Investment Diamonds In The Brazilian Rough?

Brazilian corporates have been under pressure since last fall, when weak commodity prices and “Operacao Lava Jato” — or Operation Car Wash, the bribery scandal rocking energy giant Petrobras (not a fund holding) — added to political and economic headwinds. As a result, investor attention has focused more intensely on myriad challenges Brazil faces.

Steadily widening spreads no surprise

Since last fall, Brazilian corporate bond spreads have steadily widened from approximately 360 basis points in September 2014 to roughly 940 basis points a year later,1 as the chart below shows. It’s worth noting that spreads are currently wider than levels reached during the global financial crisis, when they peaked at 839 basis points.2

Mind the gap: Brazilian corporate bond spreads widen dramatically

It’s not surprising that Brazilian corporate bond spreads have widened dramatically over the last year because the country is facing a host of interrelated pressures, including:

  • Lower commodity prices.
  • A rapidly deteriorating fiscal situation leading to a weak currency.
  • A weakening growth outlook.
  • Political turmoil.
  • Fallout from the Lava Jato bribery investigation.

Overshadowing emerging markets’ performance

Unfortunately, the severe weakness in Brazilian corporate credit has also been a drag on returns for the broader emerging market corporate universe, masking relatively strong performance by other key emerging market countries. In the view of Invesco Fixed Income, Brazil’s situation has also had the broader effect of generating an overall negative impact on sentiment toward the asset class.

Year-to-date, Brazilian corporate bonds were down 14%.3 However, the JP Morgan emerging markets corporate index, excluding Brazil, was up 3.5%, and major index constituents such as Russia, China and the United Arab Emirates gained 22.6%, 3.7% and 2.7% respectively.3 In comparison, the Barclays US Corporate High Yield Index is down 2.3%; the S&P 500 Index is down 3.8%; and the Bank of America US Corporate Master Index, representing US investment grade bonds, has gained only 0.25%.

Justified or excessive?

The question going forward is whether current spread levels on Brazilian corporate bonds are justified or if the movement has been excessive. It’s always difficult to gauge various risks and outcomes priced into bond spreads, especially when there are numerous risks to consider. That said, with spreads on Brazilian corporate bonds at levels not seen since the global financial crisis, and many companies at all-time wide spreads, it’s fair to say that current spread levels are pricing in a highly bearish scenario.

We must also consider where we are in the evolution of the various pressures on the Brazilian economy and how severe a downturn Brazil could be facing. It’s our view that Brazil is in the early stages of what could be a prolonged and rather severe downturn as key issues — such as the Lava Jato investigation, efforts to impeach President Dilma Rousseff and potential rating agency downgrades — remain on the horizon. In addition, we believe many of the external pressures on the economy, such as low commodity prices, are unlikely to reverse in a meaningful way in the near term.

Proceeding with caution

Weighing extremely bearish valuations for Brazil corporate credit against concerns of continued negative developments within the country leaves us broadly cautious. We think further deterioration in the Brazilian economy and continued negative news will likely continue to weigh on the Brazilian corporate sector.

However, we do see opportunities within the space as the broad sell-off in Brazilian credit has created some severe dislocations. In particular, we see value among those Brazilian credits that are trading at highly distressed levels but ultimately have sustainable operations and offer good asset coverage. We also favor those high-quality credits that came into the current situation with strong balance sheets and have significant international operations or non-commodity-related export revenues. In contrast, we remain negative on many of the state-owned non-financial credits and lower-quality credits with locally focused businesses, especially those that have high US dollar debt balances or are tied to commodities.