International investors fell over themselves to get a piece of the action when Brazilian lender Banco Votorantim sold an off-shore local currency inflation-linked bond in May – so much so that the bank doubled the deal size in response to demand.
Amid soaring enthusiasm for Latin American debt, Votorantim's five-year note was one of the largest local currency corporate deals in recent years, eventually raising R$1bn (US$582m) for the Brazilian borrower. Such was the warmth of its welcome, the deal was hailed as a gateway deal that would awaken the LatAm corporate linker market from its four-year slumber.
In the event, no sooner had the market awoken than it went back to sleep. Syndicate desks reported investor enquiries for inflation deals through mid-year, but before any were able to hit the road concern over euro region sovereign debt spiralled, sparking a back-up in spreads and wholesale retreat from risky investments. One of the funds to get a piece of the Votorantim deal was Aviva Investment’s EM inflation-linked bond fund, which turned a quick profit as the linker marched higher in the secondary market.
“We were very happy to be involved in that deal because it performed spectacularly well,” said the fund’s co-manager Kieran Curtis. “In the end it got so expensive that we could not justify holding it any longer and we sold it.”
Given the positive result Curtis and his team were quick to get on the phone to syndicate desks to ask for more inflation-linked paper. “We definitely had more appetite for this stuff, but in August and September the market went south and the new issuance space effectively shut down.”
One of the reasons behind the exceptional demand for the Banco Votorantim deal was that it represented a diversification play for emerging market inflation-linked funds, which rely almost entirely on LatAm’s thriving government linker market to satisfy investor demand for inflation exposure.
Of the roughly US$440bn worth of emerging market inflation-linked bonds globally outstanding, LatAm has about US$400bn, with Brazil and Mexico alone accounting for US$300bn, almost entirely emanating from sovereign programmes. Some 29% of Brazil’s government debt comprises so-called NTN-B notes, linked to the IPCA inflation measure.
Investor demand for the bonds is high, both locally and internationally, and emerging market inflation-linked securities have outperformed their fixed-rate counterparts, returning some 97% over the past five years, according to HSBC, nearly the double the return on nominal bonds.
Given the excellent fundamentals it would seem to make sense for LatAm corporates to imitate their sovereign Treasury counterparts by rolling out yield curves in indexed securities. That has to some extent been seen in the on-shore market (the HSBC-led Elektro Eletricidade E Servicos R$300m dual-tranche five and seven-year transaction being one example last year), but the international space has been left almost entirely bereft.
“The local market has been developing quite nicely and there are important deals that are getting access and execution with pretty good maturities, which would not have been possible five years ago,” said Katia Bouazza, co-head of global capital markets for the Americas at HSBC Securities (US).
“When banks issue inflation-linked bonds they may be very well looking at pure arbitrage between where they can place the bonds in the international market and how that would swap into CDI”
“You are getting excellent third party distribution, with pension funds, insurance companies and banks coming in and buying. However, in the international market there are dynamic elements like the cost of the swap or investor appetite, and you need to align all of these for the deal to get done.”
Finger on the pulse
A key consideration for Latin American corporates looking to issue inflation-linked off-shore is the availability of hedges. Following its inflation-linked sale last year Banco Votorantim bought the money onshore and swapped into a fixed rate, according to sources close the situation. However, the offshore inflation swap market is by no means a guaranteed liquid proposition.
“When banks issue inflation-linked bonds they may be very well looking at pure arbitrage between where they can place the bonds in the international market and how that would swap into CDI [Brazil’s interbank rate]. It doesn’t necessarily mean that they want to keep the liability indexed against inflation,” said Charles Achoa, head of LatAm at RBS.
“However, to do that sort of trade you need to have your finger on the pulse of the market, and also you need to ask how deep that market is – because the market for inflation-linked swaps is not that deep. If a number of issuers in Brazil started doing that swap, the market would dry up very fast.”
One country that does offer a liquid swap market is Mexico, where the Unidades de Inversio (UDI) inflation rate can be swapped with the Interbank Equilibrium Interest Rate (TIIE) in the over-the-counter market. The fixed-rate leg of the coupon is based on the UDI and the floating leg is based on the 28-day TIIE, and tenors go from six months to 30 years.
Another variant, which is more liquid according to HSBC, is the UDI-US dollar Libor swap. This is an offshore swap that consists of a fixed coupon denominated in UDI that is exchanged against a floating coupon denominated in six-month US dollar Libor. Tenors go from one to 30 years.
For corporates that do not have earnings linked to inflation, the absence of a liquid hedge in most LatAm currencies is potentially a substantial disincentive to linker issuance, Achoa said.
“If on the other hand you have an issuer such as a toll road operator, which has earnings linked to inflation, then it’s a matter of whether you see the demand, because in that case you don’t need to do the hedge. But you need to be careful when making these assumptions because even with commodity producers it’s not always the case that they will have a close correlation to the local benchmark inflation measure, as they are very dependent on international markets and pressures.”
