Borrowers: Borrowers start to play a strategic game
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.
The market correction also slowed the frantic pace of new issuance. Following on from the $50 billion issued last year, 1997 had begun by setting an all-time record for new issues, with paper worth more than $12 billion coming to market in only eight weeks. Spreads were extremely tight and many issuers will find it hard to achieve such fine pricing during the rest of 1997.
In January, Argentine blue-chip Perez Companc sold $250 million of seven-year Eurobonds at a launch spread of 252 basis points over treasuries, in a deal led by Morgan Stanley. A few days later Venezuelan telephone company CANTV was in the yankee bond market, offering $100 million of five-year bonds and $100 million of seven-year bonds, both at spreads of 285bp. The CANTV deal was led by Chase.
In January and February some very large sovereign deals also came to market. The Republic of Colombia sold paper worth a billion dollars in two tranches – offering $750 million of 10-year notes carrying a spread of 130bp, and $250 million of 30-year bonds launched at a spread of 170bp – in a deal joint-lead-managed by Merrill Lynch and JP Morgan. And during January and February the Republic of Argentina also came to market several times, with issues in Deutschmarks and pesetas as well as a dollar global bond.
Hines at JP Morgan notes that the Colombian sovereign paper was quickly snapped up by traditional dedicated emerging markets investors and crossover players, such as insurance companies and mutual funds looking for investment-grade paper. And the Republic of Argentina global offering, also joint led by JP Morgan and Merrill Lynch, was also notable for the large number of crossover investors that came in on the deal. Many of these have an appetite for longer-tenor paper – such was the demand that a planned five-year tranche was cancelled and the entire $1 billion global offering was made at the 20-year tenor.
After the breakneck pace of January and February the new-issue market has slowed, but there has still been a steady flow of paper onto the market, with names such as Banco Itau of Brazil, Raghsa Construcciones of Argentina and the City of Buenos Aires all accessing the market. And offerings are expected from CESP of Brazil, Parmalat Brasil, Cementos Lima of Peru, and Petrozuata and Telcel of Venezuela.
How new-issue spreads will play out over the next six months is a matter of debate and, in the case of Argentina, the picture has been further confused by the surprise move in late April by rating agency Standard & Poor’s to upgrade a number of names to above the sovereign level of the Republic of Argentina.
The rationale cited by S&P was that it was re-evaluating risk in dollarized economies, where it argues that sovereign credit risk is now less of a factor affecting the ratings of private-sector issuers. “In countries such as Argentina, where the US dollar has replaced the local currency as the main vehicle for savings and investment, Standard & Poor’s believes that there is less likelihood that the sovereign would impose exchange controls on debt of private-sector borrowers,” S&P said in a recent report.
Essentially the argument is that the distinction between dollar-denominated debt and local currency-denominated debt is negligible, allowing S&P to raise a number of corporate credits one or two notches above the Republic of Argentina’s own BB rating. S&P announced that it was immediately raising to investment grade the ratings of 13 names that had all been previously rated BB. These included Perez Companc, Transportadora del Gas del Sur, YPF, Banco Rio and Banco Frances, all of whose existing paper traded up by between 30bp and 70bp immediately after the announcement.
“A huge can of worms”
The move caught the market by surprise and many analysts have questioned its logic. Arturo Porzecanski, chief economist for Latin America at ING Barings in New York, argues that the use of dollarization to determine creditworthiness should be applied first to the sovereign, and not to corporates alone. And he adds that it is awkward that S&P has rated some commercial banks higher than the central bank, even though the banks operate under the aegis of the monetary authority – which he notes is true in most countries, dollarized or not. Anne Milne, head of corporate debt research at ING Barings, says that although several of the companies deserve an investment-grade rating on the basis of foreign revenues or strong support from a foreign shareholder, the upgrades of some of them are “hard to defend on the basis of various criteria traditionally observed by S&P”.
“Very few people in the market have bought into S&P’s rationale for the upgrade” is a typical comment from the investment banking community on the initiative. The same banker adds: “I think they have opened a huge can of worms.”
Investment bankers now face the challenge of persuading investors to accept these upgraded Argentine names as true investment-grade credits. They are also faced with chief financial officers hoping to sell paper at spreads of under 200bp to US investment-grade accounts such as insurers, pension funds and high-grade mutual funds. “There are some crazy proposals around,” says one underwriter, who is waiting for a few deals to get done as a way of testing the water. The S&P move has also caused uncertainty in the secondary markets. “People are still trying to absorb S&P’s rationale and what that might mean in terms of potential upgrades in other countries,” he says.
