The Daily Update - Rio, we have a problem

Asset markets across Brazil have continued to come under pressure this week as geopolitical concerns deepen; exacerbated by the country’s bar association’s majority vote, over the weekend, in favour of President Michel Temer's impeachment. With roughly one in three cabinet members under investigation for alleged corruption, it seems the previously touted ‘EM Gem’ is set to be plagued with an uncertain outlook as the political crisis ensues, and much needed economic reform is thus put on hold. Off the back of this, rating agency, Standard and Poor’s has announced that it may cut the country’s BB, junk rating even further (within the next three months), stating ‘Amid increased political uncertainty, some progress in addressing considerable fiscal and economic challenges in the context of an already prolonged adjustment path is at risk of stalling.’

After his predecessor, Dilma Rousseff was removed from office many investors plied into Brazil last year on hopes that ‘interim-president’ Temer would help bring the country out of economic disrepair, and effectively prevent Brazil from entering a double-dip recession; unfortunately the risks of this are still high. Any regular readers are aware that we have never favoured Brazil’s bonds; the initial reasoning was the lack of value and spread cushion while the country was rated investment grade. Currently however the overriding motivations to remove the country from our investable universe are: first, its net foreign liabilities as a percentage of GDP are in excess of 50%, thus a two star rated country; second, it is sub-investment grade; and finally its sovereign bonds are strangely still ‘expensive’.

State-owned oil giant, and much loved Petrobras is highly embroiled in the corruption ring and has thus seen a continued sell-off on its bonds; the 7.25% 2044 USD issue, for example, has plummeted over 5.7 points from the all-time high $103.60 witnessed on the 12th of this month; in other words, the yield on the bond has widened ~50 bps in 7 trading days to 7.43%. With such an attractive yield and expected returns of ~15% some might think this bond would be a no brainer position, however, with the risk of further downgrades and a credit cushion of less than 2 notches we would steer clear.

We prefer to instead invest in Mexico's state-owned oil company, Pemex, where the investment-grade, USD 5.5% 2044 issue - as a comparison - is trading at a yield over 6.2%, has an expected return around 23%, with over 4 notches of credit cushion. The bond currently trades at a spread of 340bps over Treasuries and we calculate fair value for the bond at around 160bps which suggests that the bond still has over 20 points of capital appreciation to reach fair value.