Brazil: Downgrade sparks fears of sell-off spiral

By:
Rob Dwyer
Published on:

IRB Brasil Re delays IPO pricing; debt markets down 52% on year.

Although Brazilian assets initially shrugged off the country’s downgrade to speculative grade by Standard & Poor’s last month, the ratings action is clearly having an insidious effect. 

Long-anticipated Brazilian IPOs have been shelved – with reinsurer IRB Brasil Re pushing back its mid-October target date for pricing its $960 million transaction. The company is reported to be concerned that the downgrade will lead international investors to push for a lower price, especially amid the increased FX volatility, so decided with its global coordinator and bookrunner JPMorgan to postpone.

Meanwhile, Caixa Seguridade Participacoes – the insurance arm of Caixa Economica Federal – has kicked off investor education meetings with a similar target date but, despite its urgency for funds, it is unlikely that lead banks Banco do Brasil and UBS will advise the issuer that current conditions are conducive to conduct its $1 billion IPO. 

These deals are likely to join Petrobras’ BR Distribuidora and airline Azul in delaying IPOs until 2016. 

Meanwhile debt markets remain depressed, with combined international, domestic and syndicated loan volumes down 52% in 2015 compared to 2014.

Heightened FX volatility is the main driver of instability. The real barely moved (nor did the Ibovespa) on the day following S&P’s downgrade, leading some analysts to conclude that the downgrade had been priced in.

However, the real has subsequently collapsed – largely due to continued political paralysis in congress and the executive’s failure to pass reforms that would stem the country’s fiscal problem (which threatens to take government debt to 70% of GDP at some point in 2016).

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This in turn leads to the prospect of a loss of investment-grade status from Moody’s and/or Fitch. 

Towards the end of September the real had set a new low of R$4.14 to the dollar (at which point the central bank intervened), falling in line with Brazil’s CDS spread, which hit 450 basis points in September – the highest of any leading emerging market and surpassed only by Venezuela. The real is now down more than 35% this year and is the worst performing major currency. 

Daniel Tenengauzer, head of emerging market and global FX strategy at RBC Capital Markets, says that the dynamics of the currency are complicated by investors’ tendency to avoid being underweight Brazil because of the carry dynamics of the currency.

"Because the carry is so painful, investors’ bias has been to hedge Brazilian exposure in markets that are cheaper to hedge," he says, using the example of portfolio managers typically hedging Brazilian exposure via the Mexican peso.

"All of a sudden many of these managers are realizing that what they thought was a hedge really isn’t a hedge. For example, today [September 22] the real opened 1% down but the USDMEX was only down by 70bp – so this perception that the protection isn’t protecting them is leading to the sell off."

If Tenengauzer is correct, there could be further depreciation: a report from UBS on September 11 showed that foreign investors’ participation in the local fixed income market remains close to its peak and is considerably larger in the NTN-F (fixed rate) market than NTN-B (inflation-linked) market, at 60% compared to 10%. If investors are finally beginning to unwind these positions and exit because of a lack of cost-effective hedges this will increase depreciation and lead to increased interest rates – particularly on nominal bonds. 

"There is also a technical point that high yielding countries tend to see sell-offs that are a lot more violent, because to compensate for the high yield you need to sell a lot," adds Tenengauzer, raising the spectre of a spiral of further sell-offs and further depreciation. 

Fed risk

Nick Verdi, senior FX strategist at Standard Chartered Bank in New York, thinks the recent peak in FX volatility is, in part, being generated by Fed policies. "I would argue that the Fed is becoming more unpredictable, which is normal as we move away from the zero-bound policy. That means for high volatility currencies like the real the volatility-to-carry ratios become lower and the real becomes a less attractive proposition."

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However, he agrees that while there are some exogenous factors to the real depreciation, much the cause of the weakness is domestic. "My advice would be for an investor who is looking to enter [the market with the FX as a major component of the timing decision] would be to wait – I think the currency will continue to weaken into the first quarter of 2016," says Verdi.

The risk perception of the country is also effectively preventing any international DCM issuance from Brazilian issuers – even exporters that should benefit from a weaker currency and earn dollar revenues.

The reason is the spike in CDS of Petrobras, to 900bp, suggests to investors that the sovereign CDS spread, although high, is likely to deteriorate further as there is an implicit guarantee of the sovereign to support Petrobras and the current gap between the CDS of Petrobras and Brazil doesn’t reflect this support. This means there is likely to be convergence between the two, with Brazil’s widening further.

Without stability in the sovereign benchmark, bankers say it will be hard for any Brazilian company to price an international deal at a valuation that makes commercial sense.