Widening pool
But even if they take issue with S&P’s rationale, bankers and analysts are obviously happy to see some more Latin credits upgraded to investment grade, as it helps widen the potential investor pool. Colombia and Chile have reaped the benefits of standing apart as investment-grade Latin issuers, and Chile in particular has pulled away from the pack to establish itself as a unique Latin American entity, selling into its own pool of investors. Chile is rated single-A, and its top corporate names are currently able to raise financing at extremely fine spreads – usually less than 100bp compared with between 200bp and 300bp for comparable names in Argentina (before the S&P ratings initiative) and between 350bp and 450bp for Mexican credits.
The key to Chile’s success has been to sell its paper into an entirely distinct set of accounts in the US – with the yankee market being where nearly all Chilean corporates choose to issue. This may cause some jealousy elsewhere in the region, but in fact it benefits issuers from other Latin American countries as well. Competition for capital in the high-yield market will become more intense over the next few years, but billions of dollars of paper from the region are now being absorbed by a totally different pool of investors, creating space in traditional emerging markets accounts for paper from lesser credits.
In effect, below-investment-grade credits from Latin America no longer have to compete in the new-issue pipeline with Chilean corporates, or with names such as Banco Rio or Perez Companc. With over $3 billion in yankee bonds sold by Chilean corporates since the first deal for Celulosa Arauco in December 1995, a sizeable amount of borrowing requirement has been removed from the pipeline of new issues being sold to traditional emerging markets investors.
Chilean electricity utilities have been particularly quick to take advantage of their access to investment-grade investors, at a time when they are not only expanding in their domestic market but also making acquisitions around the region in such countries as Argentina, Brazil and Colombia.
Acquisition finance was part of the reason why Enersis entered the yankee market last November, when it came out with a $500 million offering that was bumped up to $800 million on the back of enthusiastic demand from US instititions. The 20-year tranche in the deal, led by JP Morgan, was at that time the longest tenor seen for any Latin American private-sector credit, illustrating the appetite for longer-tenor paper among investment-grade accounts. And the spreads of 82bp on the 10-year, and 100bp for the 20-year, were the tighest yet seen out of the region.
Enersis CFO Juan Dominguez explained at the time that over half the buyers were new to Chilean paper – an important point since the company wants to broaden the spectrum of its investors. Insurers, pension funds, and investment-grade mutual fund accounts were all big buyers of the paper.
In January, Chilean electricity utility Endesa followed in the footsteps of Enersis, coming to the yankee market with a $650 million offering in three tranches, in a deal led by Chase. It included a $200 million tranche of 100-year bonds, the first ever out of Latin America. The selling of this century bond was a milestone for the market, and has confirmed Chilean corporates as being in a league of their own among Latin borrowers.
Just as Chilean corporates are helping to broaden the investor base for Latin paper, so the growth of Latin securitization is helping to reach a wider and deeper pool of capital. Latin American corporates are turning in increasing numbers to the asset-backed market in order to raise capital, with securitization receiving a boost from the Mexican peso crisis. In its wake, some Latin names were forced to look at securitization techniques as the only way they could raise capital.
Valuable addition
Last year asset-backed issuance from the region grew rapidly, with around $3.4 billion of paper sold, excluding the $6 billion refinancing done by the United Mexican States, which was backed by oil receivables.
The pool of sophisticated US institutional investors buying into these deals, which are mostly done as private placements, is relatively small, but appetite for paper is strong. Investment bankers do not consider investor demand to be an inhibiting factor in the growth of the Latin asset-backed market.
Bankers Trust has done deals involving credit-card receivables, wire-transfer receivables and telephone receivables. Last year it closed a securitization of the proceeds from future sales of autoparts, involving a Mexican company exporting to the US.
And in early May, Minera Yanacocha, a large Peruvian gold-mining company, successfully sold $100 million of notes backed by future receivables, in a deal led by Salomon Brothers. The seven-year notes were sold to US institutional investors via the 144A market, and achieved a pricing of only 185bp over the five-year treasury bond. The asset-backed notes were rated BBB minus by S&P and the offering met with an enthusiastic response.
Bankers say that an annual $3 billion or $4 billion of securitization deals will be a valuable addition to the investor base for Latin corporates and financial-sector issuers, and will help take the strain off the unsecured debt market. Similarly they note that big sovereign issuers such as Mexico and Argentina will probably be issuing less paper in the coming two years, helping to ease the crowding-out effect that sovereign paper can have on corporates.
