Brazil: Project bond push called into question

by Rob Dwyer

Incentives to promote infrastructure bonds lie at the heart of the Brazilian government’s latest investment plan, but questions are being asked about whether or not buyers of these complex instruments understand the risks inherent in them.

Brazil’s government has for many years tried to increase private-sector participation in financing long-term infrastructure projects. For many reasons – not least the relatively high interest rates that deter long-term financing structures – private sector participation has been slow to grow. 

There is now an acceptance from the government of the need to offer a decent internal rate of return Fernando Barbosa, Bradesco Asset Management

But as the Brazilian government’s fiscal problems escalate (the government’s target of a primary surplus of 1.2% of GDP in 2015, which excludes debt financing costs, is almost certain to be missed, putting the country’s investment-grade rating in doubt), the amount of funding from state development bank BNDES is set to fall.

The country is desperate for the improvements in productivity and GDP growth that these projects achieve. With projections of the recession this year heading quickly to a consensus of around -2% this year, the government is pressing ahead with an increased investment plan. 

In June, it unveiled proposals that envisage R$69.2 billion ($22 billion) of projects between 2015 and 2018 and a further R$129.9 billion beyond 2019. A central part of the plan – one that specialists say still needs clarification before the private sector can assess its financial attractiveness – will enable project sponsors to attract additional subsidized financing from BNDES if they have already issued infrastructure-related debentures.

Fresh doubts

However, the promotion of these infrastructure-related projects has raised fresh doubts about the suitability of investors for infrastructure-related bonds. To date, buyers of these debentures have been almost exclusively local, and the majority has been sold to private banking clients. The tax incentives appeal to high net-worth individuals, allowing them to lower their portfolio’s average tax rate while picking up the increased yield offered by these instruments. Meanwhile, other types of investors, such as asset managers, insurance companies and pension funds have reportedly not bought many.

One financier active in Brazilian infrastructure bonds, who declined to be named, says these private banking investors may not fully understand the products they are buying.

“These bonds are some of the most complex vehicles in the market, and they are being sold to the investors that are least equipped to understand them,” he says. “The sale is all based on lower tax rates, which seems good for everybody, but it’s a problem that has me a little worried because when you look at who buys these single-project bonds globally, it isn’t private banking clients, it’s specialized houses that have dedicated teams that assess the specific risks of individual projects.”

The financier adds that these global houses are not only better equipped to analyse project-specific risks but also to build up industry knowledge on structures, as well as getting comfortable with the reputation of independent engineers, for example, that are involved in projects.

In Brazil, he says private-banking clients rely on ratings and sales teams within the private banks, and he believes outsourcing this risk assessment is problematic.

“If you look at rating agencies, the ratings on these single-project transactions don’t include a whole range of issues that need to be considered,” he says. “For example, rating reports don’t cover market risk, liquidity risk – is the bond tradeable? – nor does it comment on whether the spread reflects the risk of the project or the potential recovery on default.”

The decision of other investor groups not to buy these products contrasts starkly with private banking individuals. International investors can’t hedge the local currency risk and the ratings are too low quality (only two electricity transmission lines are investment grade-equivalent) to interest foreign participation.

As interest rates fall in the country, asset management companies may become interested but the financier says the complexity/premium pick-up would need to be big to tempt an investor to dedicate the time to analyse these products. “If the yield pick-up over a Vale bond is just 50 basis points or so, why would anyone bother?” he says.

Emphasis welcomed

Meanwhile, Fernando Barbosa, chief economist of Bradesco Asset Management, welcomes the government’s renewed emphasis on infrastructure, but says he does not expect capex to start to flow to help a recovery in GDP before the second half of 2016 or early 2017.

“Brazil needs to have tackled inflation and have brought real interest rates down to a rate close to the Latin American average [from close to 6.5% to around 3.5%], which hopefully can be done in about two years’ time,” he says. “There is now an acceptance from the government of the need to offer a decent internal rate of return, and a new financing system is being designed to enable companies to leverage the BNDES part of the financing package.”