Citigroup Inc. is in talks with Brazilian regulators to create global depositary notes tied to local corporate bonds as the government seeks to boost trading in the domestic market by luring foreign investors.
Average daily trading volume in Brazil’s local corporate bond market was 1.25 billion reais ($609 million) in May, according to the nation’s capital markets association. Daily trading volume in the U.S. high-yield corporate debt market was $3.3 billion on June 15, according to Trace.
Brazil’s efforts to stem gains in the real by imposing taxes on foreign investors have hurt its push to wean companies off subsidized loans from state banks and develop a local market for long-term financing. The real has dropped 9.5 percent this year as Brazil stepped up measures to protect manufacturers. Global depositary notes, or GDNs, mirror the equity market’s American depositary receipts by allowing foreigners to buy local securities without moving money into the country.
GDNs “make it just as easy to trade a local currency bond as a hard currency bond,” Joe Kogan, head of emerging-market strategy at Scotia Capital, said in a telephone interview from New York. For investors “who aren’t big enough or are new to a particular market, it makes a lot of sense,” he said.
The discussions with Citigroup are in a preliminary phase, according to the Rio de Janeiro-based markets regulator known as CVM. Nina Das, a spokeswoman for Citigroup in New York, declined to comment.
Brazil’s sovereign dollar bonds due in 2021 yielded 2.8 percent on June 15, while the yield on similar-maturity Mexican dollar debt was 2.94 percent. The yield on the 10-year U.S. Treasury bond was 1.58 percent.
Real-denominated bonds due in 2013 from Vale SA, the world’s largest iron-ore producer, yield 0.48 percentage point more than Brazil’s interbank rate, or about 8.8 percent, according to the country’s local capital markets association. The average yield on Brazilian corporate dollar bonds was 6.1 percent on June 15, according to JPMorgan Chase & Co.
Citigroup, which created the first GDN in 2007, has GDN facilities in nine countries. It arranged a 10 billion peso ($723 million) offering by state-owned Petroleos Mexicanos last November and three sales from the government of Peru. Investors can use global depositary notes to buy new bond issues or to purchase existing local-currency bonds.
Citigroup is looking to expand its GDN business to Brazil as the government seeks to attract foreign capital to help finance 955 billion reais in infrastructure spending by 2014. Finance Minister Guido Mantega removed a 6 percent levy on overseas investment in corporate bonds tied to infrastructure in December as part of a series of measures designed to spur growth in Latin America’s biggest economy.
IOF Tax Exemption
It is unclear whether corporate bonds sold in the GDN format will be eligible for the IOF tax exemption, according to Ricardo Russo, a partner at law firm Pinheiro Neto Advogados in Sao Paulo.
“The best thing would be for the tax authorities to issue a specific rule on GDNs,” Russo said in a telephone interview. “The momentum seems to be quite right to do that, because now we have the infrastructure debentures and this willingness of the Brazilian government to promote long-term investments.”
In addition to CVM approval, the central bank would need to expand its rule allowing traditional ADRs in Brazil to include debt securities, Russo said.
President Dilma Rousseff’s government is rolling back measures implemented earlier this year to weaken the real and protect local manufacturers as Europe’s debt crisis prompts investors to shun developing-nation currencies.
Repeal of Levy
The government repealed a tax on overseas loans last week, part of a series of measures unveiled in the past 19 months that helped make the real the worst performer among 25 emerging-market currencies tracked by Bloomberg.
“If the main premise of GDNs is to expand the investor base for local-currency denominated debt issuance, I think it might serve as a temporary bridge,” Robert Abad, who helps oversee $41 billion in emerging-market assets at Western Asset Management in Pasadena, California, said in an e-mailed response to questions. “The optimal way for a local-currency debt market to develop in its own right is when investors become more comfortable with emerging-market exchange-rate management and the relative volatility associated with those markets.”
Concessionaria Rodovias do Tiete SA, the Brazilian highway administrator, scrapped plans last month to issue what would have been the first bonds to take advantage of the tax incentives as the European debt crisis quashed demand for higher-yielding assets. The company has postponed any return to the bond market until 2013, according to a person with knowledge of the matter who declined to be identified because he wasn’t authorized to speak publicly.
Pablo Cisilino, who helps oversee about $35 billion in emerging-market debt at Stone Harbor Investment Partners, said he will shun local Brazilian corporate debt as long as there is a tax on foreign investors’ purchases, known as IOF.
“We are not buying local corporates in Brazil until they remove the IOF, and stop tinkering with the currency,” Cisilino wrote in an e-mailed response to questions.
The real declined 0.5 percent to 2.0621 per U.S. dollar at 2:32 p.m. in Sao Paulo after falling 1.3 percent last week. The extra yield investors demand to own Brazilian government dollar bonds instead of U.S. Treasuries rose six basis points to 210 basis points, according to a JPMorgan Chase & Co. index.
The yield on the overnight interest-rate future contract due in January 2014 decreased four basis points to 8.05 percent.
The cost of protecting Brazilian bonds against default for five years fell one basis point to 151 basis points on June 15, according to data compiled by Bloomberg. Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent if a government or company fails to adhere to its debt agreements.
GDNs have helped governments sell bonds to a broader swath of investors, Scotiabank’s Kogan said. In a typical transaction, Scotiabank’s local branch in the Dominican Republic will buy a local government bond for a New York-based client. Scotiabank gives the bond to Citigroup to hold as a custodian. Citigroup then issues a GDN to Scotiabank, which is then transferred to the investor.
The counter-party risk associated with GDNs is “marginal” because in the event of a bankruptcy, the bonds would be separated from the custodian bank’s debt obligations, according to Kogan.
“The counterparty risk is very small,” he said. “The only caveat is that it’s never happened.”