JPMorgan Exploits 15-Year Ban With De Facto Munis: Brazil Credit

JPMorgan Chase & Co. and Credit Suisse Group AG are finding ways to profit from Brazil’s 15-year ban on municipal bond sales, issuing notes tied to state loans guaranteed by the government.

The banks last month sold notes backed by a $1.27 billion loan to the state of Minas Gerais yielding 4.216 percent. While the debt was issued at a lower rate than the 5.33 percent Credit Suisse charged Minas Gerais in November for the loan and lets the state pay back a portion of the principal along with interest payments, they yield 1.3 times more than similar-maturity government bonds and carry the same guarantee.

Wall Street’s biggest banks are capitalizing on Brazil’s decision in August to ease some restrictions on state borrowing put in place after a $44 billion federal bailout in 1997 by securitizing the loans they extend as local governments seek to refinance bailout debt and fund investments. With virtually no outstanding muni bonds in Brazil, the Minas Gerais notes have risen 0.32 cent since they were issued at a premium of 109.18 cents on the dollar, according to Cantor Fitzgerald.

“It’s clear that the market likes it,” Ulisses de Oliveira, a money manager at Galloway Capital Management in Sao Paulo who helps oversee $400 million of emerging-market debt, said in a telephone interview.

Brazil Spread

The percentage point in extra yield investors get to hold the notes instead of federal government bonds compares with an average spread of 0.13 point between U.S. municipal debt and similar-maturity Treasuries. The U.S. municipal bond market is $3.7 trillion. Mexico has 60 billion pesos ($4.85 billion) in municipal debt outstanding, according to Finance Ministry data compiled through March 2012.

The Minas Gerais loan was assigned to a special purpose entity, which in turn issues pass-through notes to investors. It was the first state borrowing to be repackaged for the bond market since Brazil authorized 21 states in August to borrow 60 billion reais ($30 billion) through 2014 with government guarantees to compensate for lower tax transfers and help finance investments.

The securities received a preliminary BBB rating from Standard & Poor’s, the second-lowest level of investment grade and in line with Brazil’s sovereign rating.

States’ Plans

States are in talks to borrow at least $6.5 billion from private lenders this year, more than double last year’s total following federal authorization last August, with each loan subject to approval by the federal government. No other banks have filed to package such loans to investors, according to data compiled by Bloomberg.

Mato Grosso, an agricultural state in western Brazil, is waiting for approval for a $1 billion, 15-year loan from Credit Suisse with a 4.5 percent interest rate, Deputy Finance Secretary Vivaldo Lopes said March 4.

Parana state, in the south of Brazil, is seeking approval for a 1.1 billion-real loan from Credit Suisse to repay debt owed to the state-owned electric utility, according to state Finance Secretary Luiz Carlos Hauly.

Press officials in Sao Paulo for Zurich-based Credit Suisse and New York-based JPMorgan declined to comment on the debt sale. The Finance Ministry declined to comment.

States ran into financial difficulties in the early 1990s after years of mismanagement and hyperinflation.

Spending Limits

After the rescue, Congress approved a fiscal-responsibility law that limits spending in election years and prohibits local governments from selling bonds until they finish paying off about $200 billion of debt stemming from the bailout that’s owed to the federal government.

It makes sense for the federal government to ease restrictions as rising tax revenue creates room for some states to take on more debt, according to Raul Velloso, a former economic secretary at the federal Planning Ministry who is now director of ARD Consultores Associados in Brasilia.

“The credibility of the states is rooted in this mechanism,” he said in a telephone interview. “The states are still held in a very tight straitjacket, so these deals don’t inspire a lot of worry.”

States’ revenue probably exceeded net debt last year, according to a Feb. 22 report by Fitch Ratings. States had a total of 408 billion reais of debt in 2011, 88 percent of which was owed to the federal government, according to the report.

TCW View

Even with a sovereign guarantee, not all Brazilian states’ debt would be attractive to foreign investors, said Marcela Meirelles, a Latin America strategist at TCW Group Inc. in Los Angeles, which oversees $128 billion of assets.

Rio de Janeiro, whose finances are being squeezed as federal lawmakers seek to funnel some of the royalties from crude produced within the state to other local governments, would face more scrutiny from investors, she said.

The federal guarantee creates “some sense of comfort with the credit, but it’s not the only requirement,” Meirelles said in a telephone interview. “They’re still case by case.”

The extra yield investors demand to own Brazilian government dollar bonds instead of U.S. Treasuries narrowed five basis points, or 0.05 percentage point, to 187 basis points at 2:36 p.m. in New York, according to JPMorgan indexes.

Default Swaps

The cost of protecting Brazilian bonds against default for five years was little changed at 139 basis points, 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 borrower fails to adhere to its debt agreements.

The real fell 0.1 percent to 2.022 per dollar. Swap rates on the contract due in January 2014 fell four basis points to 7.74 percent.

Future sales of such debt could cause yields on quasi-sovereign and high-grade bank debt to rise as investors sell the bonds in favor of higher-yielding notes with similar credit risk, according to Galloway’s Oliveira.

The 4.2 percent yield on the Minas pass-through notes is greater than for similar-maturity debt sold by state-owned lender Caixa Economica Federal, which yields 4.1 percent, according to data compiled by Bloomberg.

“There is a market for this, they’re coming with a premium, and they have an outright sovereign guarantee,” he said. “Not every state is created equal, but it’s clear that some states will be able to capture this.”

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