Roberto Apelfeld recalls the hazards of investing in Brazil's turbulent fixed-income market just over four years ago. The country's history of hyperinflation and worries about a possible leftward lurch by Luiz Inácio Lula da Silva, then leading the polls in the presidential campaign, made investors skittish. Bond prices tumbled as interest rates soared and the real skidded. The government could issue only short-term paper, and the rollover risk was so great that it had to go cap in hand to the International Monetary Fund for a $30 billion bailout to avert a default.
"At that time, a portfolio with a duration of more than three months was considered extremely aggressive," says Apelfeld, head of the São Paulo office of Western Asset Management Co., the fixed-income arm of Legg Mason.
Today's environment is a world apart. The real has strengthened and interest rates are half what they were four years ago as investors have piled into bonds, reassured by President Lula's policies, which have supported moderate growth and driven down inflation. The government, which used to finance itself with debt maturing in less than a year, now issues fixed-rate paper domestically with maturities of up to seven years and plans to issue a benchmark ten-year bond in 2007. The stability has fostered a surge of corporate bond issuance, enabling Brazilian companies to borrow in size from investors in their own currency for the first time. Brazil's capital market, in short, is fast developing the characteristics and capacity of counterparts in the developed world and providing rich opportunities to fund managers.
"In Brazil today we dedicate much more of our time to our search for alpha rather than trying to protect ourselves against major swings in interest rates," says Apelfeld in his office overlooking Brooklin, a lush residential neighborhood in São Paulo that is rapidly being enveloped by corporate skyscrapers.
The dramatic transformation was evident during the recent presidential election campaign, when investors stayed calm. The central bank was even able to cut its benchmark interest rate by half a point, to 13.75 percent, between the two rounds of voting in October that gave Lula a fresh mandate. It followed up with another 50 basis point cut in November. The rate now stands at an all-time low of 13.25 percent, and with inflation remaining low and growth moderate, many analysts believe there is plenty of room for further reductions.
"The foreign investors we speak to said they weren't worried about the outcome of the election," says William Bethlem, director of global distribution and foreign exchange at the investment banking division of Unibanco, Brazil's third-largest private bank by assets and the fourth-ranked fixed-income underwriter in 2006.
Corporate issuance also continued unabated throughout the electoral period. Brewing company AmBev issued 2.05 billion reais ($960 million) of bonds in September, just one month before the election's first round, and Companhia Vale do Rio Doce, a mining company with global ambitions, in December launched a R5.5 billion bond offering -- the biggest ever by a Brazilian company -- to help finance its $17.6 billion takeover of Canada's Inco.
"The market is on the verge of a major growth spurt," says Nuno Almeida, a fixed-income analyst at Unibanco.
Emerging markets have soared in recent years as investors have sought to gain exposure to new growth areas, but few have risen as dramatically as Brazil's bond market. The EMBI+ Brazil index of the government's dollar-denominated bonds has risen 150 percent since the end of 2002, the third-best performance among the 33 emerging-markets countries tracked by JPMorgan Chase & Co.; only Ecuador and Venezuela have produced better returns.
And it's not just the bond market that's hot. Brazil's stock market has surged as well. The Bolsa de Valores de São Paulo index rose 31 percent this year through mid-December, when it hit a record high of 43,754, unleashing a rash of initial public offerings (see box, at left).
The market gains reflect a stunning turnaround in Brazil's macroeconomic climate. When Lula was elected in 2002, many investors feared he would repudiate the country's foreign debt or go on a massive spending spree, positions he had espoused during more than a decade as the country's leading leftist politician. Instead, he stuck to the market-friendly policies of his center-right predecessor, Fernando Henrique Cardoso, maintaining a strong primary budget surplus (before interest costs), supporting the independent central bank and its inflation-targeting regime and continuing to allow the real to float freely.
The results of that pragmatic stance have been dramatic. Inflation, which rose to 12.5 percent because of a preelection spending spree in 2002, has been reined back to about 3 percent currently. A surge in exports, reflecting robust Chinese demand for commodities like soybeans and iron ore, have turned the current-account deficit of 1.7 percent of GDP in 2002 into a projected surplus of 1.3 percent in 2006. And the government has greatly reduced its vulnerability to crisis by making early repayment of its $15.5 billion debt to the IMF, slashing its dollar-linked domestic debt to just $1.2 billion in November from $73 billion in January 2003 and quadrupling its foreign exchange reserves to $80 billion.
