Borrowers: Bring on the corporates

Latin American corporate bond issuance is on the upturn, with a long list of first-time issuers looking towards international capital markets for funding. Bankers expect that over the next 18 months corporate credits will come to constitute a bigger proportion of overall Latin bond issuance, moving closer in market share to the sovereign credits and financial institutions that are now dominant.

There are several reasons for the new emphasis on corporate borrowers. Many Latin American companies are underleveraged and can afford to take on new debt as they pursue expansion strategies. In addition, the wave of privatization across the region is creating new private-sector names that will soon be coming to market. Then there is the fact that market access has been established - the sovereign borrowers, banks and blue-chip corporates that have come to market thus far have helped establish Latin paper as an asset class, paving the way for the next generation of corporate issuers to tap into the same pool of investors.

Those investors bought Latin bonds in record amounts during 1996, when new issues worth more than $50 billion came to market, more than double the previous record set in 1993. And bankers point to a growing appetite for Latin paper and a depth and sophistication in the marketplace that should mean similar levels of new issues will be absorbed over the next two years.

There is one cloud on the horizon for corporates with plans to tap the market: the extreme sensitivity of emerging markets bonds to US interest rates. Some analysts expect there will be successive interest rate tightenings by the US Federal Reserve, following a move at the Federal Open Markets Committee meeting in March to raise short-term interest rates.

The belief that a rising interest rate trend is under way is inevitably reviving memories of 1994, when moves by the Fed to raise interest rates led to a panic sell-off in emerging markets paper, adversely affecting new-issue activity in the 10 months running up to the Mexican peso crisis in December of that year.

The emerging markets corporate debt market is seen as particularly sensitive to US interest rate rises compared, for example, with the US high-yield market. This is because emerging markets corporates have issued a lot of US dollar debt in short maturities, with two-thirds of the issuance at tenors of five years or less. The underlying sovereign risk for corporate issuers also intensifies as US interest rates are increased. Countries with heavy external debt burdens, large current account deficits and fixed exchange rates are particularly sensitive, for example, Argentina and Brazil.

Cooler money

In addition, higher interest rates in the US will persuade many investors that they should stay at home rather than move into new asset classes in search of yield, a quest that has been one of the driving forces behind the market over the past two years.

Investors may be wary of the current US interest rate outlook, but there is also some confidence that even if rates rise things will be different this time around. First, the optimists point out that the 1994 Fed move took investors by surprise, whereas today the market is highly sensitized to the possibility of rate increases. And the investor base has changed, with less hot money deployed in highly aggressive trading strategies and more longer-term buy-and-hold type players in the market. Nonetheless, bankers do not foresee the same sort of smooth sailing this year as last, expecting difficult periods for new issuance. The message to Latin American chief financial officers is that they will need to be patient, monitor the markets closely, and be ready to move opportunistically to take advantage of conditions in various markets, tenors and currencies.

"The perceived composition of the holders of the market today versus February 1994 is that by and large the market has a whole lot less leverage in it, and that is one of the key drivers that spurred the big sell-off in 1994," says Chris Gilfond, vice-president in the Latin America capital markets group at Salomon Brothers in New York. He notes that the hedge funds were especially prominent in 1994. At that time many Latin American wholesale banks were also trading bonds very aggressively, whereas today they are much more conservative.

Gilfond points to a maturation of the marketplace since 1994. "Portfolio managers tend to maintain their allocations, and that money is much more stable money than the traditional emerging markets trading oriented accounts that had been the principal drivers pre-February 1994," he says. "The quality of the holdings for the sector at large is much better than we have seen for a long time, and the validity of the sector as a place where people want money allocated is going to hold, and you are not going to see people run for the hills if the Fed raises interest rates. We would expect the sensitivity of the marketpace to be considerably less than it was in 1994, though there will be dips and sell-offs."

Rachel Hines, managing director at JP Morgan in New York, adds: "We still have hedge funds that are highly leveraged, but they constitute a much smaller part of the overall market than in 1994."

Hines acknowledges that the sell-off in February encouraged some players to move out of bonds and hold more cash, but adds: "We have not seen the kind of client outflows that we saw in 1994." And though the market for new issues has had some difficult moments since late February, Hines says that "the market is ready for the right name, at the right price, at the right time".

Market correction

The late February sell-off began in Brady bonds, but quickly spread into corporate bonds. It ended an impressive year-long rally in emerging markets paper during which spreads had tightened to levels few would have predicted early in 1996. This rally was driven at the margin by many non-dedicated investors moving into Latin bonds, including Asian total-return investors that came into the market aggressively in the third and fourth quarters.