S&P downgrades Brazil’s rating – impact on corporates

S&P downgraded the foreign currency sovereign rating of Brazil to below investment grade (now at BB+) and maintained its Negative outlook for the sovereign

While we had already highlighted that the investment grade rating of Brazil is at risk due to deteriorating credit fundamentals (challenging public finances/political headwinds stalling progress in terms of fiscal reforms), the downgrade of the foreign currency sovereign rating of Brazil by S&P to below investment grade came earlier than expected. Additionally, the Negative rating outlook opens further room for an additional downgrade over the next year. S&P highlighted in the downgrade report that the weak economic situation additionally increases execution risk, while downside surprises to fiscal targets cannot be ruled out, which is also our view. Currently, the two other rating agencies, Moody’s (Baa3) and Fitch (BBB), still have Brazil’s sovereign rating at investment grade level. However, as Moody’s rating is already at the lowest level above junk, and as we see the risk that Moody’s follows suit, the likelihood of Brazil’s foreign currency rating falling to below the investment grade level remains elevated. For a more detailed assessment on Brazilian fixed income markets, please see the Investment Alert “Brazil: Valuations aligning to macro political risks,” published on 19 August 2015.

The downgrade of S&P’s foreign currency rating for Brazil’s sovereign affects most Brazilian corporates
S&P’s methodology for corporate ratings is based on the lower of the credit’s local currency rating and the transfer and convertibility assessment of the respective country. The transfer and convertibility assessment is based on S&P’s transfer and convertibility assessment view of the likelihood of the sovereign, in this case Brazil, restricting corporates’ access to foreign currency to service their debt obligations. Transfer and convertibility assessments can lead to ratings of up to three notches above the sovereign rating. In the case of Brazil, S&P so far has assigned transfer and convertibility ratings two notches above the sovereign rating, which means that even in the case of a potential BB rating for Brazil’s foreign currency sovereign rating, individual corporates could be rated BBB- by S&P and thus still maintain their investment grade rating. The effect on individual corporate ratings depends on whether the company’s rating is assessed through the transfer and convertibility rating or the sovereign rating and if the current rating is at the largest possible notching or not. Additionally, a potential downgrade of the transfer and convertibility assessment could  further impact the rating of individual corporates. We expect that S&P will downgrade its transfer and convertibility assessment for Brazilian corporates in line with the downgrade of the sovereign rating, and thus the highest rating for companies rated on the basis of the will be BBB.
Companies most likely impacted by S&P’s downgrade thus not only include quasi-sovereign corporates but also companies which have been heavily affected by Brazil’s S&P sovereign rating and companies which haven been affected by earlier outlook and rating revisions. Thus, we expect governmentrelated companies (i.e. Braskem), banks (i.e. private and quasi-sovereign banks such as Banco Bradesco and Itau Unibanco, but also potentially Banco do Brasil), companies tied to the sovereign or transfer and convertibility rating (i.e. Klabin, which already has a Negative outlook), or quasi-sovereigns already with a Negative outlook (i.e. Petrobras) to see their ratings affected by S&P’s sovereign rating downgrade for Brazil.
On a more positive note, BRF SA and Fibria should not be affected by the downgrade as they have not been rated with respect to Brazil’s sovereign rating nor with respect to Brazil’s transfer and convertibility assessment. Both companies have sufficient liquidity to cover their debt obligations for some time.

Spreads already reflect downgrade
The performance of Brazilian corporates was particularly weak of late, while during the first half of the year, corporates significantly outperformed the sovereign. The current wide benchmark spread of Brazilian corporates (667 bp vs. 607 bp for Latin American (LatAm) corporates, on average, and vs. a historical average range of 450 bp) already reflects the sovereign downgrade, in our view. Still, we believe that it is likely that we see increased volatility of Brazilian hard currency bonds over the coming months until the market has distinguished between weaker companies more affected by the downgrade of the sovereign, and companies with more solid fundamentals, or companies which will be less affected by the downgrade.

Our view: Downgrade priced in corporate bonds but volatility expected
When looking at spread developments over recent months, we believe that when S&P lowered its outlook to Negative at the end of July 2015, the market already started to price in what was then only a potential downgrade of the Brazilian sovereign.
However, we also believe that now that S&P has actually downgraded the country’s foreign currency rating to below investment grade, the unchanged Negative outlook for the sovereign rating will particularly weigh on corporate bonds for the coming days and possibly weeks. Additionally, we believe that S&P will issue rating downgrades on several corporate bonds over the next few days leading to a further increase in volatility

Dominik Garcia – Senior Credit Analyst – Emerging Markets – Credit Suisse