Redefining Latin debt

Mexico, Brazil and Argentina increasingly defy easy labels.

Mexico, Brazil and Argentina increasingly defy easy labels.

By Sara Kandler
April 2001
Institutional Investor Magazine

Mexico, Brazil and Argentina increasingly defy easy labels. Now investors are starting to appreciate their many differences.

Not long ago emerging-markets debt players viewed Latin America’s major economies as a bloc that responded as one to changing conditions.

All that has changed. The Latin American debt markets, dominated by Mexico, Brazil and Argentina, now offer a varied landscape of political and economic realities: In March 2000 Mexico, which has drawn closer to its North American neighbors through Nafta, received the region’s first-ever investment-grade rating (Baa3) from Moody’s Investors Service; Brazil has made real progress in the past several years in tackling long-standing political and economic problems; and Argentina, once an investor favorite, tottered so close to an all-out financial crisis late last year that the International Monetary Fund and others had to step in with a $40 billion aid program in January. For better or worse, each is traveling its own unique path, and investors are increasingly distinguishing among them.

“It used to be that if something happened in Mexico, it would be felt in Argentina,” says Robert Kowit, portfolio manager at Federated Global Investment Management in New York and a veteran investor in sovereign debt. “But now that the investor base is more focused on long-term fundamentals, each economy is increasingly viewed on its own merits and weaknesses.”

Returns this year through mid-March underscore the trend. Argentina’s debt is flat, Brazil’s is up almost 3 percent, and representative Mexican fixed-income securities have gained 3.5 percent.

Investors in high-grade debt, who are increasingly active in emerging markets, are the primary cause of this shift. Indeed, in the middle of 2000, such investors, who tend to invest long term, accounted for more than 30 percent of Chase Securities’ total trading activity in emerging-markets debt. At the time, that represented a new high and was double the level reached in the third quarter of 1998, when Russia imploded and global markets were in turmoil. Hedge funds, which tend to be more speculative, dropped to 13 percent of Chase’s total trading in the second half of 2000, the lowest level since the fourth quarter of 1998.

Joyce Chang, global head of emerging-markets research at J.P. Morgan Chase & Co., believes that two years of solid outperformance in emerging-markets debt and a healthy 3.25 percent allocation to the asset class in the Lehman U.S. universal index bodes well for continued growth in participation from high-grade investors. The increasing role of such crossover institutions in the asset class has been beneficial, offering more liquidity, new diversification opportunities and less risk of contagion between the emerging markets. According to J.P. Morgan Chase, annualized volatility has dropped to as low as 25 percent in recent months, from as high as 300 percent following the Russian crisis.

London-based emerging-markets debt specialist Ashmore Investment Management, a $700 million investment firm started by the emerging-markets debt team from ANZ Investment Bank, emphasizes local policy dynamics as the key to investment decisions. “What is important is democracy and the gradual change in policy,” says Jerome Booth, head of research and a member of the firm’s investment committee. To predict future developments, he says, “you have to get inside the head of the finance minister, the person who is making the decisions, and ask yourself, ‘If I were in this guy’s shoes, what would I do?’ ”

In Booth’s view, the political system in Brazil has improved so much that it can now effectively address problems that once would have sorely tested the government. For instance, he says the December passage by Brazil’s Congress of legislation to crack down on tax evasion as a means of funding a proposed minimum wage hike was pragmatic and logical. It was also a key element in a timely and successful budget approval process that Standard & Poor’s rewarded in January with an upgrade of the sovereign to BB-, from B+. Brazil has also been able to meet the tough objectives set in its revised 1998 IMF program. Despite high oil prices last year, which hurt the net importer of petroleum, economic growth reached 4.2 percent, inflation dropped to 6 percent, interest rates fell to 15.75 percent, and the nominal fiscal deficit shrank to 4.6 percent of GDP, all within the IMF plan’s target ranges. By comparison, at the end of 1999, economic growth was 0.8 percent, inflation was 8.9 percent, interest rates were 19 percent, and the deficit figure was 10 percent of GDP.

Brazil’s credit quality is comparable to Mexico’s, Booth believes, but its debt prices do not yet reflect the progress. Ashmore currently has a “healthy weighting” in the country’s sovereign debt, especially the very liquid C-bond, one of the country’s Brady bonds, which had a total return of 14.88 percent for the six months through January, according to the J.P. Morgan emerging-markets bond index plus.

Argentina, whose sovereign debt was actually more expensive than Brazil’s as of mid-February, is falling far behind, in Booth’s opinion. For the past ten years, the country has been constrained by high external debt, low export revenues, fiscal imbalances and persistent unemployment. Although news of an IMF-led loan package helped Argentinean debt return an impressive 5.68 percent in January alone, according to the EMBI plus, longer-term concerns remain, especially about the country’s ability to meet its IMF growth and fiscal targets. An export-led recovery is seen as unlikely: Exports accounted for just 9 percent of Argentina’s GDP in 2000, and its fixed, 1-to-1 peso-to-dollar currency regime keeps its products expensive. In addition, an unemployment rate of about 15 percent severely undermines efforts to boost the government’s revenues through tax collection. Ashmore, whose $200 million Emerging Markets Liquid Investment Portfolio had annualized five-year total returns of 19 percent through the end of January, has kept away from Argentinean securities for more than a year.

