If a large corporate borrower wants to lower its funding costs in Latin America and avoid mismatch of currency risk, should it borrow locally or in the international markets? If an emerging markets investor wants to extend duration in a local fixed-rate instrument, what are the options?
Taking a hard look at these kinds of local currency strategies is vital for borrowers and investors alike, says Pradeep Kumar, Salomon Smith Barney vice president and strategist in emerging market quantitative research. The downward trend in real interest rates and lower exchange rate volatility in several Latin American markets have made it easier to invest and hedge there.
Kumar says new floating currency regimes, an increasing variety of local currency instruments, longer duration alternatives and improved liquidity are positive developments for investors in the region. For borrowers, the ability to “piggyback” on the local sovereign yield curve and the availability of cheaper hedging opportunities have made local markets much more attractive than in the past.
Brazil is the prime example. There, Kumar says, “local markets have out-performed sovereign debt.” Brazil’s pension funds have driven increased demand for inflation-linked local corporate and government securities, and mutual funds have boosted demand for two- to three-year corporate paper. As a result, debt issuance in Brazil’s local capital market increased to an expected $12 billion this year, from $8.2 billion in 1999. Kumar says there is a clear preference for longer duration securities in all local markets and that the “favorite trade of the year” in Brazil has been in three-year, fixed-floating swaps.
A similar picture is emerging in Mexico, where new types of local currency instruments have appeared. Says Kumar, “An investor could take advantage of falling real interest rates in Mexico by extending duration in the newly issued three- and five-year government securities.”
Foreign investors can access local currency markets by buying traditional cash securities such as treasury bills and bonds, or by using newly developed financial instruments, including forwards, non-deliverable forwards (NDFs), total return swaps, currency options, structured deposits and notes. Exposure to risks such as currency volatility, inconvertibility, counterparty and sovereign default, and leverage determine each investor’s approach.
Sharon Spiegel, director at Lazard Asset Management and a specialist in emerging market fixed income products, warns, “A lot of risk in the local markets isn’t obvious at first look. Credit risk is [particularly] tricky to analyze.”
Cost is the main concern for companies using local markets. Theodore Helms, general manager of Petrobras’ New York corporate finance office, says the Brazilian national oil company has traditionally borrowed in dollars because offshore banks provide much cheaper financing than domestic capital markets.
Nevertheless, Helms agrees that local currency instruments in Brazil are starting to look more attractive. As an example, he cites the project finance for Petrobras’ Marlim oilfield. When only half the needed funding of $1.3 billion was raised in global financial markets, the company looked homeward and was able to raise R$1 billion ($541 million) in the local capital market.
“Within one week [of the local bond issue], banks responded with five-year instruments below the dollar cost of Marlim,” Helms says. “[Local financing] provided tax benefits, had no debt-service reserve, more prepayment flexibility and was fully underwritten at a firm price. It lowers our overall risk in the event of a devaluation.”
While originally conceived as bridge financing, Helms says, “Eighteen months down the road, the local issuance turned out to be more effective.” LF