Latin American credit research: Poor research poses risks to investors

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Investors are concerned that while low yields on Latin American sovereign debt and increasing opportunities in the corporate sector are driving more and more investors towards corporate fixed income, Wall Street credit research can’t keep up.

"Sell-side fixed-income research is not as adequate or as developed as equity research," says Jean-Dominique Bütikofer, head of emerging markets fixed income at Swiss asset manager Union Bancaire Privée. "Wall Street research on Latin American fixed income is quite limited and you really have to dig deep a lot of the time, either by going directly to the issuers to get the info or by asking for equity research. A lot of research is interpretation of ratings agencies’ comments, reports are flow-driven and there’s no guarantee of follow-up notes after the deal is launched. The level of research on corporate debt is similar to what was available on the sovereign side seven to 10 years ago."

Assessment skills needed

Elaborating on comments he made at a Euromoney/LatinFinance conference in New York in May, Bütikofer says that the investors flocking to invest in high-yielding corporate debt could face substantial risks if they lack the necessary credit assessment skills.

"We’ve seen Latin American-focused funds grow tremendously," says Will Landers, manager of BlackRock’s $5.2 billion MLIIF fund. "There’s lots of new money coming in and liquidity has improved. The thing to realize is that quantitative research alone simply is not going to work: you need qualitative work too, to meet company managers and understand their goals. Sell-side research gives you an idea of what the market thinks but we have never made a buy or sell decision based solely on what an analyst has said. If you’re not doing your own research you will most likely get caught out."

Latin funds have been performing strongly of late, and the MSCI Latin American Index shows a return of 28.2% for the year up to 30 April 2007. The consensus on the region remains broadly bullish, with Brazil in particular attracting a lot of attention.

A bargain market

"Latin America is still the best-priced, or you could say cheapest region in the world," says Landers, "and Brazil is perhaps the best emerging market to invest in. It is a large exporter of dollar goods, so the weak dollar is good for it, and as the banks increase their lending, credibility and credit affordability within the financial system, both improve. One notable improvement for equity investors is that corporates are increasing dividends: rather than keep cash on the balance sheet they’re paying it back, which also provides liquidity to the market."

The region is also much less isolated from the vicissitudes of the global markets than it once was. "I think you have to look outside Latin America for the biggest risks to the region." says Landers. "You need to watch Chinese growth rates, since their demand for commodities has obviously been a big factor in the Latin boom, and you should also keep an eye on the Fed’s moves in the US. As for political risk in Latin America, I don’t see much threat of a wave of Chávez-like leaders taking over. Look at what happened in Mexico, where the more market-friendly Calderón won a narrow victory, or look at Brazil. It’s almost more important to note that democracies are working in Latin America, that regardless of the result the systems are in place."

Despite these improvements, the strengthening currency and the possibility of Brazil finally achieving an investment-grade rating, the threat of a significant correction in any region experiencing such growth and such attention from the investment community remains. The downside of such a repricing could be exacerbated by weaker credits, according to John Cleary of London-based fund of funds Focus Capital.

Mismatch

"Investment banks have scaled back their research and the buy side are trying to recruit analysts in the emerging markets," he says. "There is a mismatch in the amount of experience available and the amount of issuance coming out... We think that there could be a big problem if the market reprices and that could hinder the recovery of the market."

Much of the difficulty stems from the fact that quality analysts are quickly snapped up by fund managers, and the present bull market has led to a certain degree of complacency. "Credit analysts are in hot demand, as fund managers study new opportunities," writes Walter Molano of BCP Securities. "The due diligence operation is no longer a jaunt around the company cafeteria. It requires a deep understanding and analysis of company operations."

Fund managers, of course, have an interest in downplaying the importance and reliability of mainstream Wall Street research since it is in the strength of their own independent analysis that they can claim to justify their fees. "I have 30 meetings with corporate executives next week, and 30 the week after," says Landers, "and going to these meetings, attending conferences and understanding these companies is where we can add value."