Latin America debt: A complex opportunity
Latin American debt is no longer just a tactical trade
• Latin American bonds offer a range of choices for debt allocations.
• Investors can benefit from the specific political factors that affect economic policy and fiscal discipline in each country.
• Central banks are supporting growth and reducing inflationary spikes.
• Local pension funds and institutions have emerged as natural investors in their respective fixed income markets.
Institutional investors considering how to deploy capital to emerging market debt might not have to look further than Latin America to achieve a full allocation.
That is the picture that emerges from discussions with investment managers with specialist teams dedicated to Latin American emerging market debt strategies.
Gone are the days when Latin America was a tactical trade in a limited inventory of hard-currency sovereign bonds with enough liquidity for a speedy exit when growth faltered or inflation surged.
Today, Latin America debt presents a complex opportunity set comprised of individual country stories that offer different risk-reward profiles reflecting prospects and the progress made on structural reforms.
Changes in political leadership – even in Brazil – are fuelling reforms in fiscal and regulatory policies that have historically held Latin America in limbo between optimism and pessimism. Regional central banks have been successfullly using monetary policy tools such as inflation targeting to reduce the volatility of growth – and that has moderated swings in current account deficits and currency values, which had been the primary, if not sole, mechanism for adjusting outlook against global financial conditions.
“Argentina is an island within Latin America. It’s an uncorrelated investment for at least the next two to three years”
In addition to these budgetary and fiscal reforms, many countries taken steps to increase the attractiveness of their bond markets – both those denominated in local currency and hard currency – to international investors. These steps have included encouraging Latin American pension funds to invest in sovereign bonds, thereby increasing liquidity.
Another measure is to structure debt with multiple maturities similar to developed-market sovereign debt. The aim is to develop national yield curves that allow global investors to evaluate the yield and risk of a country’s bonds against accepted standards.
Argentina has surged onto the radar as a large issuer of sovereign debt with the 2017 issuance of a 100-year dollar-denominated bond, raising $2.75bn (€2.34bn). The offering was oversubscribed, and managers say the four anchor investors – not officially disclosed but believed to include Argentinian pension funds – absorbed so much that many international investors only received small allocations.
The managers who spoke to IPE emphasised the economic diversification in Latin America, and in turn, the divergence between bond market opportunities in the region. While Latin American economies are typically seen as dependent on commodity prices, managers note that the primary commodities produced are affected by different underlying factors. The dependence on commodities varies to a greater extent than two or three decades ago. The divergence in economic performance between Argentina and Brazil, for example, and Chile, Colombia and Peru, suggests that dependence does not leave an economy vulnerable to swings in the commodity market on an absolute basis. That exposure depends on how a country manages the fiscal windfalls that occur in the boom phase of a commodity cycle, each country’s spending on social programmes and each country’s fiscal and regulatory regimes.
But there are advantages to lower commodity prices, says Steffen Reichold, portfolio manager at Stone Harbor Investment Partners. The slower global economic growth has not only caused commodity prices to decline, he says, it has caused lower inflation and interest rates – and that is helping Latin American countries control their historically high inflation rates. “Very specific individual country stories are playing out, so it’s hard to paint it with a broad brush, but we see more positive stories in Latin America and valuations are significantly more attractive than what we see in other markets.”
Argentina hits the bullseye
Latin American bond markets still face challenges. Ongoing corruption scandals have slowed fiscal reform in Brazil. After a strong start, the market-oriented Argentinian government of Mauricio Macri is facing mid-term elections in the autumn as he concentrates on promised reforms such as moving energy prices to a global market level from the artificially low levels engineered by previous government subsidies. Peru, while it enjoys market power as the low-cost producer of high-grade copper ore, remains sensitive to Chinese housing construction, which accounts for demand for copper wire.
The high real yields that are attracting capital represent a penalty for the high inflation, volatile currencies and fiscal imprudence that have marred the region over several decades. However, investors say structural improvements and astute central bank policies demonstrate that Latin America is moving beyond boom-and-bust cycles.
