Perspectives

Brazil Downgraded to Junk—But It’s Not High Yield!

shutterstock_88463944

Brazil’s sovereign debt was recently downgraded below investment grade (IG). Before the downgrade, its index-eligible bonds were included in both the Barclays US Credit Investment Grade Index and the JPMorgan Emerging Market Bond Index, two of the more commonly followed indices. Beginning 1/1/16, these bonds will fall out of the IG index. What happens next is perhaps surprising.

There is an important distinction in the process that occurs when corporate debt gets downgraded to below IG versus when non-corporate debt (e.g., sovereign, supranational, and taxable municipal debt) does. For the corporate borrower, its debt moves bond for bond into the Barclays US Corporate High Yield Index. Accordingly, when a corporate issuer is downgraded to below IG, some investors are forced (or incented) to sell its bonds, but natural buyers are created in the ranks of high yield managers. On the other hand, non-corporate debt that is below IG has no new natural buyers when it becomes “junk” because it will not be added to any widely accepted non-IG indices. Of course, it remains in emerging market indices (e.g. the JPMorgan Emerging Market Bond Index or the Barclays Emerging Market USD Aggregate), but this does not create any new demand.

So what? Intuitively, it makes sense that the “hand off” between seller and buyer will be smoother in the case of a corporate downgrade from IG than for a non-corporate. The graphic below illustrates this reality, with Weatherford International, an oilfield services company downgraded from investment grade in November, serving as our illustrative corporate issuer.

Returning to Brazil, its bonds have performed poorly for quite some time. It will be interesting to see their price performance in the trading days around year-end.

We are not ringing an alarm to sell non-corporate bonds. The added diversification of a portfolio that includes non-corporates may be appealing, and over an extended period of time we have found excellent relative value investment opportunities within the non-corporate sectors. We also believe that the construction and constituent rules of the IG and high yield indices may present additional relative value trading opportunities for the diligent investor during the period surrounding a downgrade. From NISA’s perspective, it’s useful to keep in mind the IG/below IG dynamic, given that non-corporate bonds have a material presence in most credit indices.

Disclaimer: By accepting this material, you acknowledge, understand and accept the following:

This material has been prepared by NISA Investment Advisors, LLC (“NISA”). This material is subject to change without notice. This document is for information and illustrative purposes only. It is not, and should not be regarded as “investment advice” or as a “recommendation” regarding a course of action, including without limitation as those terms are used in any applicable law or regulation. This information is provided with the understanding that with respect to the material provided herein (i) NISA is not acting in a fiduciary or advisory capacity under any contract with you, or any applicable law or regulation, (ii) that you will make your own independent decision with respect to any course of action in connection herewith, as to whether such course of action is appropriate or proper based on your own judgment and your specific circumstances and objectives, (iii) that you are capable of understanding and assessing the merits of a course of action and evaluating investment risks independently, and (iv) to the extent you are acting with respect to an ERISA plan, you are deemed to represent to NISA that you qualify and shall be treated as an independent fiduciary for purposes of applicable regulation. NISA does not purport to and does not, in any fashion, provide tax, accounting, actuarial, recordkeeping, legal, broker/dealer or any related services. You should consult your advisors with respect to these areas and the material presented herein. You may not rely on the material contained herein. NISA shall not have any liability for any damages of any kind whatsoever relating to this material. No part of this document may be reproduced in any manner, in whole or in part, without the written permission of NISA except for your internal use. This material is being provided to you at no cost and any fees paid by you to NISA are solely for the provision of investment management services pursuant to a written agreement. All of the foregoing statements apply regardless of (i) whether you now currently or may in the future become a client of NISA and (ii) the terms contained in any applicable investment management agreement or similar contract between you and NISA.

NISA Investment Advisors, LLC is an independent, employee owned investment management firm. We focus on risk-controlled asset management for large institutional investors.

Content © 2008–2020 NISA Investment Advisors, LLC.

NISA Investment Advisors, LLC
101 South Hanley Road
Suite 1700
St. Louis, MO 63105-3487
P: 314.721.1900
F: 314.721.3041

Agree to Terms

Please review and accept the following to proceed.

I have read and agree to the Terms of Use, Disclaimer, PSRX Disclaimer, and Privacy Policy. I am either (i) an investment professional and an employee of an institutional investor, or a consultant to an institutional investor, or (ii) an employee of, or a student in, an institution of higher learning and I am involved in the study, research or teaching of subjects related to investments, finance, or economics. I reside in the United States or Canada. I understand that the information is not and should not be regarded as investment advice or as a recommendation regarding a course of action.

By clicking “Accept” below, you hereby acknowledge, understand and accept the foregoing.