Emerging market debt suffers angst over Brazilian politics, Greenspan; C bond swap seen helping curve

By Reshmi Basu and Paul A. Harris

New York, July 18 - Emerging market debt drifted lower Monday as investor angst pervaded the market on new developments in Brazil's political scandal. Additionally, the market remained in a holding pattern as investors await testimony from Federal Reserve chairman Alan Greenspan on Wednesday.

Meanwhile the Brazilian Treasury announced what could be the end of the road for the country's C bond.

The Treasury started an exchange of up to $5.6 billion outstanding on the sovereign issue.

The new global bonds will carry the same 8% coupon rate. However, the maturity on the new global bonds will be extended, with the precise extension to be set by a modified Dutch auction. Unlike the C bond, the new bonds will be non-callable.

There was a time when the C bond served as the benchmark for Brazilian sovereign debt, but has since been replaced by the global bond due 2040.

The call option on the bond capped the price and hence, distorted the yield curve, according to an analyst note. The C bond pays the equivalent of a spread of Libor plus 325 basis points.

Another emerging market analyst said that the new global bonds should have a moderate positive impact on the curve, bringing spreads slightly lower.

"The Cs are skewed higher in spread terms because of the call option, and that is probably spoiling that part of the curve.

"Once you swap the Cs out, you don't have that skew any longer, and that part of the curve should rally to fit the rest of the curve.

"Also, a C swap that extends the maturity schedule would be positive for Brazil's credit profile, so that so that should help, at the margin, to improve sentiment across the curve," he added.

JP Morgan and Credit Suisse First Boston are managing the exchange offer.

Meanwhile during Monday's session, the market has reacted well to the announcement, according to a market source.

"There is a lot of technical noise around the bonds. There was a lot of trading today [Monday]. That's settling down," said the source.

During activity Monday, the C bond moved up 0.062 to 102 3/8 bid.

EM angst on Brazil, Greenspan

But at the same time emerging market debt generally saw lower price action Monday in response to new developments in Brazil's political scandal.

In a television interview Monday President Luiz Inacio Lula da Silva blamed top officials of his Workers' Party (PT) for alleged illegal fund-raising methods in hopes of insulating himself from the "bribes for votes" scandal.

"The situation in Brazil continues to complicate on the political side," said Enrique Alvarez, Latin America debt strategist at IDEAglobal.

"Although the PT is trying to take the fall, it's beginning...to look like that there's more that meets the eye."

Also the market ticked lower in response to U.S. Treasury prices closing at their lows Monday. The yield on the 10-year notes hit a two-month high at 4.22%.

The market is becoming increasingly nervous that Greenspan this week will hint of more tightening in monetary policy during his Wednesday's testimony.

"We are essentially stuck here between the politics of Brazil and what Greenspan might say," said Alvarez.

But emerging markets still continued to do better than Treasuries. Even as debt prices fell, the JP Morgan EMBI+ Index tightened by two basis points.

Alvarez said from a technical side, it may appear that the market needs a market correction "because you are looking at net prices and prices have been at very historical peaks."

"And for them to come off...would be something beneficial for the market over the medium term.

"That being said, I think you still have to look at the global liquidity environment and where Treasuries are. And judge from there if we really need have to come off very much. That I think is sort of uncertain," he said.

And as the market grinds tighter, investors are having a hard time finding value.

Ecuador in favor

Just look at Ecuador over the course of the last two weeks, said Alvarez.

Ecuador has gone from being the highest risk component of Latin America to being in demand, he observed.

"All of the sudden people have come back and drifted back into the credit - off of a number of different events that have gone on locally as far as financing," he added.

That had happened even though the financing is risky because it relies on Venezuela as a source, noted Alvarez.

"But people have come back in. It's gone from a plus 800-type risk credit to a 723.

"That only denotes the appetite for risk that is out there," remarked Alvarez.

During the session, the Ecuador bond due 2012 added 0.15 to 99.15 bid while the bond due 2030 was down half a point to 87 bid.

In other trading, the Brazil bond due 2040 lost 0.60 to 117.95 bid. The Russia bond due 2030 slipped a quarter of a point to 110¾ bid.

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