Legacy of the past
One of the key impediments to the development of an offshore LatAm local currency linker market, is the historical and continuing widespread reliance on fixed rate dollar funding, a legacy of the governance and currency concerns of the past. Nonetheless, the local currency market has begun to mature over recent years, and saw record issuance in the 12 months up to last summer, in particular from Brazilian corporates.
Still, while the euro crisis is blamed by many for the recent slowdown in issuance, there are also in some cases deeper structural concerns at play. In Brazil in particular this has been manifested by the government’s increasingly forthright attempts to control inflows of so-called hot money playing the carry trade against low interest rates in Europe and the US.
A particular problem for corporate local currency issuers was the decision by the Brazilian government in July to impose a 1% financial transaction tax on short dollar positions in the futures market. That fed through into swap prices and then into underwriting costs, reflecting the need for dealers to hedge inventory held on behalf of investors.
The derivative tax came on top of a 15% withholding tax paid on coupons for offshore issuance, introduced in 2010, and the combined impact was a substantial increase in the all-in cost of Real-denominated offshore funding, which in some cases prompted a falling off in liquidity and a widening in bid ask spreads. IFR reported in August that the spread on the 2015 Real-denominated bonds of utility CESP had widened from an average of 50 cents to as high as US$3.
“It’s pretty clear that 15% withholding tax on a Real-denominated bond paying 200bp over the Real curve is going to be a whole lot more than 15% paying even 300 basis points over the Dollar curve, particularly in longer maturities” said RBS’s Achoa. “That is a big difference and a big disincentive to issuing in local currency.”
As issuers juggle decisions over swap rates, tax regimes and domestic yield curves, they must also weigh the demand side of the equation, which is surprisingly limited on some measures. For example, of the more than 900 inflation-linked bond funds in the Lipper database, only four are exclusively focused on emerging market inflation. They are: HSBC MIF Emerging Inflation-Linked Bonds HC US dollar fund, HSBC Emerging Markets Inflation-Linked Bond A fund, the Julius Baer BF Emerging Markets Inflation-linked US dollar fund, and the Aviva fund mentioned above, all of which have been regular supporters of the LatAm market.
“The credibility of the Latin America market has risen exponentially, and that has led to the creation of smooth yield curves, at least on the government side”
“There is no doubt on the government side that LatAm countries outside of Argentina, have taken enormous steps making the right structural reforms towards controlling inflation and to becoming high quality issuers of inflation-linked bonds,” said Julien Renoncourt, deputy head of fixed income at HSBC Global Asset Management in Paris. “The credibility of the Latin America market has risen exponentially, and that has led to the creation of smooth yield curves, at least on the government side. On the corporate side, however, there is still a reliance on the dollar-denominated market and I think we will have to wait a bit longer before we start to see more [offshore] inflation issuance in the local currency.”
Tax is also a critical issue for investors, particularly in Brazil, where international buyers since October 2010 have had to pay a 6% IOF tax on local fixed income securities.
“For foreign investors it’s a matter or working out whether it’s better to invest onshore and pay the 6% tax, albeit at a higher yield, or offshore and don’t pay the tax,” said Aviva’s Curtis. “This will often be a factor of the loss of yield on offshore versus onshore, versus the additional flexibility on the offshore and the holding period you are considering – for onshore you need to hold for longer to offset the 6% upfront tax.”
Another consideration for investors is the widespread absence of corporate linkers from benchmark indices, such as the JP Morgan Corporate Emerging Markets Bond Index. However, overriding such concerns is the central and key consideration of the potential payoff, and in early 2012 the outlook for LatAm inflation is a matter of some debate.
“One of the reasons we have seen restricted linker issuance is that the outlook for inflation in Latin America is extremely uncertain,” said Thierry Apoteker, chief economist at Britanny-based risk consultancy TAC Financial. “Part of the reason for that is that swings in commodity prices since the financial crisis have been so unpredictable, particularly in food which is a major component of LatAm indices.”
The inflation picture across LatAm countries is also highly differentiated, Apoteker said, driven by varying levels of productive efficiency, with countries like Peru and Mexico posting a relatively insignificant output gap, compared with Brazil, and at the other extreme Argentina, where booming economic growth has led to record levels of inflation, and a debate between the government and its critics over the credibility of its inflation index.
“Argentina has some issues with its inflation readings, in comparison to the rest of LatAm, where governments have largely committed to credible inflation-targeting,” Apoteker said. “Still, there are signs that liquidity expansion and rate cuts are beginning to raise some red flags.”
Brazilian policy makers made clear in recent weeks that a battery of interest rate reductions launched mid-year 2011 is unlikely to end anytime soon. The central bank has trimmed the benchmark overnight Selic rate four times since August to 10.5%, amid concern over the impact of the global economic slowdown.
The rate cuts have boosted demand for sovereign inflation-linked securities, and may be the catalyst for increased enthusiasm among corporates to test the waters.
“Energy producers as well as corporates in other sectors are motivated to try to build liquidity in the inflation-linked-bonds markets, and given the volume of issuance we have seen from sovereigns so far over the last couple of years, it would make sense for these corporates to do the same,” said Roberto D’Avola, head of Latin America debt capital markets at JP Morgan.
To view the digital version of this report, please click here.