Share the article
twitter-iconcopy-link-iconprint-icon
share-icon
AmericasMarch 5 2007

Foraging for yield from scarce sovereign bonds

Despite Latin America’s buoyant economy, external sovereign issuance from the region will be limited this year – hence investors are focusing on local currency bonds to obtain better yields. Kathryn Tully examines the risks involved.
Share the article
twitter-iconcopy-link-iconprint-icon
share-icon

It is hard to believe that just five years ago, Argentina defaulted on $81.8bn of debt. A year is a long time in the capital markets, let alone five years, but the reversal of fortunes for sovereigns in Latin America is dramatic by anyone’s standards. New inflows from dedicated emerging market funds are increasing all the time, some governments are running fiscal surpluses so have little need for much bond funding at all, and those that do are switching bond issuance to local currency markets.

Last year, there was $24.9bn of new external sovereign debt from the region, this year there is likely to be $11.6bn, less than half. As $5.7bn has been completed for the year already, that process is well advanced. Colombia, for example, has already completed its external funding for 2007.

Hunt for yield

Spreads on outstanding external bonds held by governments have mostly compressed to such levels that they scarcely resemble an emerging market asset class at all. JPMorgan’s EMBI Global index of external debt posted returns of just 6.5% in 2006 and overall EMBIG returns fell for the first time in five years to 8.5%. Investors are still scrambling to get hold of external sovereign bonds because of the diminishing supply, yet the hunt for yield is focusing investor attention on local currency government bonds, and beyond that, the $22.7bn of new corporate issuance expected from the region this year.

The emergence of far more liquid local currency debt markets, better fiscal management and improved economic conditions in the region is not great news for banks that formerly cashed in by underwriting reams of government external debt, although there are still juicy mandates for reprofiling sovereign liabilities. These factors all point to the fact, however, that Latin American economies could be out of the woods at last. The sustainability of that recovery looks more likely now than it has done for a long time. That does not mean that investors cannot get their fingers burnt, but the risks have changed.

More stable markets

The fact that sovereigns in the region have cut back their hard currency external debt drastically and substituted it with local currency debt makes local financial markets look much more stable than they did a few years ago. “If you look at Brazil, its total debt hasn’t changed much but debt relative to GDP [gross domestic product] has fallen a lot as the economy has grown and much more of it is denominated in reais,” says Michael Dooley, a professor at the University of Santa Cruz California, who formerly worked as a senior adviser in global markets and consultant to emerging market hedge funds at Deutsche Bank and prior to that at the IMF. He is now partner and head of research at Cabezon Capital in San Francisco, which launched Bretton Woods II, a new global macro emerging markets fund last July.

“The big threat that some financial upset could lead to the depreciation of the currency and therefore make the domestic currency value of dollar debt go up, which has contributed to the whole series of financial panics in Latin America for the last 30 years, is just not there,” says Mr Dooley. The fact that there are foreign investors in local dollar and local currency bonds and domestic investors holding external dollar paper has hastened this structural shift.

Fiscal deficits

However, most of the region’s countries are still running overall fiscal deficits, so have a need to issue more local paper; and there is no shortage of investors wanting local currency government debt. There is now a diversified and deep pool of investors in those local currency instruments from inside and outside each country.

“We saw very little interest from foreign investors in local markets two years ago, but in 2006, 30% of the new inflow from dedicated emerging market funds went into local markets and this year that could be 40%,” says Luis Oganes, managing director at JPMorgan emerging markets research.

Given the spread compression on external sovereign debt, local markets offer a more attractive yield (JPMorgan’s GBI-EM global index returned 7% for local currencies in 2006) and the extent of foreign demand for local currency product has led some countries to launch global bonds denominated in local currencies.

cp/14/pSchoenMichael.jpg
“You’ve seen Brazil and Colombia do global offerings in local currencies,” says Michael Schoen, managing director and head of Latin America debt capital markets at Credit Suisse. “I think Brazil and Colombia are likely to continue to develop their global real and Colombian peso curves.”

 

However, many investors have just surfed the wave of currency appreciation across the region for the past two years. Mr Oganes says that appreciation can no longer be taken for granted, so investors need to be more selective in their search for yield. “Weak commodity prices could cause potential repercussions for the region’s local currencies this year. Argentina and Brazil aren’t so exposed, so we recommend that investors position themselves in local currency accounts in both,” he says. On the other hand, he thinks that there could be more depreciation in Colombia, Chile and Peru.

The strategy of Cabezon Capital’s Bretton Woods II fund is to invest in the Bretton Woods II framework of building export economies: the strategy of keeping an undervalued exchange rate and creating a competitive export environment in order to grow the economy, pay down foreign currency debt and build up reserves. It monitors the currency and inflation backdrop across the region, and looks for discrepancies between government and central bank decisions and what the market is pricing into local bonds, equities and currencies.

It likes to focus on five to six directional trades, which offer a real rate of return, rather than just carry. It did well buying Argentina’s domestic inflation-linked peso debt last year, issued after the country was aggressively buying dollars and selling pesos to keep the currency depreciated and to build up its hard currency reserves.

The fund has also invested in Argentina’s federal guaranteed bonds (Bogars) when the bonds were trading cheap to the curve and it was not clear that the government was going to guarantee them. Since the government agreed to guarantee the bonds, they have appreciated considerably.

