Tracking the progress of Latin America’s corporate bonds

Following the plunge in commodities, there is still value in Latin America’s corporate bonds, as Bci Asset Management attests


After some years of not being on any financial radar, the Latin American stock and bond markets jumped into the spotlight again when the prices of commodities began to rebound after last year’s lowest levels in 15 years. There are several reasons that can be attributed to this rebound, including the shift in the Chinese Central Bank’s approach towards its exchange rate, as well as the rebalancing growth policies it introduced in February.

Even so, investors around the globe were caught off-guard when Latin American stocks and corporate bonds began to exhibit stellar performances in February, reaping profits of 20.1 percent and 12.4 percent in USD (as of May 31), according to the MSCI EM Latin America Index and JPMorgan CEMBI Broad Latin America Index respectively.

“Despite this recent recovery in Latin America’s financial assets – which is still overshadowed by its mediocre performance over the last five years – we at Bci Asset Management decided to review Latin America corporate bonds from a more fundamental point of view”, said Gregorio Velasco, Head of Institutional Fixed Income Funds and Portfolio Manager at the company. “In order to achieve a comprehensive analysis, having in mind this commodities super cycle that went on from 2002 and began to revert by 2011, we organised this review from four different angles: macroeconomic, corporate fundamentals, performance and valuation.”

Macroeconomic review
The impact of commodities in Latin America’s economies is undeniable, particularly given 53 percent of its exports are related to some type of commodity. Commodities in aggregate – as measured by Thomson Reuters’ CRB Index – rose 213 percent from 2002 up until June 2008, and only stopped as a result of the financial crisis that year. During this period, Latin American economies grew at annual average rates that ranged between five and seven percent. Just a year after the crisis unravelled, Latin America started heading upwards again, achieving growth rates of seven percent in 2010 in a V-shaped recovery of its aggregate domestic product. However, in 2011, commodity prices started to slow again, causing a negative impact to the region in various ways.

The impact of commodities in Latin America’s economies is undeniable, particularly given 53 percent of its exports are related to some type
of commodity

Economies in Latin America therefore began to bear the consequences from the slump in commodities (see Fig. 1), firstly through lower exports, but also via the impact of central governments lowering their fiscal spending, due to lower income from commodity-related government-owned companies.

The exchange rates in Latin America played a pivotal role in helping the private sector adjust in the last few years, by exhibiting depreciations in the range of 25 and 70 percent, from December 2012 to date.

“This FX adjustment came with an extra cost, and domestic inflation levels experienced elevated pass-through effects. Last year, Brazil, Colombia and Chile saw their domestic inflation indices reaching 11, 7 and four percent”, said Velasco. Domestic inflation also implied less manoeuvring for local central banks, which in most cases within the region were forced to raise their rates and implement more restrictive monetary policies, which ultimately resulted in lower private consumption and activity.

“In sum, the region is growing its product today at an average rate of minus five percent (two percent excluding Brazil), far below the four to six percent average range from the previous 15 years. Countries are running current account deficits between two and six percent, while public sector budget deficits in the north of 2 percent and 10 percent”, Velasco told World Finance.

Despite this challenging environment, it can be argued the region faces difficult times with sound macroeconomic fundamentals, and is also weathering the turbulent scenario reasonably well. “First, public sector debt levels are considerably lower than in previous crises. While Peru and Chile enjoy public sector debt levels of around 20 percent of their GDPs, Colombia and Mexico show levels at or below the 50 percent mark”, he said.

The only exception is Brazil, whose public debt is reaching 70 percent of its GDP, which, naturally, has become a focus of concern for local authorities and an issue that garners consensus in terms of the necessity of a resolution.

Another relevant point is the disciplined and market-orientated policies countries are implementing in order to address the region’s slowdown through flexible exchange rate regimes, the autonomy of central banks and central governments that focus on reducing public sector deficits. This combination of factors now allows regional central banks to afford the maintenance of foreign reserves in the coffers of around 15 to 30 percent of their GDPs, something never seen before in Latin America.

The task of rebuilding the history of Latin America’s companies over the last 15 years is not as complex as some argue, especially when considering 42 percent of the corporate issuers are directly related to the metals and mining, and/or oil and gas sectors, according to figures published by JPMorgan. “When analysing financial indebtedness of companies soon after the Argentine default in 2001, together with the previous Brazilian and Russian crises, it was possible to find average net financial debt over EBITDA ratios, also known as the ‘net leverage’, a metric commonly used in credit analysis, above 3x”, Velasco said. “Five years later, by the end of 2006, this same financial ratio was below 1.4x”.

The main driver for this dramatic decrease in leverage can be seen when looking at the companies belonging to the metals and mining sector in the region, which shows that, if by December 2001 their net leverage ratio was about 2.9x, by December 2006 this same measure registered levels below 0.7x. “The explanation is pretty straightforward: it’s all about commodities”, said Velasco. “But as the commodities super cycle came to an end by 2011, indebtedness for issuers within the metals and mining segment started to increase, and today, using the latest available information, one can observe net leverage ratios for this group of companies above 3.5x, while for the whole industry – including companies in all sectors – it is at 2.9x”.

Latin americaDespite the abrupt fall in commodities over the last three years, debt metrics for corporate issuers remain at reasonable levels and, most importantly, they are not higher than before this super cycle period began. Furthermore, companies are much larger, so they generate operating cash flows at significantly different scales, while many are competing on a global scale. All these factors point towards a greater quality of credit.

Reviewing performance
“Despite the poor performance of Latin America corporate bonds in recent years, the story from the last 15 is remarkable: an annualised return in USD of 7.6 percent, with an average annual volatility (standard deviation) of 9.1 percent”, said Velasco. “But again, the story told from the commodities standpoint has two marked chapters. While the annualised return of Latin America’s corporate bonds during the expansive phase of commodities – from 2002 until 2010 – was 8.2 percent, which can be explained by the 12.4 percent average annual return experienced by the metals and mining bonds, the performance since 2011 and up to date has been an annual return of 3.5 percent, with the bonds within the metals and mining sector delivering an annual average of four percent.”

According to JP Morgan, an average corporate bond in Latin America currently trades at a spread of 559bps, which is roughly around 200bps below the levels seen prior to December 2001. During the peak of commodities’ expansive era in 2007, Latin America’s corporate bonds priced an average spread of almost 200 basis points, yet a year later, during the financial crisis, spreads reached levels close to 1,000bps. Right after, in 2009, the compression trend was resumed, and spreads went back to a range between 250 to 300bps during 2010. And then from 2011 onwards, corporate spreads in Latin America started to widen along with the systematic fall seen in commodities.

“Going back to the beginning, Latin America’s corporate bonds have recently bounced back significantly in terms of returns, showing a relevant compression in spreads. In Bci Asset Management’s view, from a long-term perspective, we still believe today’s situation offers a very attractive entry point”, Velasco said. “Fundamentals in the region are sound from a macro perspective and also from the companies’ individual point of view, despite the collapse in commodity prices. In the short term, we see an opportunity in bonds within the investment grade category in the region, which offer spreads close to 360bps, compared to the 170bps of their equivalent counterparties in the US”.