The Big Idea
Out-of-consensus calls on Latam credit in 2024
Declan Hanlon | November 17, 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.
As Latin American corporate credit rolls toward 2024, amortization walls loom of approximately $20 billion in 2025 and $25 billion in 2026. Though rates may plateau or potentially decline in the coming year, balance sheets across the region will need to absorb a much more expensive cost of financing. I anticipate an increased bifurcation in performance as ‘BB’ and stronger credits manage the higher costs while weaker issuers face significantly more difficulty preserving or even accessing liquidity. To that end, I expect an increase in reorganizations, restructurings and defaults in the coming few years. And my selections of out-of-consensus picks here unfold against this evolving credit market reality.
Complicating access to credit is investors’ current appetite for risk. Latin American corporate credit generally lacks the depth to offer a rote thematic approach to investing, aside from rates in 2023. So, the approach to deploying capital is often to hug the index for portfolios outside the total return crowd. Over the last 10 months, in the absence of a ‘normal’ primary calendar, this has led to volumes across the board dropping by 30% and 50%. Outflows along with a strategy of avoiding further landlines have combined to limit risk taking across the board. From 2021 through 2023, issuers across the region actively managed the amortization wall in advance of the interest rate ramp over the last year, reducing pressure on credit metrics and limiting a material increase in credit events. But things are about to change.
With this landscape, a few calls stand out.
Quasi-sovereign: Pemex long bonds
Though marginal buyers remain elusive for the Pemex capital stack and ESG concerns continue to drive inaction or outright selling, governmental support is more readily visible in Mexico’s budget while production levels continue to run at higher levels. Softness at the EBITDA line in the third quarter of 2023 was likely a little worse than expected after accounting for the lower average Mexico Mix price during the quarter. Beyond that, there was limited new information to affect valuations. Investors continue to anticipate the necessary level of government support in 2024, balanced by a substantial further reduction in the profit-sharing tax (DUC) to 30%, which accounts for the retention of about $5 billion a year, going forward.
Further, the present government budget proposal includes direct federal government support for Pemex, without materially affecting the public debt trajectory. That support includes the DUC reduction as well as direct transfers of approximately $8.25 billion. These would combine to exceed Pemex’s 2024 external debt maturity total of $11.2 billion, with the additional liquidity expected to be directed to capital expenditures. And with Pemex’ 2024 oil-price budget at $56.7 a barrel, materially lower than prevailing market prices, there should be incremental liquidity from operational cash flow.
Why then have the bonds not responded more aggressively to relatively positive data with the 2024 budgetary proposal specifying line-item support measures for Pemex in a budget for the first time? This specific data is an improvement in transparency and further underlines the capacity and willingness of President Andrés Manuel López Obrador’s (AMLO) administration to support the oil company.
In the contra-account, several key, independent forces combine to answer this question so far in 2023. With a minimal ESG story to tell and an increasingly concerned marketplace, the Pemex investor base has continued to shrink. Further, the large amount of bonds outstanding creates the obvious technical overhang, with minimal marginal buying interest creating asymmetric price action across the news spectrum. Moreover, as AMLO enters his final year in office, though the base case for Pemex support continues to be an AMLO 2.0 strategy within the office of a President Sheinbaum, starting in 2025, the background political uncertainty adds to the demand pressure. Finally, fundamentally, the company remains a laggard, with depletion rates expected to more forcefully challenge new production well growth in core fields in the coming years, particularly considering the speed of converting capex to cash flow. In a Sheinbaum administration, discussion of joint ventures and farm outs should renew, more out of necessity than strategy.
In the interim, Pemex spreads in the belly have again been trending wider, with both the 2033s and the 2050s offering yields of 12% or more—both at sovereign + 535 bp compared to mid-summer wides of sovereign + 650 bp. With the ‘black out’ period for US dollar issuance having ended on October 19, so too has the near-term potential for opportunistic new issuance in 2023. However, given that a Pemex yield threshold is likely in line with the 10% level crystalized by the most recent bond issue in February, near-term market access was not likely anyway. Further, though theoretically Pemex could benefit from duration, without incremental cost, the $64.5 dollar price and 12.2% yielding long bond suggests any investor appetite for par paper in that part of the curve to be essentially nil.
Hacienda and the company had also been considering a secured oil receivables facility that could generate $2 billion in cash initially and up to $4 billion in the coming years. However, it seems the required high-single-digit interest rate was unpalatable for the firm. This structure—oil contracts delivered to an SPV that subsequently issues secured financing—still potentially remains an option, as market conditions evolve.
Additionally, it appears that refinancing negotiations for the US dollar components of the existing credit lines remain under negotiation, with the MXN line rolling off by year-end and with the maturities as follows: PMI $1.5 billion in December this year and the remaining $8.0 billion jumbo line due in June 2024. The PMI line looks likely be refinanced and rolled in full; however, I expect that a new jumbo line will be as much as $2.50 billion smaller, given scaled back risk exposure requirements and ESG stipulations within the associated bank group.
