Things Are Getting Junky For Brazil ETFs

The iShares MSCI Brazil Capped ETF EWZ closed modestly lower Wednesday, finishing the day a mere $0.50 off its most recent low, which is a more than 10-year low.

Thursday could bring more glum price action for EWZ and other Brazil ETFs because Standard & Poor's downgraded Brazil's sovereign credit rating to BB+ from BBB- after the close of U.S. markets Wednesday, becoming the first of the major ratings agencies to slap a junk rating on Latin America's largest economy. S&P may not be done downgrading Brazilian debt.

“The negative outlook reflects what we believe is a greater than one-in-three likelihood of a further downgrade due to a further deterioration of Brazil's fiscal position, potential key policy reversals given the fluid political dynamics, including a further lack of cohesion within the president's cabinet,” said the ratings agency in a statement.

In late July, S&P revised its outlook on Brazil's sovereign credit rating to negative from stable, a move that served as a harbinger for the downgrade to junk territory.

One Of Many Problems

S&P's decision to place a non-investment grade rating on Brazil comes as the country is mired in a recession with President Dilma Rousseff's administration ensconced so deeply in corruption controversy that Brazil's benchmark Bovespa has bled so much market value that Mexico could usurp its southern rival for the title of Latin America's largest equity market.

“We believe Brazil's credit profile has weakened further since July 28, when we revised the outlook on Brazil to negative. At that time, we signaled increased execution risks to the corrective policy changes already underway, mainly stemming from fluid political dynamics in Congress associated with spillover effects from investigations of corruption at state-owned energy company Petrobras. We now perceive less conviction within the president's cabinet on fiscal policy,” said S&P.

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EWZ enters Thursday with a year-to-date loss of 34.6 percent, by far the worst performance among the four major single-country ETFs tracking BRIC nations and more than 2 1/2 times worse than the comparable China and India ETFs.

With Brazil being one of the developing world's most prolific issuers of sovereign and corporate debt, some well-known emerging markets bond funds could also be stung by news of the S&P downgrade.

For example, the $1.2 billion Market Vectors Emerging Markets Local Currency Bond ETF EMLC allocates 8.4 percent of its weight to real-denominated debt, making Brazil the fund's third-largest country weight. EMLC is in the midst of an eventful week. The ETF tracks a JPMorgan Chase & Co. index and earlier this week, the bank decided to remove Nigeria from its emerging markets bond benchmarks. EMLC allocated 3.1 percent of its weight to Nigerian debt.

The Vanguard Emerging Markets Government Bond ETF VWOB has an 8.5 percent to Brazilian debt, also making the nation that fund's third-largest country exposure. VWOB is only down 1.55 percent year-to-date, something of a minor miracle when considering the ETF's exposure to debt issued by emerging and frontier markets that are either in recessions, have devalued their currencies or both.

Indeed, we continue to believe that economic weakness exacerbates execution risk. We now expect the contraction in real GDP to be deeper and longer, with another revision to our growth outlook. Our projections estimate a contraction of about 2.5 percent this year followed by another 0.5 percent contraction in 2016, before returning to modest growth in 2017,” adds S&P.

A month ago, global investors cheered when S&P rival Moody's Investors Service did not place a negative outlook on Brazilian bonds, though the ratings agency downgraded Brazil's sovereign credit rating to Baa3, the ratings agency's lowest investment grade. Fitch Ratings has a BBB rating on Brazilian debt, which is two notches above junk.