Argentina’s creditors

Of any country, Argentina has the least impetus to tap the external capital markets again in the near future. It still has $6.5bn of Paris Club debt to restructure, and there are also the numerous investors who have not participated in the restructurings to date and who are still holding out for cash. While it still has creditors, among them many distressed debt funds, looking to make a claim as soon as the sovereign ventures back to the capital markets, new external issuance is a less than appealing prospect. Nevertheless, hedge funds are still buying up Argentina’s unrestructured debt. “Ultimately, the government will have to address it,” says one emerging markets hedge fund player.

Ecuadorian jitters

There are potential hot spots across the region this year that could upset external debt investors, too. First up is Ecuador, although fears that new leftist president Rafael Correa, who was elected last November, would not pay the next $135m coupon on the country’s 2030 global dollar bonds due on February 15 proved groundless in the end. But the prospect of a restructuring still looms. In the run up to the election, he said he was averse to servicing external debt and was going to undertake an audit to uncover any “illegitimate” obligations.

Mr Oganes says: “I take [Mr Correa] pretty seriously when he says he’s going to force a restructuring. In my view, he won’t default outright; he will offer a deal that will cause considerable disadvantages to the holders of the debt.”

By the end of January, Ecuador’s 10% 2030 benchmark dollar bonds had gained much ground to trade at around $0.80 in the dollar after the new government suggested that it wanted to be friendly to creditors and renegotiate its debt. However, the jury is still out on what a friendly renegotiation will look like and the situation looked a little less convivial when Moody’s downgraded Ecuador’s foreign currency government bond rating and its foreign currency country bond ceiling immediately afterwards to Caa2 with a negative outlook from Caa1 with a stable outlook. Its local currency deposits were also downgraded from Caa1 to Caa2 with a negative outlook.

Yet this is unlikely to cause any contagion for bondholders in the rest of the region. After all, 2006 was a year packed with political change and elections held throughout the region had little or no impact on bond spreads. “Last year and this, there have been plenty of political or economic events that could have thrown things off, so I think it is becoming evident that you would need some more fundamental change outside the emerging markets to really hurt spreads,” says Mr Schoen.

Investors seem to agree. “If US rates rise next year, that could make people start questioning their emerging market portfolios, but the balance sheets of these governments are so much stronger that any crisis will be briefer and they’ll be much more differentiation among countries,” says Dr Dooley.

Sovereign value

Stomaching any sort of emerging market risk when investors are getting paid such a miserable amount for holding external debt from Latin American sovereigns seems unpalatable, but some bankers think there are still opportunities to be had in this market. “It’s hard for spreads to come in any further from where they are but, still, these markets offer some value in my view,” says Marcelo Delmar, head of Latin American debt capital markets at UBS.

JPMorgan’s emerging market analysts are advising that investors buy into sovereign dollar external debt where they can because it is becoming more scarce and the EMBIG index is predicted to tighten another 150 basis points this year. Given the prevailing view that several governments will continue to reprofile their existing external debt, paying off expensive pieces of paper and extending maturities, there could be other opportunities to profit. Brazil has declared that it has not got any new issuance plans for 2007 but that the government intends to continue liability management transactions and extend the duration of its debt.

Bright spot

This is clearly a bright spot in the sovereign world for Latin America-focused debt capital markets teams. Uruguay recently closed its debt reprofiling in November 2006 with Citigroup, Morgan Stanley and UBS as dealer managers. The sovereign launched a cash tender and series of exchange offers to reduce its dollar debt, extend its maturity profile from 8.7 years to 13.2 years and enable it to follow the lead of Brazil and Argentina in paying off its more expensive $1.08bn of debt to the IMF ahead of schedule. Mr Oganes thinks that Peru, Colombia, Mexico and Venezuela are all likely to pursue liability management transactions and debt buy back trades this year.

The issuance of sovereign debt warrants also continued last year. Last March, Mexico completed its second offering of debt exchange warrants, lead managed by Credit Suisse and Goldman Sachs. Following a similar transaction involving outstanding dollar bonds, the new warrants entitled investors to exchange a market value of E600m of Mexico’s euro and old European legacy currency global bonds for peso-denominated MBonos, allowing buyers to take a directional view on Mexican rates and take advantage of spread compression between Mexican peso and euro rates.

It was another way in which Mexico could reduce its foreign currency debt load and increase its local bond issuance, yet it is a strategy that may be less compelling to other governments in the region than straight cash bond exchanges and tenders. “Mexico’s debt exchange warrants deal last year worked very well and it has said that it is continuing to look at the product within its future funding plans. But selling options is not something that every government is going to be comfortable doing because some want certainty over the ongoing costs,” says Mr Schoen.

Great expectations

At the moment, it seems that Latin America’s governments are the ones calling the shots. With investor demand for Latin American debt outweighing supply and its economies in growth mode, perhaps the biggest cause for concern is that the performance of the region’s economies are not matching expectations – or that they are performing far too well.

There is cause for concern over inflationary pressures in Argentina and high interest rates in Brazil mean that economic growth is still weak. There may not be the potential for a region-wide financial meltdown as there was in 2001, but macroeconomic and political risks are still prevalent.

It might be good idea for the fund managers pushing new money into Latin America to remember that.

cp/14/pchartp68.jpg

Was this article helpful?

Thank you for your feedback!