In the case of Argentina an important development is its move towards more domestic issuance to complement its foreign debt. In early May it held a $750 million auction of Bontes – dollar-denominated domestic bonds – which was well received. “It looks, smells and feels like the five-year global, but is governed by Argentine law,” says one banker. And with Argentina now having a better organized treasury bond market, he says that “they are going to be looking to the external markets for a decreasing amount of their funding”.
“The refunding requirements for the sovereigns in general are levelling off,” the banker says, “and from a liability management perspective they are reducing strategically their reliance upon the external markets. That is a function of beginning to have a real savings rate in Argentina,” he says. Mexico, though, he points out, is lagging behind in developing its internal savings rate.
With sovereign issuance likely to drop off slightly, and with more corporate names coming to market, corporate issuance will take up a bigger proportion of issuance over the next few years. In 1996 two-thirds of the total $50 billion issuance from Latin America was from sovereigns, with corporates accounting for 22%. The remaining 10% was issued by banks and other financial institutions.
In 1996, two-thirds of new issuance was dollar-denominated. Dollar issuance is expected to increase, since corporates play a more important role in that market – currencies such as the yen and Deutschmark have traditionally been seen as favouring sovereign issuers. “I think that the amount of dollar-denominated issuance is likely to continue to increase as we see a shift away from sovereign borrowers and a greater emphasis on the private sector,” says Gilfond at Salomon. “As the percentage of borrowing that is done by the private sector grows, so will the percentage of borrowing that takes place in US dollars.”
Corporates will, however, continue to access other currencies on an opportunistic basis, as was illustrated this year by the high level of activity in the Italian lira market. Pricing in Italian lira bonds is attractive, as bond yields in Italy have converged with other European countries ahead of European monetary and economic union, and Latin borrowers have been quick to take advantage of this.
In January Brazilian development bank BNDES issued L500 billion ($297 million) of five-year bonds in an offering led by Credito Italiano. This was followed in February by the United Mexican States, which also came to market with a L500 billion offering led by Chase. In March Perez Companc went to the lira, raising L300 billion in a deal also led by Chase. And in April Pemex came to the market, with a L350 billion transaction led by JP Morgan. More lira deals would probably have been completed were it not Italian monetary authority rules restricting issues – normally to two a month – a situation that has led to a queue forming for Eurolira offerings.
There have also been a number of peseta deals in 1997, featuring the Republic of Argentina and Citicorp Equity Investors, also out of Argentina. And there has been a small amount of yen issuance, most notably the ¥500 billion ($4.2 billion) offering for the United Mexican States led by Daiwa.
Brazil worry
The Deutschmark sector has been much busier, with offerings by such names as the Republic of Brazil, United Mexican States and the Republic of Argentina. The Deutschmark sector has traditionally been driven by a search for attractive yields rather than concerns about credit quality, and over the past couple of years issuers from such countries as Venezuela have found willing buyers among the predominantly retail investor base.
But in the US institutional market investors are more sophisticated, and credit analysis of issuers is becoming much more intense, including research at company as well as sovereign level. For this reason Brazil remains a potential problem for the Latin bond market, since its current account deficit is a worrisome factor for many holders of Latin debt.
This deficit is now running at around $30 billion annualized, 4% of Brazil’s GDP. The government has responded with regulations to tighten up import-financing rules, but analysts see too little progress towards longer-term solutions of boosting domestic savings and export capacity. Even the vast privatization programme, including the sale in April of mining conglomerate Companhia Vale do Rio Doce, cannot solve fiscal and external imbalances of a structural nature.
The future progress of the Brazilian economy is of great concern to the market, since it is Brazilian corporates that make up the most promising sector for new names to tap the international debt markets. Walter Stoeppelwerth, analyst at Robert Fleming in Sao Paulo, points out that “the Argentine companies already know and love the international debt markets, but the real increase you are going to see in issuance is from Brazilian companies”.
Stoeppelwerth continues: “The first stage will be swapping expensive local debt for longer-term and cheaper foreign debt,” and this will be followed by raising debt for large expansion projects. Names expected to come to market this year include electricity utilities Cesp and Electropaulo and, such is the size of many Brazilian corporates, that many of them will be looking at initiating large borrowing programmes of $500 million and upwards.
These corporates represent the biggest potential for growth in Latin bond market, and bankers will be watching Brazil closely during 1997 for signs that capital inflows into Latin America can be sustained.
