Latin American corporate credit generated an impressive 19% return in 2016, outperforming all other emerging market regions which, in aggregate, generated a 10.8% return. We think this solid performance still has room to run and believe Latin America continues to offer attractive investment opportunities in the corporate fixed-income space.
The Appeal of Corporate Credit in Latin America
We recently met with several management teams representing corporations in the region. Our meetings reinforced our view that interesting investment opportunities continue to exist in Latin American corporate credit. As Exhibit 1 shows, corporate credit in this region still offers the highest yields and spreads when compared to other emerging market areas.
* The Yield to Worst (YTW) is the lowest potential yield that can be received on a bond without the issuer actually defaulting.
** The Spread to Worst (STW) is the difference in overall returns between two different classes of securities, or returns from the same class, but different representative securities.
*** The Corporate Emerging Market Bonds (CEMBI) Indices are liquid baskets of emerging markets corporate issues representing multiple issuers and countries throughout their respective regions. The indices shown are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. Past performance does not guarantee future results.
A Closer Look at Brazil and Mexico
When digging deeper into Latin American corporates, it’s crucial to analyze the two biggest economies in the region: Brazil and Mexico. We believe these two countries are bellwethers for investor sentiment toward the region, and understanding the risks and opportunities therein is crucial for seeking to generate stronger returns.
1. Brazil’s Credit Cycle Is in Recovery Mode and Company Management Teams Remain Conservative
Our investment process integrates our economic and sovereign views with the strong credit convictions coming from our fundamental, bottom-up corporate analysis. For example, we turned defensive on the sovereign bonds in the Summer of 2015 in anticipation of the country entering a recession, and bonds getting downgraded to sub-investment grade later that year. At the same time, we found investment opportunities amongst exporters benefitting from a weaker local currency—in such sectors as pulp and paper, and food.
Going into 2016, we could see that a positive political transition was likely, and that a key element for economic policy would be to repair state-owned entities contributing to fiscal weakness, such as Petrobras. We assumed a long position in Petrobras bonds, which performed strongly throughout the year as the new management undertook a comprehensive program of capital-expenditure reductions, cost-cutting initiatives, asset divestitures and a new market-based fuel-pricing policy. This translated into better cash flow generation and helped stabilize and reduce leverage.
The spreads of Brazilian corporates tightened by an average of 400 basis points in 2016 (Exhibit 2). Yet, in our view, they remain attractive as the Brazilian economy is showing signs of stabilization, local interest rates are declining, and Brazil’s currency (the real) is strengthening. Brazil remains one of our top overweight positions.
We recently highlighted the current investment opportunity that presents itself in Brazil (see our previous blog, “Brazil: Economic Transition Creates Potential Opportunity”). As the recovery proceeds, we see positive signs that suggest a reduction in risk aversion is materializing in the domestic economy after a sharp contraction in bank lending last year. Domestic bank spreads are declining, delinquency rates have started to show more benign behavior in recent months, and interest rates are falling more rapidly—all suggesting more positive prospects for credit conditions and indeed, positive growth in total lending in 2017. We expect the recovery to be a gradual process, given the deleveraging cycle and still high levels of indebtedness in the economy, as well as weak labor market dynamics.
Consequently, we are gradually shifting our portfolio’s composition by adding more names that benefit from the improvement in the domestic economy. These names span sectors such as media, fuel distribution and logistics. Recent meetings with local corporations reinforce this view and, importantly, we find management teams to still be conservative, focusing on costs and managing their debt exposure rather than risky growth projects. We also maintain our investment in Petrobras bonds, as we think there is more upside to be captured from operational and financial improvements being implemented by the company’s new management team.
2. Mexico Warrants Caution Given Political Uncertainties
We have a more cautious view on corporate bonds in Mexico, and we had started to pare down our exposure on the basis of valuations ahead of the U.S. elections in November of 2016. We reduced our exposure further given the outcome of the U.S. elections and the ensuing increase in uncertainty regarding the U.S.-Mexico relationship.