In Argentina, that means studying the Macri administration’s efforts to reverse the effects of populist Peronist policies in effect since the 1960s. “We have been positioning our portfolio so it aligns with the prioritisation of the economic reforms being undertaken in the country under Macri,” says Mauro Staltari, an analyst at Highland Capital Management, which has a dedicated Latin American team that includes offices in São Paulo and Buenos Aires. “That is what’s driving the alpha,” he says.
The main positive shift came in April 2016, Staltari says. The country tapped the global capital markets for the first time in 15 years by raising $16.5bn – an emerging markets record. The issuance – which came as the sovereign debt of several developed countries was trading at negative yields – comprised of tranches with maturities ranging from three to 30 years, with yields of 8% for the longest maturity. A 10-year bond was issued at a yield of 7.5%, beyond the average yield of 6% for the JP Morgan Emerging Markets Bond Global Diversified index. “This issuance constructed a new sovereign yield curve” for Argentina, says Staltari.
Building a new yield curve was a key priority for Argentina, and Highland opted to invest across the curve, with a preference for bonds in the “belly”, Staltari says. “We like to be right in the belly of the curve, that is, the medium-duration bonds that maximise the ratio between yield and duration,” he says. In this case, that is bonds with a duration of four to five years, which are currently yielding between 6.5% and 7.0%. “That is where you maximise yield without going so long on duration that you introduce too much sensitivity to macro factors that are external to Argentina’s economic policies.”
Concentrating on economic policies is critical. “Argentina is an island within Latin America,” Staltari says. “It’s an uncorrelated investment for at least the next two to three years,” he adds. “Of course, a rise in interest rates by the Fed will affect the curve and yields, but Argentina has drivers of its own, such as the normalisation of energy tariffs, and for better or worse, it’s distinctive from the rest of Latin America.”
That has seen Highland go local. “Right now, we like provincial bonds,” Staltari says. The debt issued by Argentina’s 23 provinces yields between 150 to 250bps over sovereign debt of equivalent duration, he says, despite the fiscal profile of some provinces being better than the sovereign – several provinces have deficits of only 1% to 2% of their respective GDP, compared with 5% for the federal government. But because most have never issued debt, they must pay a premium that reflects the lack of history in credit markets – a plus for investors. With 10-year Argentinian dollar sovereigns trading at yields of 6.5-6.75% and 5.0 to 5.5 years duration, Staltari says, recent issues from well-managed provinces such as Mendoza and La Rioja, for example, are yielding between 750 and 850bps. “That is quite some yield,” he says.
Mexico also illustrates the importance of keeping fixed income portfolio strategy aligned with the pace of structural reform. It was the first country in the region to enact energy, fiscal and regulatory reforms. “Mexico was quite unfortunate in terms of timing,” says Damien Buchet, CIO and portfolio manager of the EM Unconstrained and Total Return funds at Finisterre Capital. “Mexico addressed their issues very early on, which was great,” but implementation of the reforms coincided with a fall in oil prices. While that delayed the benefits of reforms such as auctioning off property to private energy companies, “clearly we now see the green shoots and the early dividends,” including an improved credit rating outlook from Moody’s this July.
Mexico had one of the best-performing Latin American bond and currency markets in 2016, and the better rating reflects confidence that the reform agenda will stay on track even though leftist politician Andrés Manuel López Obrador is leading in the polls ahead of the 2018 presidential election, Buchet says. Despite early concerns in capital markets, “now there is a much a more constructive tone among investors and banks,” he continues. “His tenure as mayor of Mexico City didn’t entail any major budget problems and the city’s finances were actually quite in order during his mandate.” In addition, Lopez Obrador “fully understands that he needs to win the favour of major investors, one way or another, if he wants to be voted in, and he’s been reaching out to investors quite constructively over the past few months.”
Reduced fears of trade conflict with the US are also constructive, says Stone Harbor’s Reichold. Negotiations over the North American Free Trade Agreement treaty will take time, and the US administration is learning that Mexican-based production links are vital to American global competitiveness, he says, so trade issues “won’t be as disruptive as initially feared.”