The Brazilian National Treasury, headed by former Citigroup economist Carlos Kawall, has taken advantage of the improved conditions to develop the domestic bond market and extend maturities. The outstanding amount of real-denominated government bonds has nearly doubled over the past four years, to R1.06 trillion in October 2006 from R556 billion at the end of 2002. Fully one third of that paper carries a fixed-rate coupon, compared with just 2 percent in 2002; Kawall said recently that the outstanding amount of fixed-rate bonds would exceed that of floating-rate bonds in 2007. The Treasury also intends to lengthen the yield curve to ten years in 2007 from its current maximum of seven.
"The idea has been to create a liquid yield curve that can also serve as a reference for the corporate market," Paulo Fontoura Valle, the Treasury official who manages public debt, tells Institutional Investor. In mid-December, yields ranged from 12.78 percent for one-year bonds to 13.45 percent for seven-year paper. The yield on the government's two-year bond stood at 13 percent, down from 18.6 percent at the end of 2002. The government also offers inflation-indexed notes with maturities extending as far as 2045; that bond was yielding about 7.94 percent in December, down from 11.05 percent when the bond was first issued in March 2002.
"The profile and duration of the government's debt has improved significantly in the past four years," says Unibanco's Almeida.
The government has pushed maturities even further with foreign investors by issuing real-denominated, fixed-rate bonds maturing in ten and 15 years in the international market. The issues were designed to appeal to global investors who seek exposure to the real but do not want to deal with the expense and red tape of registering their companies in Brazil and settling bond transactions locally.
The government's 12.5 percent bonds due in 2016 were yielding 11.3 percent in mid-December and its 12.5 percent bonds due in 2022 were yielding 11.6 percent. "Creating a real-denominated curve in the external market helps you do the same for the internal market as well," explains Treasury official Valle.
Corporations have been quick to seize on the market's development, issuing nearly R60 billion in real-denominated, floating-rate bonds this year, compared with just R8.7 billion in 2002. The buyers are mainly local investors, who until recently have filled their portfolios with floating-rate government securities but -- with interest rates tumbling -- are turning to corporate paper in search of yield.
As a result, there was plenty of demand for offerings like electric utility Enersul's R337.5 million five-year bond, which was priced in June to yield 104.3 percent of the interbank deposit rate, known by its Brazilian acronym, CDI. That interbank rate stood at 13.25 percent in December, which would imply a yield of 13.82 percent on the Enersul bonds. Vasco Barcellos, head of investor relations for Energias do Brasil, the holding company for Enersul, says tapping the bond market proved to be much less expensive than borrowing from the banks.
"We had negotiated a standby facility with our banks in case the bonds didn't work. That would have cost us 107 percent of CDI," or 14.18 percent based on December's rate, notes Barcellos. Enersul used the proceeds to pay off outstanding debt priced at 108 to 110 percent of CDI as well as a dollar-denominated senior note. The bond issue, as well as similar offerings from two other utility subsidiaries of Energias, produced one-time savings of R100 million.
"In the past two years, companies have become concerned with creating yield curves -- which is a relatively new part of the corporate culture in Brazil," says Denise Moura, head of capital markets at Banco Bradesco in São Paulo. Other notable issues in recent months include a R2.14 billion offering from telecommunications operator Telemar, which included R1.6 billion of five-year notes paying 103 percent of CDI and R540 million of seven-year notes paying the interbank rate plus 0.55 of a percentage point. And AmBev sold R2.05 billion of bonds in two tranches, including R810 million of three-year bonds priced to yield 101.75 percent of CDI and R1.24 billion of six-year bonds priced to yield 102.5 percent of the interbank rate.
The flurry of bond issuance has been a boon for Brazil's investment banks. As of September the top five corporate bond underwriters were Banco do Brasil, Itaú BBA, Bradesco, Unibanco and ABN Amro Real, all of which rely on hefty commercial banking networks for access to both borrowers and investors.
The strength of the local market has attracted the interest of foreign players too, as evidenced by UBS's recent $2.5 billion purchase of Banco Pactual, a major equity and fixed-income underwriter (see box, below).
