By Rob Dwyer
“The local market needs to step up now that the international market has closed,” says Rodrigo Gonzalez, head of DCM for the Americas at Standard Chartered Bank. “The local market has historically been a short-term but big market that has absorbed the majority of local needs. The question is, for all those corporates that have capex and longer-term financing – to what extent will the local market take over?”
| We are in a period of such volatility regarding interest rates and premium for specific risks that market participants are discussing what will be the right pricing for companies from now on|
The effective freeze-out of Brazilian issuers from the international markets since the corruption at Petrobras came to light, coupled with its inability to file audited 3Q2014 results, has shifted the focus on to Brazil’s local debt capital markets. According to Dealogic, Brazilian issuers placed 51 deals worth over $42 billion in the international markets in 2014, which is a lot of money to now be sourced in the local markets.
However, refinancing requirements this year are low and Petrobras, a $10 billion-plus annual issuer in the international markets, is unlikely to be raising any fresh funds for a while. With a recession forecast in 2015, many Brazilian companies will be rethinking their capex needs. Also, at some point the Petrobras issue will be resolved – one way or another – and Brazilian issuers will have access to the international markets again. So the actual amount to be absorbed is likely to be much less – some expect under $10 billion – and last year, according to Anbima, Brazil’s Financial Capital Markets Association, the local market’s fixed income volumes topped R$140 billion ($49 billion), of which debentures, the local bonds, were R$70.5 billion.
If Brazilian companies can, therefore, be optimistic about seeking the volumes they need from the local markets there is less good news about the tenors available. Brazil’s local debentures are structured much like loans. Banks fully underwrite the deals and therefore have to take paper onto their books if there is a lack of appetite from investors (there are very rare examples of ‘best-efforts’ arrangements). In the past many of these debentures weren’t at all distributed but were simply passed along to the asset management arm of the bank. Some still are, although this is rarer today. Tenors are short – averaging around five years, with 3.5 years the average life. Deals were getting longer when the Selic base rate was forced down a couple of years ago to 7.25% but as it has rebounded to 12.25% the lengths of debentures shortened.
In 2009 the Brazilian Securities Commission (CVM) launched Regulation 476, which is designed to speed up debt issuance in the local markets. The specifics changed recently, but the concept is that these deals can be marketed to a select number of investors (now 75) and sold to a sub-set of them (up to 50). Also, as opposed to the formal offering regulation (400) there is no need for prior notification or a deal prospectus given to the CVM – although 400 deals can be marketed and sold to an unlimited number of qualified investors (those with more than R$1 million in liquid assets). Also, with 476 deals, the bank can distribute to an unlimited number of investors through secondary distribution after 90 days.
The effect of 476 was to create a nimbler debt-raising tool for companies, which is particularly useful in times of volatility. This can impact on the longer 400 transactions. Leandro Miranda, head of investment banking at Bradesco BBI, says Brazil is in a 476 moment: “We still have huge liquidity, nevertheless we are in a period of such volatility regarding interest rates and premium for specific risks that market participants are discussing what will be the right pricing for companies from now on.”
The local markets are restricted to the strong investment-grade rated companies in normal times, and the contagion has spread from Petrobras to affect the local market (albeit to a much lesser extent than the international markets). But Miranda says he is working on a new Regulation 400 deal that will come to market in March and will re-establish a solid local benchmark, with which to reprice all local investment grade credits.
“We are about to experience a shift in the risk premium,” he says. “This will be a major transaction from one of the top Brazilian private companies that will bring everyone together, create momentum and fix the pricing issue. It will set a new benchmark that other private companies can use and from this point the market will pick up.”
Miranda believes that Brazil is close to an inflection point, with the barrage of bad news about to bottom out and the outlook set to take a more positive tone. Even if power and water rationing are introduced, he argues investors will shrug this off as “all the positive downsides are already priced in”. However, even if international investors – and many domestic investors – share this optimistic reading of the outlook for the Brazilian macro-economy they won’t be participating in this upcoming 400 transaction. Simply put, sovereign paper pays too well. With the base rate at 12.25% investors can pick up very high yields almost risk-free and so there is absolutely no incentive to add credit risk and pick up 100 or 200 basis points. Plus the sovereign investment is tax free.