From here, as the year turns, with oils prices resilient and government support well telegraphed, even with stable production levels, Pemex is likely to deleverage more in 2024 than in previous years. In addition to that, as rates stabilize and potentially decrease, the yield and price convexity inherent in the capital structure can make Pemex an outperformer, despite the ongoing technical overhang. With more than $2 billion in US dollar and Euro bond maturities coming due in January and February, the promise of Hacienda support will quickly be called to task: a successful and efficient response may generate increased positive sentiment at the prospect of gross debt falling below $100 billion in 2024, for the first time since 2016.
Crossover credit: Braskem SA
Braskem’s expected weak earnings print for the third quarter of 2023 hit the headlines in November in tandem with an updated bid for the majority of Novonor’s controlling stake. That muddied the initial price reaction in the bonds. The weak overall petrochemical market was once again crystalized in a third quarter earnings report that illustrated a near 30% decline in the top line and a 50% drop in EBITDA year-over-year, taking net leverage up to 12.2x, well in excess of the typical guard rails for investment grade ratings. Though the quarterly comparisons ease in the fourth quarter, weak demand and wide spreads continue. And some production issues in Brazil will likely further hamper a better year-over-year relative performance in the current period. Further, a material broader industry recovery is being pushed out until 2025, limiting any meaningful credit improvements in the near term. As the negative EBITDA print of the fourth quarter of 2022 cycles out of the calculation in the next earnings report, net leverage will likely drop below 10x once again. However, the ratio is still more in line with a ‘B’ rating rather than the current ‘BBB-‘ from two of the three agencies.
In parallel with the fundamentals, ADNOC updated its interest in Novonor’s controlling stake in Braskem with a new non-binding proposal to acquire at least 35.3% of this stake for R$10.5 billion, which implies a value of R$37.29 a share. The mechanism for payment would be a 50% cash on closing and the remaining 50% converted into US dollar on the transaction closing date and paid in a subordinated PIK instrument. The instrument would have a 7-year maturity and annual coupons of 7.25% to be paid-in-kind until the end of the third year and then in cash from the fourth year onwards. The latest proposal is contingent on further due diligence and a determination on the contingent liabilities imbedded in the ongoing Alagoas process as well as an investigation into the potential for any further, unreported material contingent liabilities. Finally, the proposal also depends on the structuring of a new shareholder’s agreement with Petrobras. Given the ongoing Alagoas litigation, don’t anticipate imminent clarity on that front. Completing this transaction, even if the parties are aligned, is likely to still take significant time.
In the interim, while the focus remains on the weak fundamental overhang, the company has shored up liquidity in anticipation of an elongated trough period in the cycle. Braskem’s recent $850 million market tap has resulted in a total cash position of nearly $3.5 billion at the end of the third quarter, excluding the $1billion revolver, that remains undrawn. This liquidity faces $1.2 billion in maturing debt through the end of 2027, which implies that available operational liquidity is sufficient to fund operations in the near-to-midterm. Bond prices reacted positively to the initial M&A headlines, tacitly ignoring the weak earnings print, with buyers driving the on-the-run 2033s up 3 points, equating to a yield of about 8.625%. I expect a downgrade to reframe some of this price action lower in the near term, even if largely priced in, with very limited forced selling to follow. At more than 9% in the belly, the bonds are factoring in the cycle and the downgrade and should see demand, particularly as the calendar turns. The less liquid hybrids also look attractive at more than 12%.
High yield credit: BRF SA
Though chicken oversupply remains a pervasive drag on pricing and on results in BRF’s international segment, earnings in the third quarter of 2023 were about in line with expectations. The R$1.2 billion of EBITDA marked the strongest print of 2023, and margins improved to near 9% on grain costs and further benefits from an efficiency program. Brazilian operations improved, with EBITDA margin rebounding by 220 bp to 12%, mainly reflecting lower grain input costs, which is near 50% of operating expense. The international division’s results remained weak with EBITDA margin declining by 60 bp quarter-over-quarter to 4%, driven by continuing low export prices amid a global oversupply of proteins as a response to past outbreaks of avian flu. Export volumes were a positive surprise despite the export suspension to Japan, growing 6% sequentially. Though cash generation was again weak, the trend improved sequentially once again, with expectations of positive cash flow in current quarter. In the third quarter, about R$217 million of asset sales and operational improvements led to a cash consumption of R$21 million compared to a cash burn of R$1.7 billion in the preceding periods during the year. As a result, net leverage declined 0.4x quarter-over-quarter to 2.66x, aided in large part by the earlier equity secondary offering.
The company confirmed that the pet food division sale process has ended, given the lack of acceptable offers at the sought-after level of around R$2 billion versus apparent bids of around $R1.7 billion. The sale was expected to drive further debt reduction. But given the capital injection, combined with the fundamental improvements, the easing comps in the coming quarters should engender further metric gains on the balance sheet, underlying my continuing view that the BRF 2050s at near 9% are the cheapest bonds in the protein space and should benefit from additional operational gains in 2024. Additionally, given the underperformance in recent years, bond prices have reflected the required premia, trading to 100 bps over the MRFGBZ 2031s, before convergence and now approximately a 40 bp discount, largely on the back of the disparate expectations in the respective markets in 2024. Additional divergence in spreads should show up as results are crystalized in the fourth quarter this year and in 2024.