junk bonds scrabble

Junk Bonds in Europe Crater on Emerging Market Woes

January 27th, 2016 by

Major emerging markets have plunged into contraction, one after another, over the last 18 months. From China to Russia to Brazil, these once-promising opportunities for investment have been oozing losses and trying to stanch the bleeding from more than one place. Junk bonds, a popular asset when investors are searching for better yields, have crumbled along with these economies.

junk bonds dictionaryHowever, the situation has been far worse in Brazil (and its market for junk bonds) than its counterparts in the East.

Junk Bonds Collapse

According to data compiled by Bloomberg, “[m]ore than half of the region’s worst-performing junk bonds in euros over the past year were sold by companies with operations in Brazil, exceeding those with even indirect exposure to China.”

brazil-junk-bondsTo put this into context, almost everyone in Europe has exposure to China now, as does much of the rest of the world. But this is especially true in Europe’s case. The cheap manufacturing capacity of China and its ready-made market for buying the finished goods exported from the eurozone. This rare combination made possible the run-up of emerging markets that occurred in the aftermath of the financial crisis.

Source: goldstockbull.com

Source: goldstockbull.com

As a sovereign debt crisis began to grip the European continent in 2010, European firms naturally piled into junk bonds in places like Brazil. These corporate bonds offered high yields—always the overarching appeal of junk bonds—but were high risk. Their quick rise was a reflection of the overheating of emerging markets in general. The surge in crude oil prices benefited Russia greatly, while we’ve already mentioned the massive bull market China enjoyed during this period.

It’s true that developing economies reliant upon commodity exports have all suffered in the last several years. So why is the situation so much worse in Brazil, a market that has been likened to “trying to catch a falling knife“?

Recession

down graphFirst and foremost, the once-booming Brazilian economy has fallen into its worst two-year recession in more than a century. The economy has been thoroughly mismanaged by the country’s officials. They continued to over-leverage the position of various state-owned corporations during the boom years with no plan for how to handle the inevitable reversal of this cycle. (It’s worth noting that few would have imagined how swiftly the situation changed.)

Other missteps by the administration included accepting the role of host country for the 2016 Summer Olympic Games, a move that has rarely been the economic shot-in-the-arm that the IOC makes the event out to be. Along the same lines, the country spent billions on more soccer stadiums than were truly needed to host the most recent World Cup; now, these expensive stadiums are financial eyesores that sit idle.

Corruption

gavelWrapped up in the Brazilian recession is the uncovering of a rampant corruption scandal involving how government contracts were awarded. Recall that most of Brazil’s largest and most vital industries operate under state-owned monopolies. Chief among these institutions is Petrobras, the state oil giant.

Investigations have revealed that government officials were taking kickbacks in order to give contracts to preferred contractors (at inflated prices, of course). This is not only inefficient, costing more money than going with the most competitive contractor, but corruption always robs an economy of real value. (This played out to an extreme extent with the former Soviet Union.) These corrupt practices bled into virtually every level of the economy. Several of the highest-ranking leaders of government and industry have been arrested and indicted in connection to the bribery and graft scandal.

Political Turmoil

Photo: Roberto Stuckert Filho

Photo: Roberto Stuckert Filho.

The corruption probe was a devastating blow to the political order in Brazil. Such instability erodes citizens’ confidence in their own government and thereby also influences how they see state institutions in general. At the center of the corruption controversy was President Dilma Rousseff (pictured), who had previous served as the head of Petrobras during the worst of the scandal. The distrust among the populace only made the recession worse.

At this point, the entire economic apparatus is in disarray in Brazil. The situation regarding junk bonds mainly indicates that foreign investment is drying up (and losing faith). As much as Europe disproportionately benefited from the rise of emerging economies, it is equally feeling the worst of the pain now that the situation has flipped.

 

The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.