Emerging market debt rallies as Brazil, Mexico move to cut debt; India's NTPC sells $300 million bonds

By Reshmi Basu and Paul A. Harris

New York, Feb. 23 - Emerging market debt sprung higher Thursday as supply looks to be drying up - and adding to the positive technicals, Brazil announced that it would redeem $6.64 billion of Brady bonds while Mexico launched a tender offer for $5 billion in foreign currency bonds.

In the primary market, India's NTPC Ltd. sold a $300 million offering of 10-year senior fixed-rate notes (/BB+/BB+) at 99.523 to yield Treasuries plus 140 basis points.

The deal came inside of revised price guidance, which was set at 140 to 145 basis points more than Treasuries.

Barclays Capital and Deutsche Bank were lead managers.

And the Republic of Indonesia will begin a roadshow next week in Asia, London and the United States for a benchmark-sized offering of dollar-denominated fixed-rate bonds (B2/B+).

The structure of the bonds remains to be determined.

Barclays Capital, JP Morgan and UBS will lead the offering which will be marketed via Rule 144A and Regulation S.

Brazil and Mexico soak up paper

Early morning, both Brazil and Mexico announced plans to reduce the amount of debt owed to foreign investors.

Treasury secretary Joaquim Levy said Brazil would exercise a call option to redeem $6.64 billion of Brady Bonds. Funding will come from international reserves.

And Mexico said it would offer to buy back up to $5 billion of foreign currency bonds via a modified Dutch auction.

Indeed, investors were pleased with both announcements. The asset class, including local markets, shot up. Emerging debt spreads hit record levels on the buybacks, noted sources.

Spreads on JP Morgan's EMBI+ index also narrowed to their tightest level ever at 193 points.

During the session, the Brazilian bond due 2040 added 0.55 to 133.10 bid, 133.35 offered while the bond due 2030 gained 1.55 to 160.10 bid, 160.80 offered.

The Mexican bond due 2026 moved up 1.50 to 164.50 bid, 166.50 offered while the bond due 2033 added 1.65 to 120.25 bid, 120.75 offered.

The repurchases mean diminishing supply, according to Enrique Alvarez, Latin America debt strategist for IDEAglobal.

"And with diminishing supply, you get higher prices. And that's what you are seeing throughout the day."

Both Latin American countries are taking advantage of a supportive environment.

Each has seen its coffers filled with cash due to the boom in commodity prices, noted Alvarez.

Furthermore, local currency deals have become increasing popular, according to a debt strategist. Sentiment in January was strong and net new money into emerging markets exceeded $3 billion.

"You can see it as a way of using hard currency inflow that has been coming into these countries," he said.

"If you wanted to keep your currency from being pushed higher by that weight of foreign capital coming into your country, one of the things you can do is to pay down your foreign debt."

And that is exactly what Brazil is doing, said the strategist, since the country is calling the Brady bonds at par.

Shift to local currency market

The move by Brazil and Mexico to reduce their external debt may mark the beginning of the shift from a foreign currency-denominated debt market to a very liquid local currency market, observed sources.

"That's the direction that the market is going to head in," remarked Alvarez, adding that the retirement of a large portion of dollar-denominated debt by two of the largest players in the market means that the countries are becoming wiser as to how they use their resources. In essence, by getting rid of their dollar liability, they are reducing the risk of an external shock, which has been a major overhang for Latin American markets.

Moreover, the countries are sending a message that financing will be obtained in local markets in the future, observed Alvarez.

One emerging market analyst sees this currency rotation as a blip.

"I think this is more a cyclical trend than anything else," he said.

"Right now liquidity conditions are excellent, and fiscal deficits are low. That makes it easy for governments to turn to local markets for all their financing.

"In time, though, as liquidity conditions tighten and fiscal deficits grow as economies cool off, I expect we'll see many countries return to external markets for new financing," he added.

But the strategist noted that the transition is happening.

"It is very important," he noted, describing the shift as "a kind of redemption" of what Harvard economist "Ricardo Houseman called original sin."

"Houseman says that the reason why these countries have such volatile business cycles and go through these periodic financial crisis is because they borrow in foreign currency and in currencies that are harder than their own," the strategist explained.

But when a country which already has an external borrowing problem is faced with other challenges such as rising domestic demand or a change in terms of trade, the results can be dangerous.

"There's usually a panic and then whatever their original fiscal problem is, it's amplified by the weakness in the currency and the fact that they borrowed money in the currency that is appreciating against their own, just when things are worse," noted the strategist.

"So that really acts as an amplifier on their business cycle volatility," he said, adding that such volatility could be disruptive enough to result in depression and default, as seen in Argentina in 2001.

"If you can shift your borrowing to your home currency, then the risk is shifted to the investor but there is a much better matching of the currency of the obligation of the borrower and the lender," he added.

The debt strategist observed that there are obstacles to the transition of local markets such as capital controls in many of the countries.

But governments are recognizing that more and more people are looking to local markets. Last Thursday, the Brazilian government's moved to eliminate a 15% withholding tax on income and capital gains in local-currency government debt for foreign investors.

"But it really does present the opportunity to extend the maturity of the local real yield curve and actually get local interest rates down," the strategist said.

Furthermore if Brazil is able to roll out a local curve, then the country will likely see an upgrade from ratings agencies such as Moody's.

"Moody's has been very unhappy with the structure of their debt," noted the strategist.

"It's either interest-rate linked or it's inflation-linked. It's short. And if they churn it out in local terms, it starts to look more like Italy or something. And Italy is double-A.

"You've got ratings upside from a successful evolution of this phenomenon."

Additionally, emerging market debt becomes more complicated with the local market component.

"It means that emerging market investment will become more like global bond investment and less like credit investment.

"You will be analyzing cycle dynamics across currency boundaries rather than solvency dynamics," the debt strategist observed.

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