazilian Reais.

They have been, indeed, so keen to adhere to the latest fad that some were willing to work virtually for free just to get a tombstone with a Real-denominated deal – with a couple of mandates having been given for a single basis point in fees.

Everybody wanted to do one of these deals because they seemed to be where most of the future activity out of Latin America would be. The argument gained strength as inflows to local currency emerging market bond funds held up even as equity markets were selling off and investors were pulling out of riskier assets. And given that many Brazilian companies suffered during the credit crisis because of their exposure to the dollar, it was natural to assume they would love to issue in their own currency.

But as the European credit crisis swayed markets, it became clear that the fad may have been short-lived and that there are several hurdles that need to be overcome before this market is fully established. One of the main bumps is the liquidity issue. The problem was underscored as some investors tried to reduce their positions on offshore local currency bonds during the recent market volatility and were unable to find buyers, even at deep discounts.

“The lack of dedicated buyers is an impediment” for further development of the market, said Polina Kurdyavko, portfolio manager at BlueBay Asset Management. “For all of the foreign investors, it is an off-index bet in a highly volatile investment.”

To make matters worse, deals denominated in Reais tend to be smaller. The first deals in this market were usually for less than US$300m equivalent. And while the last few deals priced before the market shut-down were larger, at an average size of R$1bn (US$532m), they barely made the cut as benchmark issues. That means that even as off-index bets, many important accounts could not participate in prior deals simply because they are obligated to only hold bonds with more than US$500m outstanding.

Before the credit crisis spiralled in Europe, there was some talk about creating an offshore local currency bond index, and some asset-managers, as BlueBay itself, were creating specific funds to follow the new benchmark. That would partly reduce the liquidity concern.

But as the uncertainty about the future of the eurozone increased, investors were painfully reminded of one of the main components of any equation to assess fair value of local currency bonds: FX volatility. While investors initially bought emerging market currencies and throughout July the Brazilian Real was less volatile than the euro, that quickly changed as risk aversion increased in August and September.

By September 22, open-high-low-close volatility for the Brazilian currency soared to almost 34%, the highest since December 2008. For most of 2011, even during the swings caused by the tsunami in Japan and the Egyptian revolution, the Brazilian Real had traded in a range between R$1.57/US$1 and R$1.68/US$1, meaning its maximum variation was around 6.5%.

But from the last week of July until the third week of September, the currency depreciated almost 18.5%.

That threw out of whack all of the fair-value models being used by investors for local currency bonds. As one asset manager explained, to assess a potential investment in a local currency bond, they assume a certain volatility in the currency so they can evaluate if the coupon is enough to justify the additional risk.

With a potential variation of 6.5%, depending on your entry point, it was not too hard to justify investing in a five-year bond of an investment-grade company at 10%. Even if the potential loss of having entered at the top of the range were incurred, the investor would still have a net carry of 3.5%, which, compared with the 0.8% that five-year US Treasuries were yielding by the end of September, seems amazing.

And if the investor has a long-term view that the currency will appreciate further, the potential return could be much higher. “In the last two years it was much easier to create a positive case for real-denominated bonds,” Kurdyavko said. “If you expect 5%–10% appreciation on top of 10% carry, adjusted for volatility, the investment proposition is much easier.”

But the recent drop of the Brazilian Real means that accounts that bought bonds earlier this year with a 10% coupon already have a 7% negative carry. In short, instead of boosting their overall returns, their off-index bets are weighing on their results.

So close, so far

If investors have become averse to local currency deals, Latin American issuers continue to dream of them. By early September, bankers had at least seven mandates for offshore Real-denominated bonds. These included even meatpacker Minerva, rated B2/B+/B, which was hoping to create a local currency high-yield market.

Chilean and Colombian companies had also started to queue up to issue in their revenue currency as the Brazilian deals whet their appetite. And even sovereigns such as Peru and Uruguay kept on repeating their mantra of hoping to issue local-currency debt to foreign investors.

By September, however, bankers had started to send the message to their clients. “I don’t see any deals in local currency happening anytime soon,” admitted a banker in New York who had several mandates in Reais from Brazil. The same applied to most other countries in the region.

And yet, bankers in the region have not given up. A senior DCM person from Sao Paulo said that he expected the global Real market to return as soon as volatility subsided. “The depreciation will actually provide a better entry point for investors,” he said. However, he admitted, first the Brazilian currency will have to settle in a new range and trade within it for a while.

It could be wishful thinking, though. After having been burned this time around, investors are likely to require higher premiums to buy Brazilian Real bonds. Until recently, most accounts worked with a basic premise that a corporate bond should yield at least 300bp more than the local currency curve of the sovereign. But their recent losses mean they will want much more now for the risk.

Meanwhile, domestic rates for Brazilian issuers have plummeted, making the global Real avenue less attractive in relative terms. With the interbank rate DI, against which most Brazilian deals are priced, having hovered around 12.5% most of the year, it was easy to convince an issuer that it was better to seek international investors instead of staying home.

Even when the 15% withholding tax – which is applied in Brazil to all money raised as debt abroad – was included in the equation, the five-year deals of Arcos Dorados and Banco Safra priced at less than 90% of DI. Meanwhile, locally, they would have a hard time getting money for that tenor for less than 107% of DI.

But a recent transaction by Brasil Telecom looked much less sexy. In early August, the company priced the largest ever fixed-rate corporate real-denominated global bond, while also printing the tightest ever coupon on such transactions. The R$1.1bn five-year Reg S/144a bond priced at 99.516 with a 9.75% coupon to yield 9.875%. In spite of all the bells and whistles, at pricing time, one banker calculated that BrT’s bonds could be swapped into 108% of local interbank rate DI.

As investors bet on a slowdown, Brazilian rates continue to tighten. At the same time, it will be a while before another real-denominated deal gets a 9.75% coupon. So the issuers that mandated their deals earlier in the year expecting to raise funds in local currency for less than what they would pay at home are already rethinking their strategy.

If that means less business for the banks that were pitching the structure, it at least may halt the fee-cutting that was affecting the nascent market. The last few mandates for global Real bonds had been heard to be as low as 1bp to be shared among four banks.

And when investors are once again comfortable with local currency bonds, at least the lessons learnt from this round of attempts will have been learnt. Deals will be bigger in size to allow for more liquidity. Issuers will have to offer more premium and protections to investors. And banks will not be so aggressive in their pitches.

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