Argentina's Long Shadow

The risk of default is killing the region's debt market

Latin American borrowers are springing into action after months of hibernation. Since the start of May, the governments of Mexico, Brazil, and Colombia have raised a combined $2.4 billion via offerings of dollar- and euro-denominated bonds. Corporations are also getting in on the act: Petrobrás, the Brazilian oil company, and Teléfonos de México, the Mexican telecom giant, recently sold $950 million worth of bonds between them. "Latin issuers have become extremely intelligent," says Amer Bisat of of Morgan Stanley Asset Management in New York. "They go for windows in the market as soon as they see them."

This Latin boomlet is all the more remarkable given investors' deep fears that Argentina might default on its $128 billion public debt. The unease is reflected in total returns on Latin bonds, which have declined more than 2% this year, while those of non-Latin bonds are up nearly 11%, according to J.P. Morgan & Co.'s Emerging Market Bond Index.

So is the door finally opening for Latin borrowers? Hardly. "Unless you're the bluest of blue chips, access is absolutely nada," says Chris Taylor, a high-yield strategist at ING Barings in New York. What the recent debt issues show is some slick financial engineering against a background that's bleak--and getting bleaker.

RISK INSURANCE. Take the May 2 Petrobrás $450 bond issue. The seven-year bond received a Baa1 investment-grade rating from Moody's Investors Service, which is six notches higher than the B1 rating Moody's gives the Brazilian government. How come? Petrobrás took out political risk insurance on the bond from Zurich North America in Schaumburg, Ill. That means bondholders are guaranteed their payments even in the event of catastrophe, such as a government ban on overseas cash transfers. Petrobrás won't say how much it paid for the insurance, but it was probably well worth it. Its paper was priced at 475 basis points over seven-year U.S. Treasury bills. By comparison, Brazilian government debt of equal maturity was trading at 664 basis points above U.S. Treasuries on the day of issue.

Governments, too, are having to jump through hoops to raise cash. The Brazilian government wants to sell long bonds. But investors are reluctant to take on long-term risk given the uncertainties over the economy. So Brasília issued a 50-month bond that can later be swapped for a 20-year bond. Bisat explains: "They said: `We know you're afraid, so we'll give you defensive short-term paper. But if Brazil does well, you can have long-term paper."' But even with this option, Brazil had to offer a return of 648 basis points above U.S. T-bills.

BEAR RAID? Bond buyers have good reason to demand extra security. An Argentine default would wreak heavy collateral damage on other Latin borrowers. Investors are desperately hoping the specter of default will just fade away. Under a deal now in the works, Argentine bondholders may soon be able to trade as much as $20 billion in short-term paper for longer-term bonds. By stretching out the debt-service schedule, Argentine authorities are hoping to buy much needed breathing room.

But even if Economy Minister Domingo Cavallo pulls off a successful swap, Argentina is not home free. Walter Molano, head of Latin American research at BCP Securities Inc. in Greenwich, Conn., believes the only reason hedge funds aren't shorting Argentine bonds is that they fear the paper will disappear as a result of the swap. Once the swap is done, Molano says, "the talk on trading desks is that market players will attack Argentina viciously." If a new bear raid is launched on Argentine debt, other Latin paper will get hammered, too.

Indeed, the thinking in some investment circles is that, hard as it may try, Argentina may not be able to avert a default. After nearly three years of recession, the economy is showing no signs of life. "It's time to encourage them to default," Molano says.

On the surface, that may seem like a rotten idea: An Argentine debt default would keep the international capital markets closed to the whole region for some time. But don't let the recent wave of bond issues fool you: For most Latin borrowers, they already are.

By Jonathan Wheatley in São Paulo

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