The Big Idea
A midterm exam in LatAm corporate credit
Declan Hanlon | July 14, 2023
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
After the broadly poor performance of 2022, we turned the clock to 2023 with an expectation of renewal in Latin American debt. We would see positive fund flows, new issue activity, price recoveries and a year of volatility but with opportunity. And that is what happened. For the lone month of January. In the last five months, we have seen funds leave the market after cash built up from coupon clipping has struggled to find opportunity. Limited new issue has failed to soak up liquidity or, as importantly, to reprice the secondary. Still, the LatAm corporate market seems to have clear opportunity to pick up return through security selection.
New issue trails prior years
The month of June had suggested a turning point, or at least did up until macro data provided cover for the Federal Reserve to suggest more rate increases ahead. Nonetheless, with the passage of the first half of the year, corporate capital structures are obligated to address looming amortization schedules, while sovereign Treasuries project fiscal balances for the year ahead. As such, we have seen some resurgence in the primary market with a mix of sovereign and mostly investment grade corporates accessing a healthy demand, as illustrated by the thin new issue premia. As of June 30, in Latin America, we have had $35.3 billion of USD new issue, with corporates and financials accounting for 43.1%. This is slightly below the comparable year-to-date total issuance of $38.0 billion in 2022 and well below the run rates of 2021 and 2020.
Returns rely largely on coupons
Corporate performance broadly, year-to-date, has come mainly from coupon as Treasuries have weighed on total return and higher costs have squeezed margins at the operating levels, particularly for the smaller, lower-rated credits. The CEMBI total return year-to-date is 3.14%, with only 0.39% accruing from price return. This is further manifest in the near complete lack of high-yield new issue in Latin America, with investors monitoring rising default rates as historical divergence in risk pricing resumes and we see an increased split in credit performance as yields rise. On an asset class level, in both investment grade and high yield, emerging market credit continues to offer thin premia to US credit. And until this dynamic changes, significant capital deployment through fund flows to dedicated emerging market investing or from crossover global credit seeking yield seems unlikely, corralling total return opportunities, at least for the near term.
Oil and gas outperforms
In the region year-to-date, few sectors have performed well, though some clearly better than others, with oil and gas names broadly benefitting from stable oil prices, after multiple years of strong cash generation: PETBRA has maintained investment grade credit metrics, though the sovereign ratings ceiling and political backdrop implies a spread premium, which we continue to maintain is inadequate. ECOPET has weathered a political and regulatory overhang, while refinancing a substantial amortization wall this year, positioning the credit to outperform through year end. PEMEX remains the laggard, with the perennial amortization schedule about to step up to more than $10 billion in 2024 and the government maintaining distance from a structural assistance package. Spread convergence to the sovereign, with PEMEX trading wider than 600 bp over the sovereign at times this year, is a function of political strategy and will rather than corporate performance. And the market appears increasingly exhausted at the prospect.
Pulp and paper looks rich to fundamentals
In pulp and paper, despite the well-telegraphed drop in pulp prices across the sector, the market has been comfortable in maintaining substantial exposure to the main issuers, leading broad-based conclusions that the sector is rich to fundamentals. I concur, at least in general terms, for the Chileans—CMPC and CELARA—though maintain a view that SUZANO is the relatively ‘best priced’ credit in the sector, particularly considering the related convexity for the company as pulp prices stabilize and eventually regain positive momentum as global inventories restock and demand improves.
Proteins competes with the US
In proteins, it’s been a case of Latin America against the US as the beef cycles diverged and JBSSBZ and MRFGBZ, in particular, saw material margin pressures begin in late 2022 and accelerate this year. These pressure most recently showed up in S&P’s July 13 change in outlook to Negative from Stable for the BBB- rating for JBSSBZ. With the cost of goods sold increasing much more than the ability to pass through to customers, net leverage ratios also began to increase and should continue to increase into 2024. This has resulted in JBSSBZ offering the opportunity to position with longer-term outlooks for alpha generation, while MRGBZ has offered shorter term opportunities, as in the 2026 bonds, with greater than 8% yield for duration of less than three years. This week’s announcement by JBSSBZ that it is finally pursuing the long-awaited US listing adds a positive technical to the investing equation. And as non-EM investors increasingly enter the trade, the credit looks like a good counter-cyclical trade idea into 2024, particularly in the long end, where JBSSBZ trades at about 100 bp over US peer TSN. The increased ratings risk for JBSSBZA may push this gap wider in the near term, offering better entry points.
BEEFBZ was the call earlier in the year, when the largely LatAm operator offered a discount to MRFGBZ; however, this has now reversed, largely ending the thesis for the moment. Finally, BRFSBZ has been the under-performer for most of the last 10 years in LatAm proteins. And with its exposure to chicken prices (lower) and grain costs (higher), this had seemed set to continue. But between the equity injection plans (the second in recent years); divestment plans and a strategy to monetize unused tax credits, the credit may end up 2023 as the least leveraged name in the sector. To that end, BRFSBZ bonds, particularly the 2050s in the mid $60s at yields of more than 9%, are my second pick for relative value in the sector for the duration of 2023.
Pressure on petrochemicals
Petrochemicals have been under significant pressure over the last 12 months, and a near term reversal in the underlying commodity prices that would reverse the cycle seems unlikely. At BRASKM, lower demand and lower end prices are likely to drive net leverage from less than 1x to more than 4x in the space of 12 months. Though the loss of its investment grade rating seems unlikely as a result of fundamentals, price recovery is unlikely in the coming quarters. An additional and perhaps more prescient influence on spreads for the company is the ongoing M&A or LBO overhang—depending on which protagonist you reference. Though the eventual transaction should be structured to avoid triggering a change-of-control put in the bonds, the overall enterprise is likely to see incremental borrowing, increasing costs for the company and thus lessening the credit quality of the overall entity. At Braskem’s Mexican JV, the BAKIDE entity has been under price pressure on negative high-yield market technicals on top of the weakening operating fundamentals with low polyethylene prices resulting in escalating leverage ratios this year. Though the Company has sufficient liquidity to absorb the pressure and would have assistance from the parent if needed, the bonds remain under pressure and are presently at all-times lows, exceeding 18% in yield. With weak operating financials to be confirmed in the next earnings cycle, prices should weaken further in the near term. Elsewhere in the sector, on the investment grade front, the revenue diversity of ORBIA looks better than ALPEK, though as this thesis has played out and with OBRIA planning on increasing net leverage under its strategic growth initiative, we are likely to see a rebound in commodity pricing first, at ALPEK, to drive the next iteration of spread convergence.
Conservative yields in metals and mining
In metals and mining, with the exception of VOLCAN in Peru, yields have remained in conservative territory. VALEBZ recently tapped the market to strong demand and though iron ore prices are likely range-bound in the near term, the credit is one of the few names attracting crossover demand in the region. Similarly, SCCO, while maintaining 1x net leverage despite weakening copper prices this year, is also a name well known beyond dedicated EM funds and this is reflected in the sub 6% yields for the ‘BBB+’ entity. As we step lower in the ratings spectrum, scale and/or geographic diversity inhibits spread performance, though names like NEXA and MINSUR have performed well. We have viewed NEXA as too expensive to the risk profile, though maintain a view that MINSUR retains upside to the eventual positive technical from a full upgrade to investment grade (even if S&P has slowed momentum and reduced the outlook from Positive to Stable, this week). CSNABZ, at 9% in the belly, is again cheapening up, after a strong start to the year; however, the company looks likely to miss its full year net leverage target of 2x and is more likely to be a candidate for additional M&A in the cement sector, which could entail additional net leverage.