Coming out of hibernation

IFR LatAm Special Report 2012
8 min read

Latin America offshore local currency may see a revival shortly – based on the conviction that there is renewed appetite for risk and yield.

After having been pronounced dead, the LatAm offshore local currency bond market may soon be revived, bankers and investors are betting. The belief is based on the renewed appetite for risk and yield seen in the market since the beginning of 2012 and as volatility returns to levels seen prior to the downgrade of the US by S&P.

At the same time, the few global local currency bonds issued last year, which had suffered severely during the roller-coaster of the second half of 2011, are back above reoffer.

One such example is the five-year bond issued by Brasil Telecom on September 15 2011. That was the largest and the last global corporate Reg S/144a bond denominated in Reais. Hence, it also hit hardest by the volatility seen late last year as a result of the euro crisis and the US downgrade.

Priced with one of the tightest coupons ever for an offshore Brazilian Real-denominated bond, the 9.75% note was sold originally at 99.516 to yield 9.875%. It touched a low of 95.00 at one point but in mid-February was being quoted again at 99.65.

It’s a similar story for the five-year 10.25% Real-denominated global bond issued by Banco Safra in August at par. It was nearing 101.00 in February. The five-year issued by Arcos Dorados in July 2011 was doing even better, trading in February US$3 above reoffer quoted at 103.00.

With the secondary market improving, investors are no longer feeling burnt as they did late last year, when the idea of a new global local currency bond sounded outrageous to any credit committee. Besides that, the local currencies in LatAm are nearing the stronger levels they enjoyed early last year before market instability increased.

“They [investors] want the foreign currency exposure, especially now that Bernanke has signalled that he wants a weaker dollar,” said a portfolio manager in the UK.

Still, the memory of significant losses because of a sudden spike in volatility remains fresh in investor memories.

To make matters worse, the spike in volatility seen last year skewed the models that funds use to evaluate potential return on these bonds. An EM fund manager in London explains that volatility is one of the key factors used to analyse risk premiums on local currency global bonds.

With the secondary market improving, investors are no longer feeling burnt as they did late last year, when the idea of a new global local currency bond sounded outrageous to any credit committee

Basically, she explains, a return model on an offshore local currency bond has to add the currency risk to all the other normal fixed-income variables. To determine what kind of premium a currency warrants, she said, investors use volatility to determine a potential band of variation and see what kind of yield carry will mitigate potential losses.

Until July last year, that was not such a tough task. Most of the EM currencies had maintained a very low level of volatility, between January 2009 and July 2011. For instance, the OHLC volatility in the Brazilian Real remained below 20 most of the time. In October last year, that measure touched 40.

If the historical numbers – which are key to calculate premiums – are still skewed by the spike, the good news is that volatility has subsided significantly (see chart). In mid-February, the Real was safely trading with a 10.6 OHLC volatility. The way we are going, said a portfolio manager for a large fund in the New York area, “give it a month before it comes back”.

The LatAm currencies have also been on a clear appreciation trend (see charts), which could translate into additional returns on offshore local currency bonds.

Volatility apart, investors still have the same incentives they had before to invest in offshore local currency bonds from Latin America. “The dollar is toast sooner or later,” said a portfolio manager for a large fund in London.

Another portfolio manager in the West Coast of the US concurred, saying that at some point investors will have to turn their eyes to EM currency assets again. He noted that the US government has no reason to allow the dollar to appreciate, not to mention that yields there are at historical lows. No one wants to invest in Europe, and China is still dogged by corporate governance issues. The alternative is EM bonds and if they have some added currency yield, so much the better.

Hurdles ahead

But even if the stage seems set for the return of the offshore local currency bonds, there still are some big hurdles that have to be overcome. Even though there has been a decent number of corporate Brazilian Real-denominated bonds last year, it is hard to assess what kind of demand or pricing a new deal would command.

To have that sense a bit clearer, bankers say, it would be necessary for the sovereign to step in first. Indeed, the last time the offshore Real bond market reopened for corporates was after a successful retap by Brazil. There have been rumours for a long time that the sovereign would return to that market. “Brazil will start all over again this year with issuance of offshore Reais,” said the London portfolio manager. But that prediction is yet to be fulfilled.

Furthermore, there are the twin problems of volatility and liquidity. For most funds, investing in offshore local currency bonds is an off-index bet. That means that they are using the very small portion of their portfolios that they can fiddle with to increase overall returns and beat their benchmark. But whenever these bets go sour, they underperform the index.

And some that placed their wager on local currency bonds endured just that last year. “The big sell-off in August and September really rattled the market and EM currencies took a big hit,” said Robert O Abad, senior analyst at Western Asset Management Co.

He adds that while funds have been putting cash to work, trying to make up for having underperformed some indices last year, not all of the new issues have been well-received. Some of the riskier stuff has been given the cold shoulder altogether. “The next test is the local currency of corporate [bonds] kick in and I would argue that is even harder.”

He adds that, while the Greek problem may have come to a temporary solution, with elections in France and the US, volatility is hardly something of the past. “Volatility is the Achilles heel of the offshore local currency market,” he said. On top of that, he said, investors were reminded how important it is to have liquid assets when the market turns south. And offshore local currency bonds are notably illiquid.

And yet, even Abad concedes that it is just a matter of time before the offshore local currency market returns in full force. “I think it is going to be the next generation asset class but you need to pass this period of these global imbalances.”

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Coming out of hibernation
A shopkeeper arranges her bottles of perfumes and oil made from fruits and plants that grow in the A
Coming out of hibernation graph 1