Notwithstanding the increased activity, the corporate bond market still suffers from several impediments to its growth. Liquidity is negligible, with turnover averaging just R53 million a day for a market with R120 billion in bonds outstanding; price information is hard to come by save for a few online postings of some banks' bid-offer quotes.
"Since it's still a relatively small market in which the demand for high-quality credits still far outweighs the supply, investors tend to buy the paper and hold it until maturity," says Rodolfo Riechert, head of Banco Pactual's investment banking operations in Rio de Janeiro.
Local investors -- mainly mutual fund arms of major Brazilian banks, such as Unibanco Asset Management and Bradesco Asset Management -- manage close to R800 billion but are reluctant to trade their fixed-income positions because they worry they won't be able to replace their outgoing paper with new bonds of the same or higher yields. The lack of liquidity deters the use of dynamic trading strategies, such as long-short, and impedes the development of a local credit derivatives market, says Riechert.
Brazil's 15 percent tax on interest income and capital gains is a deterrent to most foreign investors, who tend to be much more active traders than their domestic counterparts. Brazil's National Association of Investment Banks, among others, has lobbied to have the tax removed, so far to no avail, but many investment bankers are optimistic the government will eventually repeal it.
Such a move could reap big dividends. The government lifted a 15 percent capital gains tax on investments in its public debt last January, and foreigners scooped up a whopping R55 billion worth of inflation-linked bonds in the following two months.
In an effort to stimulate liquidity, Brazil's development bank, Banco Nacional de Desenvolvimento Econômico e Social, or BNDES, is building up a R2 billion portfolio of corporate bonds and plans to trade them.
"The market has been asking for this for a long time," says Eduardo Rath Fingerl, a director in charge of capital markets at BNDES. "The bank's role here will be, as it has been many times in the Brazilian market, to provide an example for others to follow." The bank will use bond prices from the Bolsa de Valores de São Paulo and from Cetip, the country's main securities clearing and depository company.
The jumbo bond issue from Companhia Vale do Rio Doce also should give a fillip to the secondary market, bankers say. The floating-rate issue -- R1.5 billion of four-year bonds paying 101.75 percent of CDI and R4 billion of seven-year bonds paying CDI plus 0.25 of a percentage point -- should be attractive because of the offering's large size and the quality of the issuer. The mining outfit is one of Brazil's leading corporations and boasts a domestic rating of brAAA from Standard & Poor's, one notch above the government's rating of brAA+. CVRD hasn't issued real-denominated paper in several years, and the company's $3.75 billion international bond issue, launched in November to help finance the Inco acquisition, was heavily oversubscribed.
"I think this issue, with its size and credit quality, could see lots of action in the secondary market," says Nicolaus Theodorakis, a fixed-income analyst at Banco Pactual in São Paulo.
As much as Brazil's bond market has developed over the past four to five years, many investors believe the best is yet to come. Just three weeks after Lula's reelection, Standard & Poor's put Brazil's double-B international debt rating on outlook with positive implications, indicating a possible upgrade in coming months. An improvement would depend on the government's adherence to fiscal discipline, including a primary budget surplus of 4.25 percent of GDP, and reform of the country's pension system, the agency says.
Such reforms won't be easy, but many investors believe it is only a matter of time -- perhaps two years -- before Brazil sheds its junk debt rating and attracts a whole new range of global investors.
"Four years ago foreign investors would use the word 'default' a lot when talking about Brazil," says Western Asset Management's Apelfeld. "Today that word has been replaced by 'investment grade.'"
Bovespa dances to an IPO beat
A surging stock market has unleashed an unprecedented spree of equity offerings in Brazil, and bankers say there's no sign of an end to the party. Twenty-eight companies raised a total of $7.4 billion with initial public offerings in 2006, as of mid-December, compared with ten deals worth $2.9 billion in 2005, according to financial data provider Dealogic. Fifteen companies raised an additional $6.1 billion with secondary offerings in 2006, compared with 11 that took in $3.1 billion a year earlier. Bankers and analysts expect as many as 30 companies to make their market debut in 2007.