“As a percentage of your base rate the credit spreads are quite compressed in Brazil,” says Felipe Weil Wilberg, head of fixed income, DCM and structured products at Itaú BBA. “If you then include the [15%] withholding tax that further disincentives the international investor, because they are taxed on the whole coupon not the corporate spread – so for example, if the sovereign rate is 13% and you get 2% credit pick-up from a company then you are taxed on 15% – and the 13% would have been tax-free.”
|Rodrigo Gonzalez, |
Standard Chartered Bank
“There is regulatory risk in Brazil,” says one portfolio manager at a large institutional investor. “The temporary imposition of the IOF has cost them long-term and embedded premium into Brazilian bonds, just in case it is reintroduced again in the future. I can’t tell you if it’s 10bp or 100bp and it’s embedded with the bureaucratic costs of Brazil being a more regulated market.”
There is also potential currency risk with Brazil – whereas all the other Latin American currencies appear to have reached fair value after the recent sell-off, there are many predictions that the real will depreciate further against the dollar – meaning that international investors could lose out significantly in hard currency terms. And the perennial local market risk of liquidity applies just as much in Brazil as it does elsewhere – non-sovereign deals just don’t provide the ability to unwind positions quickly enough, should an investor wish to reduce or exit a position.
The disincentive to take corporate credit risk also applies to Brazilian pension funds. With sovereign credits meeting their actuarial targets, why would they invest elsewhere? So the asset management industry, which is much bigger than the pension funds, will drive the pricing of the private debenture markets. It remains a market for the strong investment grade companies, thanks to investment rules that prevent institutional investors buying non-investment grade paper, which disincentivizes the acquisition of debentures issued by any companies near the threshold, for fear of a rating downgrade, leading to forced sales. Like much of Latin America – the buyside is almost exclusively buy-and-hold, which has limited the development of secondary trading.
|Local capital markets are a good buffer to the disruptions we're seeing and will likely continue to see in the external markets|
Chris Gilfond, Citi
However, in one area there is both secondary trading and tenor. Infrastructure debentures (those that qualify for tax-exemptions for individuals under Law 12341) have been booming as private banking customers have been filling up on these tax-efficient structures. Also, with infrastructure being one of the few industries in Brazil with a positive outlook, supply of this paper looks relatively safe. Pricing has also been surprising – in a January 2014 transaction for Vale the banks (Bradesco BBI, Banco do Brasil and Itaú BBA) built such high demand, with over 5000 individuals participating, that the R$1 billion deal was the first to be priced inside the onshore Brazilian Treasury curve. These transactions for private banking individuals look like a bright spot on the local markets.
The sheer size of the Brazilian market – both now and in the future – makes it an attractive one for the international banks. Fee levels, while not in line with the US, do reflect the firm commitment of the banks that support the transactions. This requires local balance sheet but many international firms have capitalized their local operations.
|Building out Latin America's bond markets|
According to Chris Gilfond, co-head of debt and equity capital markets origination for Latin America at Citi, the bank is very active on the local side, and sends out proposals weekly, with some industries – specifically the power industry (with expected increases in tariffs) looking like an active sector in the local markets in coming months. “The local capital markets are a good buffer to the disruptions we are seeing and will likely continue to see in the external markets,” says Gilfond.
Max Volkov, managing director of Latin America debt capital markets at Bank of America Merrill Lynch, says the bank has also committed balance sheet to its Brazilian subsidiary, which it uses strategically, rather than in direct competition with the local banks.
“We are present in the local debt market to the extent that we respond to wider opportunities than just local debentures,” he says. “For example, if there is an acquisition finance opportunity that requires take-outs in the external markets as well as the domestic markets then we would participate. Most of the time when you look at the levels of funding locally and externally, then local funding is usually cheaper. However, a local financing has constraints in terms of tenors and so if a company required a multi-pronged approach we would use that local activity to win the external business.”