Death of Structured Notes Seen as Brazil Bond Tax DitchedAlastair Marsh
Brazilian Finance Minister Guido Mantega is making obsolete the world’s most-popular market for structured notes tied to bonds.
Sales of the Brazilian notes, which package bank bonds with derivatives to allow foreign investors to replicate the nation’s higher-yielding real debt while avoiding a 6 percent tax, have plummeted to $40 million in June, 97 percent less than last month’s tally. Issuance is now on pace to be the lowest since September 2011 after Mantega scrapped the so-called IOF tax June 5. Banks led by Barclays Plc had sold a record $7.3 billion of the structured notes this year, 12 times more than debt from South Korea, the second-most-popular reference country.
Investors will likely turn to Brazilian local bonds, with yields that are five times higher than U.S. Treasuries, causing demand for structured notes to dry up, Citigroup Inc. and BNP Paribas SA said. Brazil, which adopted the tax on foreigners to limit gains in the real in 2010, removed it after the currency sank 6.5 percent in May on concern the Federal Reserve may curb stimulus. Real-linked bonds sold overseas, which also let investors avoid the tax, have posted a record plunge.
“The IOF tax meant Brazil had some of the highest barriers to entry for foreign investors among emerging markets,” Thomas Beatty, New York-based managing director of Latin American credit structuring at Citigroup, said in a telephone interview. “Now the tax is gone, demand for credit-linked notes will reduce dramatically.”
Credit-linked notes, which investors can buy to access emerging-market debt securities they wouldn’t otherwise be able to easily purchase, can have higher yields and tailored maturities that may not be available in the bond market. Buyers of the securities suffer losses in the event of a default by the bank issuing the notes or the linked entity.
More than 90 percent of the notes tied to Brazil mature in less than a year and are typically linked to government bonds of longer maturities, such as the country’s 10 percent bonds due January 2023.
Brazil eliminated the tax after the real plunged to a four-year low, part of a selloff in emerging-market currencies triggered when Federal Reserve Chairman Ben S. Bernanke said May 22 that signs of a sustained improvement in the U.S. jobs market could lead the Fed to scale back its monthly bond purchases.
Mantega said June 4 he removed the tax because the Fed’s signaling may reduce the “excess liquidity” that Brazil was seeking to keep out. He had boosted the tax on foreigners in October 2010 to weaken the real, saying Brazil was the victim of a “currency war” in which developed nations were trying to devalue their currencies by pumping money into their economies to fuel export-led growth.
The tax removal could “severally impact” the credit-linked note market because “most of the investors should prefer to open local accounts and buy the bonds directly,” said Vincent Caris, who heads fixed-income structuring for Latin America at BNP Paribas in Sao Paulo. Investors will only buy structured notes if they want tailored features, such as leveraged returns, he said.
Last week, the government also eliminated a 1 percent tax on currency derivatives.
Yields on Brazil’s overseas real bonds due in 2022 have surged 2.44 percentage points in the past month, the most since they were issued in 2006, to 9.23 percent as the removal of the tax makes them less attractive and concern over Fed policy reduces demand for higher-yielding assets.
London-based Barclays issued the most structured notes linked to Brazil this year, with $2.8 billion of sales, according to data compiled by Bloomberg. JPMorgan Chase & Co. is the second-largest issuer with sales of $2.4 billion, while HSBC Holdings Plc sold $1.1 billion. Citigroup raised $469 million.
“Any decline in structured note issuance should be more than offset by an increase in overall bond and foreign-exchange trading volumes,” said Karan Madan, head of fixed-income, currency and commodity trading in Latin America for Barclays.
Barclays added more than 1 billion reals ($465 million) to a structured note tied to Brazilian government debt on June 3, the day before the IOF cut was announced, making the securities the largest of their kind in data that Bloomberg began compiling in 1999.
The securities mature on July 26, pay a coupon of 10 percent and were sold at a 6.2 percent premium to par. The notes are priced in reais and interest and redemption payment are made in dollars, meaning investors are exposed to swings in the exchange rate.
Brandon Ashcraft, a New York-based spokesman for Barclays, declined to comment on the notes.
The extra yield investors demand to own Brazilian government dollar bonds instead of U.S. Treasuries narrowed five basis points to 216 basis points at 12:46 p.m. in New York, according to JPMorgan’s EMBI Global index.
The cost of protecting Brazilian bonds against default for five years was little changed at 151 basis points, according to prices 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 0.4 percent to 2.1597 per dollar.
Before Euroclear Bank SA began offering foreign investors direct settlement of Russian government debt in February, structured notes that replicate returns of the bonds, known as OFZs, were the most issued after Brazil at $2.4 billion in 2012, according to Bloomberg data.
This year, investors have only bought $96.8 million of the notes, while foreign ownership of Russia’s ruble bonds has surged sevenfold to 21 percent of the outstanding total of OFZs, or about 600 billion rubles ($18.9 billion), according to Eddie Astanin, board chairman of the National Settlement Depository.
Sluggish growth in Latin America’s biggest economy and the selloff in emerging-market assets will curtail inflows into Brazilian bonds, Natixis analysts led by Juan Carlos Rodado said in a June 6 report.
Standard & Poor’s cut the outlook on Brazil’s BBB rating outlook to negative on June 6, citing slow economic growth, weakening fiscal accounts and a loss of credibility with investors. Gross domestic product expanded 1.9 percent from the year earlier in the first quarter, less than the 2.3 percent forecast by analysts in a Bloomberg survey.
“It is difficult for inventors to remain confident about the country,” the Natixis analysts wrote. “The removal of the IOF tax on bonds will not be enough to restore confidence.”