(Bloomberg Markets) -- Gustavo Poletto bought 200,000 reais ($50,000) of bonds issued by a Brazilian road company in 2015, lured by their high yields and tax-exempt status. His broker told him it was a once-in-a-lifetime opportunity. Now the 39-year-old radiologist from southern Brazil expects to lose it all.
His pessimism is probably justified. The company that sold the bonds, Concessionária Rodovias do Tietê, is trying to restructure its debt and says it has few prospects for fully repaying its creditors. While Poletto says he’s learned his lesson, thousands of his fellow Brazilians remain enthralled by infrastructure bonds and other high-yielding debt. Many are in for a wake-up call.
“The risks in an infrastructure project can be very large,” says Jean-Pierre Cote Gil, a portfolio manager and head of credit at Julius Baer Group’s family office in Brazil. “For a retail investor it’s difficult to analyze, understand, and put a price on that risk.”
Brazilians are taking on more risk for a simple reason: Record low interest rates are forcing them to find higher-yielding alternatives to their traditional go-to investments of Treasury bonds and bank savings accounts. But newcomers are often unfamiliar with the vagaries of the local corporate bond markets, where it can be tough to recover losses or sell securities.
Infrastructure bonds use the cash flow from a project, such as a toll road or bridge, to repay investors. Riskier projects should, in theory, pay higher premiums over Brazilian government securities, providing attractive yields. Infrastructure bonds are also tax-exempt for individual investors, adding another enticement. “Brazil gave retail investors the incentive to buy this type of bond, but we know that they usually don’t analyze a project in detail—they’re going to rely on a report they read or a recommendation,” says Cote Gil, who’s been analyzing credit risk for more than 20 years.
Some asset managers in Brazil have become concerned about how popular these bonds are with retail customers. Since the infrastructure debt program started in 2012 through October, about 75.5 billion reais of the bonds have been issued, according to Bloomberg data. Among the firms expressing concern is Quasar Asset Management. Founding partner Carlos Maggioli said in a tweet in October that investors shouldn’t buy new infrastructure bond issues because the spreads don’t adequately compensate for the risk and duration.
Why are asset managers worried? Credit is a fast-growing asset class in Brazil. Funds investing in corporate debt held about 15 billion reais in assets in 2014. That figure surged to almost 100 billion reais in June, or about 2% of the total 5 trillion-reais fund industry, says Alexandre Muller, a partner and portfolio manager at JGP Gestao de Recursos Ltda., one of Brazil’s biggest independent asset managers. He contrasts that with the U.S., where bond funds represent closer to half of total assets. “So, there’s a lot of room to grow,” in Brazil, Muller says. However, credit fund managers want to nudge the market away from problems that could sour investors on the asset class.
Retail investors are often oblivious when a bond deal is failing. That’s because brokers typically report the face value of the bonds when providing client balances, so a default that brings the value to near zero can seem to come out of the blue, according to Muller. “We are making a huge effort to improve transparency and mark-to-market processes for most bonds so they have a fair price—one that can be confirmed in real trades,” he says. JGP acts as a price provider for bonds, a role usually played by a broker or bank. That’s partly to improve market transparency, Muller says, but also because JGP’s own funds need a reference price to trade well.
In Brazil, JGP is a pioneer in credit funds, which account for 3 billion reais of the firm’s 20 billion reais of assets under management. Muller says JGP’s funds have become one of the biggest credit market makers in Brazil, with about 5% of the total trading volume, by offering for free a service for which banks charge as much as 20,000 reais a month. “Banks here have no interest in improving the secondary markets, because they earn money otherwise,” he says. “We do so to protect our own portfolio.” JGP has also created a database and launched an index called Idex-CDI JGP, which follows the approach JPMorgan Chase & Co. used for its emerging market bond indexes.
Such efforts are starting to have an effect. The total amount traded this year through Sept. 13 almost doubled from the same period last year, to 98 billion reais, according to JGP data.
The structure of the market in Brazil can sometimes contribute to big price drops after a bond is issued. How this situation arose is a little complicated, but it derives from the historical thinness of secondary credit markets. Traditionally, most local bonds were bought by banks and held on their balance sheets to maturity. In fact, to this day, many companies take out loans, but book them as bonds as a way to avoid taxes. In the past, about half of local bonds were actually these bank loans “in disguise,” a percentage that’s now down to about a third, Muller estimates. Pricing was an opaque process in which banks would name a figure at which they would commit to buy the bonds, without any particular effort to gauge market appetite.
Fast forward to today: Dutch auctions are now the most widely used method of pricing bonds in the primary markets—the price is set based on the highest level at which the whole offering can be sold. Bank underwriters, though, continue to operate much as they used to. They commit to buying bonds at prices that may be informed by a commercial relationship with an issuer rather than demand. The difference now is that instead of holding to maturity, the banks sometimes bid up offering prices, scoop up a chunk of the bonds, and turn around and offload them. Many “start selling the bond on the day after, pushing prices down and creating losses for funds that bought along with them to hold on to the bonds,” Muller says. Banks in Brazil earn more from underwriting and by doing those types of “flipper trades” than by creating a healthy secondary market, he says.
Reference prices and indexes are changing that. Many investors are simply refusing to buy bonds in the primary markets when prices are too high compared with others. To protect its funds, JGP enters a new offering only when at least 20 other investors participate and banks wind up with no more than 10%.
The tax exemption on infrastructure bonds, while attracting investors, also adds hurdles for issuers that run into trouble. Typically when a borrower can’t make its payments on time, the solution is to swap the defaulted debt for a new longer-term, lower-coupon bond. But with Brazil’s tax-exempt securities, such modifications could need government approval, according to Julius Baer’s Cote Gil.
One alternative would be to change the terms of the existing bond. But that can be even more difficult to get done. In the case of Rodovias do Tietê, for example, changing the bonds would require holders of 90% of the debt to attend a meeting and approve new terms. If that fails, 100% of those present at a second meeting must vote in favor. Muller, for one, is calling for changes to the tax exemption, citing a proposal to grant it to the issuers, which could use it to offer higher yields to all investors.
One more hidden risk lies in wait for the credit fund industry. About half the funds promise investors they can withdraw their money on the day of a redemption request or one or two days after. Yet many are investing in illiquid debt to improve returns and beat their indexes as credit spreads tighten. One potential solution, according to Cote Gil: Funds should include a lock-up period, which would help filter out clients that lack staying power. Otherwise, when a crisis comes, investors who ask for their money back will post huge losses or simply won’t be able to get it, he says.
Roberto Sallouti, chief executive officer for Banco BTG Pactual SA, says his biggest concern can be boiled down to one word: suitability. “If we don’t take care with that, we could simply sabotage the market’s growth from its birth,” he says.
It’s probably already too late for one investor—Poletto, the radiologist who bought those road bonds that are in distress. “I’m never investing in local bonds again,” he says.
Lucchesi, Marques, and Andrade are reporters at Bloomberg News in São Paulo.
To contact the authors of this story: Cristiane Lucchesi in Sao Paulo at firstname.lastname@example.orgFelipe Marques in Sao Paulo at email@example.comVinicius Andrade in Sao Paulo at firstname.lastname@example.org
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