What are some of the major factors influencing the performance of Chile’s capital markets and the economic outlook there currently?
The level of investment in Chile has been decreasing significantly over the past three years. The downturn in commodity prices is putting corporates under pressure, and is also affecting investor sentiment more broadly. What we are seeing in terms of regulatory reform, which could be interpreted by certain sectors to be ‘non-business friendly’ changes, is putting pressure on the investments of large corporates in Chile. As a result, many are taking a ‘wait and see’ approach to new investment and large CAPEX initiatives.
These challenges are starting to have a knock on effect on the country’s capital markets. We have traditionally seen about US$3bn annually in bond issuance volumes on average, with some years better than others. Last year, we saw roughly US$2bn in issuances, which amounts to a drop of about 40%. This year, we have only seen about US$500mn, with about US$1.5bn forecast to be issued by the end of the year. There isn’t really a high-yield market here, though there are some private placements. So you could say that in two years, the volume in terms of issuance has dropped to less than half the average.
Investment is very low, but liquidity – from pension funds, mutual funds, insurance companies, and other large investor stakeholder groups here in Chile – is plentiful, and those players need to deploy that money. So what we have seen in the market is substantial spread compression and all-in yields at historical lows. Whenever we have a strong corporate credit hit the market, the demand is typically significant.What are you hearing from your clients in terms of the challenges they face in the current market?
Most are deeply concerned about FX volatility. Issuers are worried about being correctly hedged because nobody knows what’s going to happen in the market, in part because of the erratic behaviour of investors, and the impact on deal flow and FX as a result. Being correctly hedged within the current volatile climate is extremely challenging, regardless of whether your balance sheets are in US dollars or local currency, and issuers are to some extent limited in terms of liquidity on these kinds of swaps: if you wanted to swap a US$1bn 20-year bond in the US dollar market back into local currency, you typically can’t because the tenor and volume make that trade prohibitive. The ability to do this plays heavily into corporate borrowing decisions.
There are also arbitrages that can be presented. For instance, for aninvestment- grade corporate credit, it is usually about 50bp cheaper on average to issue in the local market and swap into dollars rather than to issue internationally in the US dollar market. Issuers are increasingly looking at these kinds of arbitrages, whether in the US dollar market, Swiss market, Euro market, Japanese market, and so forth.
With shifts in the commodities markets are we seeing new issuing or borrowing windows emerging for some borrowers?
Yes, to an extent. Copper prices have increased over the past few months, but there is still a great degree of volatility more broadly – for instance, the ‘Brexit’ vote had an impact on the willingness of issuers to tap the markets – and it isn’t always clear how the markets are going to behave. We haven’t seen windows collapse for the kinds of credits we tend to work with, even the more commodity-linked corporates in Chile. As ever, it is always a matter of pricing.
Looking beyond traditional bonds and loans, at what point do alternative products such as hybrid and perpetual bonds offer higher economic and capital advantages for borrowers?
There is only one corporate that executed a hybrid capital transaction in 2014. We often do get questions about these kinds of instruments and the overall impact they may have on their funding profile, but they rarely tend to opt for more complex instruments. Typically, most issuers and borrowers tend to opt for very vanilla instruments. From a financial perspective, more complex instruments may even be more optimal in some situations, but generally, corporates tend to opt for more straightforward structures.
Part of this is cultural, and to some extent related to corporate governance, but the message is clear: CFOs want to keep things simple, and this is a good thing. One of the great successes of Chile, and its credit strength, is related to this financial discipline, which is what international investors tend to favour. Combined with very strong banking laws and robust legislation covering local investors, you start to get a sense of why Chile has such a strong reputation in the international sphere.
Capital markets reform – particularly Basel III adoption – seems to be on the horizon in Chile. How do you think this will affect the capacity of banks to lend?
Basel III is on the agenda now, and you have some banks that are already compliant – particularly some of the larger international banks, whereas local banks still haven’t experienced that kind of pressure yet, so there may be some disparity between what larger international players and local players can offer in terms of all-in pricing. You still have some cases where banks are moving aggressively, but there is a lower appetite for long-term loans (beyond the 5-7 year loans) because of the capital requirements. The market is going to keep moving, perhaps more slowly but nevertheless, towards the bond market.
About 8 months ago, capital efficiency wasn’t as high on the priority list for most banks operating in the region – if the deal had a good yield, good tenor, many would tend to go for it. Risk weighted assets and capital efficiency is a stronger driver in banks’ thinking on the market and their decision-making process, and will grow in importance over the 6-year Basel III phase-in period.
Liquidity is often cited as a core concern, particularly for the secondary markets in Chile. What do you think needs to happen in order for the situation to improve?
Liquidity in Chile in the secondary market for corporate bonds is extremely low. If you look at deal flow, most deals are traded on exchange, it is very thin – with one trade moving the entire market by as much as 20bp. I would hesitate to call it a secondary market as such – trades are typically still done over the phone, with a few deals traded electronically.
How do you improve that? The challenge with the local market is that 99% of fixed income investors in Chile are ‘buy-and-hold’ investors, consisting largely of local investors, insurers and pension funds. We need market makers to emerge if we want to increase trading activity, but it is very challenging within the current context of the corporate paper world. Sovereign paper is a different story, and Chile is trying to increase international access to local public sector bonds and treasury paper, which could go some way towards increasing liquidity. So could increasing regional integration, but there needs to be further regulatory reform before Latin American investors can participate across these markets in a seamless way. One good step would be to increase limits on what local investors could buy in terms of international assets.