That is allowing Mexico’s positive fixed-income story to play out. “By any measure we look at, the currency looks very cheap to us despite significant performance so far this year, and growth has been gradually picking up,” says Reichold. Inflation is about to peak and the Mexican central bank is expected to start cutting rates after one more rate increase in 2017, he adds. “The debate will start shifting when we start to see lower inflation towards the end of the year. I believe we could be in for a significant rate-cutting cycle, and I don’t think that’s fully anticipated. I believe that could help bond prices in Mexico quite significantly, and it could help support capital inflows.”
Buchet comments: “I think the silver lining for Mexico for now is very much a rates trade and a currency trade, less so a hard-currency debt trade. We’re happy receivers of Mexican interest rates, especially since the central bank is signaling a peak in inflation and the end of the rate hike cycle.” At present, he explains, there is still a pocket of value in Mexican investment-grade corporate debt, especially at the long end. The reason: “On the broad EM spectrum, credit curves are only steep in two places globally, and one is Latin American investment-grade corporates,” where 30-year bonds currently pay investors an additional 70-80% of the spread of 10-year corporates over Treasuries, compared with an average of 30-40%. “That is quite chunky,” Buchet says.
Brazil toils in political doldrums
The correlation between local political and economic developments and bond market performance is best seen in Brazil. Although Brazilian equities and the real recovered quickly after accusations of corruption were made against Brazilian president Temer, “there was a negative impact from the bond market perspective,” says Julio Callegari, executive director in the global fixed income, currency and commodities (FICC) group at JPMorgan Asset Management (JPMAM), and head of the Brazil fixed income team. “After this scandal, the odds of approval of social security reform in the near term were reduced,” he says, “and it’s unlikely that we will have the kind of reform we were expecting before [the latest corruption allegations].”
Brazil boosted social spending when commodity prices were booming in 2010 and 2011, as a law designed to restrain federal spending proved ineffective. That left Brazil with no choice but to cut federal spending in the wake of lower commodity prices and slower growth. “For bond investors, the story has changed,” says Didier Lambert, managing director at JPMAM and lead portfolio manager for local market investment in rates and foreign exchange in the emerging markets debt team. Potential GDP for EM countries has declined, Lambert says, especially for those that previously posted high single-digit growth: “Brazil is not going to grow at 6% for long, long time.”
In short, a real yield of 5% or more in Brazil is “too high for an economy which is growing at 3%,” Lambert says. He says a real yield of about 3.5% is warranted, and the Brazilian central bank will be forced to push rates lower in the still-slumbering Brazilian economy. With political uncertainty high and pension reform set to be diluted, “we expect financial asset prices to converge towards macro dynamics, which will compress yields,” perhaps as much as 200bps in Brazil, he adds.
Managers are content to collect those yields. “Brazil is by far our largest local rate position in emerging markets,” says Arif Joshi, head of emerging market debt strategies at Lazard Asset Management. “You’re getting paid significantly to take local rate exposure in Brazil, and from a downside risk perspective, Brazil local bond positions tend to be more levered to news from the central bank as opposed to news from the executive branch.”
Just as local political and policy developments have become important factors in the performance of Latin American bond markets, local investors have also taken on a larger role, says Steven Cook, co-head of emerging markets fixed income at PineBridge Investments. In the 1990s, most outstanding debt of Latin American countries was denominated in foreign currency, and held by international investors that sold at the first sign of trouble.
But after 15 years of economic growth, domestic pension funds, banks and insurance companies have become stewards of significant pools of capital. “They are natural buyers of fixed-income instruments,” says Cook, “and if there’s an event in one of these countries and the spreads start widening or the market starts to fall, the locals are typically buyers.” That could provide a bulwark against a drop in Latin American bond markets as the Fed winds down its quantitative easing policy. “When QE is withdrawn,” Cook says, “local investors are still going to invest in their local asset classes.”