We plan to keep our underweight position in the foreseeable future as several uncertainties—such as the future of the North American Free Trade Agreement (NAFTA)—remain. The strongest and fastest impact of these uncertainties was reflected in the Mexican peso, which has depreciated 12% since the U.S. election results. Over the same time period, the credit default swap (CDS) on a 5-year Mexican government bond, a good gauge for the performance of credit, had a more modest reaction, widening by about 15 basis points (Exhibit 3).
This relative resilience of Mexican credit versus its currency is consistent with the country’s generally healthy macroeconomic fundamentals. In addition to following through with the opening of the energy sector to competition, Mexico’s government remains committed to strengthening its public finances by lowering its debt-to-GDP ratio; anchoring medium-term inflation expectations to its inflation objective; and to attenuating the volatility in the exchange rate as needed. Nevertheless, we expect the business environment to deteriorate and possibly hurt the president’s popularity ahead of the State of Mexico’s elections this year and the presidential elections next year. We also expect the government to remain in control of the policy agenda and to remain focused on its policy objectives.
The depreciation of the local currency has a negative impact on Mexican companies that have U.S. dollar liabilities—be it on their cost structures or on their balance sheet. In the medium and longer terms, Mexican companies could also be negatively impacted by a slowdown in GDP driven by lower investments, lower exports and lower remittances. As a result, in our view, volatility in the prices of Mexican assets is likely to continue in the foreseeable future with a lot of “headline risk,” until there is more clarity on the policies of the new U.S. administration. Sectors we aim to avoid include those that are domestically driven, such as retailers and technology, media and telecoms (TMT).
We highlight, however, that we are watching Mexican corporate bonds closely, as opportunities might arise if volatility increases and selling is indiscriminate. In our view, Mexican companies with international bonds outstanding are generally in good shape. This assessment was reinforced by several recent meetings we had with management teams in the country. As a result, we are monitoring trading levels and looking for entry opportunities in case of a broad and severe sell-off in Mexican assets. In particular, we are looking for:
- companies with U.S. dollar-denominated revenues such as exporters and commodity producers;
- companies with a physical presence in the United States; and
- companies in sectors with supply chains that are so intertwined with the United States that they are hard to break or alter without causing meaningful disruptions to U.S. companies and ultimately U.S. consumers.
Opportunities Remain in Latin American Corporate Bonds, but Selection Is Key
Despite a strong performance in 2016, we continue to see attractive investment opportunities in Latin American corporate credit in 2017. However, seeking to capture these opportunities will require strong credit selection and a keen understanding of economic and political developments.
Brazil remains one of our top overweight positions as the local economy is showing signs of stabilization and recovery, and as companies in the country remain committed to deleveraging their balance sheets. We are more cautious on Mexico, but we are monitoring prices of corporate bonds closely, as volatility might translate into select—and, in our view, attractive—investment opportunities.
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Mutual funds and exchange traded funds are subject to market risk and volatility. Shares may gain or lose value.
The mention of specific countries, currencies, securities or sectors does not constitute a recommendation on behalf of any fund or OppenheimerFunds, Inc.
The mention of specific companies does not constitute a recommendation on behalf of the Fund or OppenheimerFunds. As of 1/31/17, the following funds had the following percentages of their assets invested in Petrobras:
Oppenheimer International Bond Fund: 1.3%
Oppenheimer Global Strategic Income Fund: 0.5%
Oppenheimer Emerging Markets Local Debt Fund: 1.1%
Oppenheimer Global High Yield Fund: 0.8%
Holdings are dollar-weighted based on assets and are subject to change. Past performance does not guarantee future results.
Fixed income investing entails credit and interest rate risks. When interest rates rise, bond prices generally fall. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, regulatory and geopolitical risks. Emerging and developing market investments may be especially volatile. Investing significantly in a particular region, industry, sector or issuer may increase volatility and risk.
These views represent the opinions the Portfolio Managers at OppenheimerFunds and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.