Friday, September 11, 2015

BRICS Downgrades Portend Bond Market Illiquidity Gates

Goldman Sachs invented the BRICS concept to attract corporate finance clients. Enterprises that sought expansion to supposedly hot emerging markets now had a fun acronym to throw around their boardrooms. Emerging markets rode the BRICS coattails with eye-popping debt issuance. The world's debt explosion now faces an implosion, beginning with some BRICS members.

The S+P downgrade of Brazil's sovereign credit rating is another ill omen for the world's bond markets. The Petrobras downgrade also matters because that company's fate is inseparable from that of Brazil's national economy. Brazil ranks 69th out of 174 on Transparency International's Corruption Perceptions Index and 118th out of 178 on the Heritage Foundation Index of Economic Freedom. The poor rankings indicate that Brazil's national government cannot resolve its fiscal problems without a much more severe political crisis. Petrobras will not be out of the woods as long as the Brent crude price tests a multi-year low.

The other BRICS problems are obvious and endless. Beijing cannot prop its equity markets forever and will eventually run out of foreign currency reserves to sell. Russia's dependence on oil exports place it next in line behind Brazil and China for drawn-out political and economic drama.

Bond investors should recall US regulators' recent discussions of bond market gates that will prevent investors from liquidating their holdings. Endowment and pension fund managers are often confined to investment-grade bonds in accord with their investment policy statements. Sovereign credit downgrades will require money managers to sell their downgraded bonds as one developing country after another faces the credit ratings axe. The SEC's theoretical bond market gates will then suddenly become reality. Retail bond investors will be unable to sell anything as the market goes bidless.

It would be unfair to blame Goldman Sachs for the BRICS debacle. The rest of Wall Street is just as shortsighted as one marquee firm. Everyone who could have seen this coming chose to ignore default risks for emerging economies tied to low-value exports. Investors who sought higher yields in fixed income will be stuck with junk bonds when the gates slam shut.