"The IPO market is where all the action is," said Jean-Marc Etlin, head of investment banking at Banco Itaú BBA, the wholesale banking arm of Banco Itaú Holding Financeira, Brazil's second-largest private bank. The investment bank worked on ten deals worth $1.3 billion in 2006, ranking it third among equity underwriters.
The strength of the Bolsa de Valores de São Paulo -- the market's main index was up 31 percent year-to-date as of mid-December -- has driven the sharp increase in issuance and enabled a broader range of companies, including smaller outfits, to offer their shares. The average market capitalization of companies making IPOs has fallen from 2.8 billion reais ($1.3 billion) in 2004 to R1.6 billion in 2005 and R800 million in the first three quarters of 2006.
"The appetite for risk is increasing, which is making it easier for Brazilian companies to access the market," says William Bethlem, head of global distribution and foreign exchange at the investment banking unit of Unibanco, the country's third-largest private bank. The unit ranks sixth among equity underwriters, according to Dealogic.
Foreign investors scoop up about 70 percent of new issues, on average, creating a big opportunity for global investment banks. Banco de Investimentos Credit Suisse (Brasil) was the leading underwriter, advising on 23 deals worth $4.4 billion in 2006, according to Dealogic, while UBS was a close second, with 21 deals worth $4.1 billion.
Real estate developers, which are enjoying a growth spurt because of the sharp decline in Brazilian interest rates in recent years, have been among the biggest issuers. Nine went public in 2006 through mid-December, and an additional five registered plans for offerings with the Comissão de Valores Mobiliários, the country's securities regulator. The latest include Brascan Residential Properties, which raised R1.19 billion in November with the year's largest IPO, and Lopes Consultoria de Imóveis, which obtained R413 million with an offering in December.
Other hot sectors include biofuels and technology. Brasil Ecodiesel, the country's leading manufacturer of biodiesel fuel, filed plans for an offering in September, no doubt hoping to repeat the success of Cosan, the ethanol maker that split its shares three for one just ten months after raising R886 million in a November 2005 IPO. Positivo Informática, the country's leading PC maker, raised R567 million with its offering in December.
Even the Bolsa de Valores is keen to get in on the action. In May the exchange announced plans for an offering, and in August it hired Goldman, Sachs & Co. as an adviser. -- D.S.
UBS bets big on Brazil
When the partners of Banco Pactual, one of Brazil's leading investment banks, were looking to sell the firm a year ago, bankers from UBS descended on Rio de Janeiro with a proposal to take the bank public. But the more the Swiss bank learned about Pactual, the less it felt like sharing. Last May, UBS agreed to acquire the firm for $2.5 billion.
The new UBS Pactual is a powerhouse in one of the hottest emerging markets in the world, managing more than $24 billion in assets and vying for leadership of the country's equity league table. The bank advised on $4.1 billion worth of share offerings year-to-date as of mid-December, ranking it just behind market leader Credit Suisse. Credit Suisse also bought its way to Brazilian prominence by acquiring Banco Garantia in 1998 for $675 million.
The Pactual acquisition was the biggest by UBS since its $11.8 billion purchase of PaineWebber in 2000. The deal is part of a wider effort by the Swiss bank to buttress its position in major emerging markets. It purchased the 50 percent it didn't already own of Brunswick UBS, a Russian investment bank, for $875 million in 2004. The following year the bank agreed to pay $210 million to acquire a 20 percent stake, and management control, of Beijing Securities, a formerly state-owned broker-dealer and investment bank.
"Brazil is very important to us," says Huw Jenkins, chairman and chief executive of UBS's investment bank. "With the development of economic growth, the reduction of dollar debt and the need for local-currency funding, we see fantastic opportunities in the emerging markets."
For Pactual, the deal enables it to service the increasingly global ambitions of Brazil's leading companies, says Rodolfo Riechert, head of the firm's investment banking operations in Rio de Janeiro. He points to mining company Companhia Vale do Rio Doce's recent $17.6 billion acquisition of Canada's Inco. UBS Pactual advised CVRD on the deal, along with Credit Suisse, and helped arrange the financing along with Credit Suisse, ABN Amro and Santander Investment Securities.
"Like other Brazilian banks we can provide good M&A advice, but unlike most of them, we can also give companies access to the global markets to fund these purchases," says Riechert. "I think banks that can't do that will end up dropping off." -- D.S.