Brazil is lucky to have a relatively large, liquid and sophisticated capital market that last year supported nearly $30 billion in bond issuance. But it is cursed by the fact that the Treasury accounts for the overwhelming majority of issuance in an unstable market where long-term private sector securities rarely mature beyond two or three years. Investors are spoiled with high-yielding risk-free returns on government paper, so they largely ignore the stocks and bonds sold by private-sector issuers. The problem gets worse with every passing year as the public debt grows and interest rates remain in double digits. This dominance by the public sector affects the fixed income and the equity markets alike.
Large companies can always issue bonds in the international markets, but the costs are rising and there is a limit to how much Brazilian corporate debt foreign investors want to buy. In any case, the international markets are only available for substantial issues by big, well-known companies willing to tack on complicated credit enhancements.
Yet, given a little creativity, there is a lot that private-sector issuers can achieve on the local market. The government is trying to do its part by lowering taxes, keeping inflation and interest rates down while pushing ahead with economic reform. “We are planting the seeds of reform,” says Armínio Fraga, the central bank president. “What is needed is a sound macroeconomic environment of low interest rates and longer horizons and we are working on that.”
Eleazar de Carvalho, president of the government’s Banco Nacional de Desenvolvimento Economico e Social (BNDES) development bank, says the bank is pushing ahead with its plan to use the local capital markets to leverage its resources more effectively. Carvalho, a former investment banker (see “BNDES Seeks An Expanded Role,” page 20), says the bank’s 2002 budget is “R$35 billion and the aim is to leverage this 2.5 times by 2005 by using the market.” The idea is to reduce the bank’s direct involvement in a project and instead encourage banks and capital market participants to commit funds that would not otherwise have done so. BNDES is working to push out maturities on corporate debt issues, creating new equity instruments, and encouraging the creation of a secondary market in corporate debt.
The fixed income market consists almost exclusively of government securities, and most trading occurs in the private interbank market. The Treasury, Central Bank and market regulators are trying to improve transparency, modernize custody mechanisms and build a yield curve that stretches out to 30 years. The government now issues larger, more tradeable series of bonds than before to improve liquidity.
The Treasury’s gargantuan appetite for credit – it issued $23.55 billion in bonds last year – has crowded out private-sector borrowers and there is almost no secondary trading in corporate bonds. In fact, issuance and liquidity have fallen steadily since 1998 when companies sold 61 bonds worth $8.25 billion. Last year, companies sold 41 bonds for $6.42 billion. The international market has not been any more receptive. Last year, the weakest ever for Brazilian corporate bond issuance, companies raised only $2.09 billion with 18 international issues, worse than in 1998, the year of the Russian default and Brazil’s impending currency devaluation.
The equity market is well past its prime too (see “Staving Off Death”, page 22). It went into decline after 1997, when trading volume hit a record $157.6 billion. Volume slumped last year to $25.8 billion and the Ibovespa index stood at half its record 1997 level. Initial public offerings are few and far between – in February, CCR, a highway operator was the first company since May 2000 to launch an IPO. Delistings far outnumber new entrants to the market. Trading in Brazil’s blue-chip stocks has migrated to the New York Stock Exchange where nearly all of Brazil’s most liquid stocks are now listed in ADR form.
Still, the corporate sector and the authorities are doing what they can to revive the equity market. The government is breathing life into the once toothless securities watchdog, the Comissão de Valores Mobiliários (CVM). Congress approved last year a new company law that boosts the rights of minority shareholders who have had to put up with years of abuse (see “Tenders Take Center Stage,” page 24).
Private pension funds are growing to complement the nominal pensions available under the mandatory state-run Instituto Nacional de Seguridade Social (INSS) pension system. Private pension funds now have R$180 billion ($72 billion) under management and the Secretaria de Previdência Complementar, the private pension fund regulator, recently issued an instruction to fund managers requiring them to match their assets and liabilities more closely. Officials hope that this rule will create demand from institutional investors for longer-dated assets, from both the public and private sector issuers. They are exposed to large potential actuarial imbalances, given the long-term nature of their liabilities and the mainly short-term maturities of their assets.