But for value-seekers Thomas Cooper and William Nemerever of Boston-based Grantham, Mayo, Van Otterloo & Co., the anomalies of Argentina’s debt universe hold an attraction. The managers of the $1 billion-in-assets Emerging Country Debt Fund seek out cheap opportunities across a wide spectrum of countries and instruments - including defaulted debt or unusual securities such as trade receivables - and make broader country allocation adjustments only when necessary. “Our approach is simpler than that of many others,” Cooper says, “because we don’t read political and economic tea leaves.”

These buy-and-hold money managers, whose fund also had a 19 percent annualized five-year total return through January, especially like the sovereign’s dollar- and peso-denominated six-year bonds, or Bocones. They indulge as well in some of Argentina’s longer-dated sovereign hard-currency debt, such as its 11- and 30-year bonds, which are inexpensive relative to their shorter-dated peers and often less attractive to shorter-horizon investors. To allay the risk inherent in markets such as Argentina, the duo uses “insurance” tools such as credit default swaps, which redeem debt instruments at par in the case of default, or options, which limit potential downside. Because of the more complex nature of the region today, the team increasingly uses these defensive tools within a country rather than across borders. Relationships between the performance of various Latin American markets have become less predictable, and betting on any correlations is a far less certain way to buffer against losses.

Despite the newly divergent profiles of the region’s big three debt markets - which together account for 65 percent of the EMBI global universe (the most diversified of the EMBI indexes) and 84.3 percent of the Latin America portion of EMBI global - none of them can escape the influence of a U.S. economic slowdown. “The history of the emerging markets is that global developed economies have been a huge factor in terms of economic performance,” says James Barrineau, head of Latin American research at New York-based Alliance Capital Management, which has $130 billion in fixed-income assets and is a large investor in emerging-markets debt. Because of the strong trade links between the U.S. and Mexico, Barrineau says, signs of weakness in the U.S. industrial sector, such as declines in production and manufactured exports, quickly spread from the world’s richest economy to its southern neighbor. In the past several months, dampened domestic demand in the U.S., reflected in slowing retail sales and rising unemployment, has begun to affect Mexico. However, Barrineau expects both slowdowns to be transitory and for Mexico to respond with the appropriate monetary and fiscal policies.

Meanwhile, Barrineau’s sensitivity to the weakening U.S. market directs his eye to Argentina. Because the country’s currency is tied to the dollar, he expects further U.S. interest rate cuts to significantly lower Argentina’s cost of domestic funding. He’s attracted to the sovereign’s foreign currency debt and anticipates that Argentina will beat the consensus GDP growth estimate of less than 2.5 percent for 2001.

Brazil, he says, should also benefit, although somewhat less. He expects a softening dollar, the by-product of the U.S. slowdown, combined with prospects for a strengthening euro, to boost demand from the European continent for Brazilian exports. Europe represents a sizable 30 percent of Brazil’s external trade.

Macroeconomic changes in these countries have also created new corporate debt opportunities. Federated Global’s Roberto Sanchez-Dahl contends that carefully selected picks in Mexico and Brazil offer opportunities. Argentina is better left untested for the time being, he says. Sanchez-Dahl, co-manager with Kowit of the $100 million-in-assets International High Income Fund, which is about 75 percent invested in emerging-markets debt, says that Mexico’s corporates used to be lumped together because their credit ratings were constrained by the sovereign’s sub-investment-grade ceiling. He sees companies falling along a wider credit spectrum now that Mexico is rated investment grade by Moody’s.

Like Barrineau, Sanchez-Dahl remains wary of the effect the U.S. slowdown will continue to have on Mexico’s industrial sector. Instead, he sees opportunity in several media and telecommunications names that are positioned to enjoy consistent consumer demand. For instance, he likes Grupo Iusacell, a wireless telecom provider owned by Verizon Communications and Vodafone Group that benefits from operating in a severely underserved market, long waits for wired hookups, attractive caller-payment plans and the fact that, in Mexico, cell phones provide a sense of security in areas prone to violence. In light of Mexico’s ties to the U.S., he says, “you have to be even more discriminating,” paying special attention to cross-border competition, foreign strategic investors and future market integration.

In Brazil only a few corporates offer higher yields than the sovereign does. Sanchez-Dahl, whose income-oriented fund posted a total return of 7.85 percent for the 12 months ended in January, searches out entities that fall within that category and are underpinned by other strengths. He likes MRS Logística, a company owned by four steel producers that bought a system of railway lines in the southern portion of the country in 1996. These manufacturers were paying high freight fees to the state-owned railroad for transporting raw materials from mines to manufacturing plants and finished products from those plants to ports. “The company’s shareholders are not going to let Logística deteriorate, because it is the key asset for their operations,” Sanchez-Dahl says.

Corporates require a lot of in-depth, bottom-up analysis, Sanchez-Dahl says, and since the upheaval of the late 1990s in emerging markets and the raft of banking mergers around the world, many research departments have reduced their coverage. So when you discover a good story, it’s a real find. “To the extent that you can dedicate some time and work to looking at which corporates are going to outperform the rest,” he says, “that’s where your return is going to come from this year.”

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