Brazil’s corporate debt market is overwhelmingly short- and medium-term. For instance, in January, Cia. Siderúrgica Nacional (CSN), Latin America’s largest steelmaker, announced it would issue R$690 million ($289 million) in bonds in the local capital markets to refinance maturing debt. The bonds have maturities of two to three years.
Still, the authorities and market participants must overcome a number of obstacles before the capital markets can meet the needs of private-sector issuers that are deprived of local currency financing at reasonable maturities and affordable rates. Corporate debt is not available for less than about 21%-22% a year for a 30-month bond.
Illiquidity in the corporate bond market is a massive headache for finance directors. “The biggest problem [in the local capital market] is that there is no secondary market,” says Mauro Molchansky, executive director at Globopar, the financial arm of the Organizações Globo media empire. “When the markets change direction and you want to sell and you have to sell at a very great discount.”
One solution would be to encourage investment banks and brokerages to set themselves up as market makers. The president of CVM José Luiz Osório, who has a long career in investment banking, says the wide bid-offer spreads – known in the market as alligator spreads – should be a sufficient inducement to attract market makers. He says, “If there were less volatility, then someone would come in with $200 million to act as a market maker for a blue chip, which offers very good opportunities.” Private market makers could start by offering large spreads and reduce them as volumes and competition picked up.
Dry Market
However, this is easier said than done. Stefan Alexander, head of financial planning at Globopar, complains that, “The market is never stable for long enough to have a market maker. It never works, because the market suddenly dries up. At the beginning of 2000 and 2001 there was hope that this would start.”
This is true, but Osório says companies could still do more to help themselves. He says they should agree on standard documentation for their bonds. At present, he says, “Each debenture is different from the other. You cannot have a secondary market without having a standard contract.” BNDES, the largest single buyer of Brazilian corporate debt, is working with the CVM and market participants on language for a standard contract. Its views matter because of its size. Once the BNDES agrees on a standard language, it will be difficult for issuers and their bankers to ignore and all will have to follow it.
Standardization would help issuers get to market faster. The CVM must approve all bond issuance, a long and laborious process. As a result, bookrunners must guarantee transactions months before they are actually launched. This is risky because it is possible that the market will have changed direction by the time the CVM approves the bonds. Osório says standard contracts would help speed up the process. It can take three months for CVM officials to check 1,000 page documents. But once all sides have agreed on language for standard contracts, companies can start shelf registrations with the CVM, further reducing delays.
Secondary Effort
Carvalho, of BNDES, adds that, “This question of [standardization] is critical for us, [because of] our big portfolio. We have talked about a standard contract a lot with the CVM and we are going in that direction. There will still be operations that will be sui generis. It is important to get transaction costs down, it is very important to create a secondary market.” Meanwhile, the São Paulo stock market and the Cetip clearing house and custody service are working on setting up a market for private debt instruments.
There are additional obstacles, such as a dearth of fixed income research. Finance directors complain that although many brokerages in Brazil and overseas analyze issuers and some of their more liquid international bonds, analysis of real bonds is scarce. The brokerages agree, but say companies could market themselves and their bonds to investors more effectively. Walter Appel, partner at Banco Fator, says “developing the corporate debt requires transparency, loyalty to the market and marketing. There are a few companies that make a small effort.”
Achieving this in a volatile market is hard, if not impossible. Windows of opportunity open and slam shut quickly and unpredictably. In January, Brasil Telecom, the operating unit of Brazil’s third-largest phone company, had to delay sale of R$1.5 billion ($620 million)in local markets bonds when the market suddenly turned against it. Telecom Italia and Rio de Janeiro-based Opportunity Asset Management control Brasil Telecom.
Issuers have to scramble to make the most of calm in the market and rarely have enough time to bother too much about what kind of investors are buying their bonds, whether they are flippers or buy-and-hold investors.
Volatility and illiquidity limit the ability of companies to raise debt and hence their ability to invest more and grow faster. According to research by UBS Warburg, Brazilian companies had debt-to-equity ratios of only 26% in 2001. Appel says, “Imagine if a company had a bond with a September 12 due date. It would go bust because it could not refinance. Companies have got to work with a very small debt load.”
If opportunities to place bonds can sometimes be fleeting, maturities still leave a lot to be desired. Maturities have increased as inflation has fallen and the economy achieved a degree of stability. Plain vanilla bonds have maturities of two to three years, always at floating rates. Decades ago, before severe inflation wrecked the market in the 1980s and 1990s, maturities on corporate debt stretched out for 10 years or more.
Although it may take many years to push maturities out that far, hybrid instruments such as convertibles and exchangeables could help. These bonds push maturities out by at least a year, to three or four years. However, they also have limitations. Companies, particularly those controlled by families anxious to avoid any dilution, are suspicious of convertible bonds. Furthermore, the illiquidity afflicting most second-tier stocks limits the usefulness of equity-linked operations, further inhibited by the very low price of most company shares.
Economic stability, longer maturities and low, stable interest rates are essential to a viable secondary market. Fraga says, “Liquidity is an interesting thing. Liquidity brings liquidity so we have got to work on it and if we work on institutional underpinnings liquidity will come back [if] we remove obstacles.”
Another such obstacle is the “provisional contribution” tax levied on all financial transactions at a rate of 0.38%. It has had a particularly pernicious effect on the equity market, where there is more turnover than in fixed income, and helped drive much of the trading in Brazilian shares to the New York Stock Exchange. It costs investors much less to trade a stock in New York than it does on the São Paulo stock market. Government ministers are aware of the effects this tax has had on the markets but say that scrapping it would weaken the public finances. The government raised $7.02 billion last year with this so-called CPMF tax, which amounted to 9% of total tax revenues.
Given these constraints it is hardly surprising that issuers should use the real market only when they have no other choice, particularly for short-dated paper. The trouble is that the floating exchange rate has made hard currency debt riskier and therefore more expensive than before. Between 1994 and 1999, when the real was pegged to the dollar, borrowing in hard currency was almost risk-free. Following devaluation in 1999 this ceased to be the case, although there were times in 2000 and 2001, when interest rates were low enough to make short-term financing in reais cheaper than in dollars, even after adding in the cost of swapping dollar or euro debt into reais or hedging current debt payments.
But investors are still ready and willing to look at deals. Richard Madigan, director for Latin American investments at asset manager Offitbank, commented at the beginning of the year that, “With average yields in excess of 13% for emerging markets debt, we anticipate 2002 to be a robust year for emerging markets fixed income investments as higher yielding fixed income investments benefit from further investment inflows.” Better still, although emerging market corporate debt yields about five percentage points more than US high-yield bonds, default rates on Brazilian debt up to last year were far lower than those for junk bonds.
Even so, investment bankers say investors will be more selective and remain closely guided by ratings. So issuers and their bankers must work harder than ever to convince the rating agencies to treat their bonds kindly. Issuers must offer greater inducements to investors by offering either political risk insurance or issuing asset-backed securities. Last year, Petrobras, the national oil company (see “Across-the-Board Issuing,” page 30) pioneered the use of political risk insurance to win an investment grade rating for a $450 million, seven-year bond, the first of a series of insured and asset-backed bonds.
Political risk insurance introduced the company to investment-grade energy investors who would normally view Petrobras as an emerging markets company, not an international oil company. This structure enabled Petrobras to borrow at 368 basis points less than the sovereign was paying on its 2009 benchmark bond.
Increasingly, investors want to have political insurance and an asset-backed security rolled into one. Aracruz, Brazil’s biggest paper pulp exporter, announced in January that it had signed up Citigroup to launch $1 billion-worth of seven year bonds in four tranches, backed by export receivables. The company further enhanced the bonds with insurance from XL Insurance to win an AAA rating.