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Brazilian 5 Year Sovereign Bonds at a 2.875% Yield: Aiyiyiyi

posted by Mitu Gulati

Paul Krugman had a piece in yesterday’s NYT about the lunacy in the stock market, where a bankrupt company like Hertz is merrily issuing new stock (here).  Matt Levine of Bloomberg has similarly, and hilariously, discussed the Hertz case and other recent examples of this bizarre pandemic bubble (here). Why the rush to buy overpriced rubbish?

I have no answer to the question posed by Krugman. But it is not just the stock market. A similar lunacy is occurring in the sovereign bond markets (here). Exhibit number one: Brazil. Reading the press, it seems clear that Brazil is in deep crisis thanks to the disastrous manner in which it has handled the covid-19 pandemic so far (see here and here, for discussions of how Brazil’s response to the pandemic has been among the worst in the world).  Yet, on June 3, it issued over 3 billion dollars in five- and ten-year bonds.  The five-year bonds had a coupon of 2.875%.  (the ten-year bonds were at 3.875%). I cannot understand this yield. What sane investor could possibly look at the current state of Brazil’s response to the pandemic, the fact that its leadership seems to show no signs of reversing course, and the resulting economic forecasts, and think that Brazil is such a safe bet to repay its borrowing in just five years that it should receive funding at 2.875%. Of course, from Brazil’s perspective, why not issue even more debt, if the response of the market to worsening conditions is to offer even more and cheaper money.

It is worth, however, thinking about what will happen if and when countries like Brazil cannot repay these bonds when they mature. I suspect that investors will not remember that they deliberately anesthetized their risk instincts when they bought the bonds. Some of those investors will loudly demand payment in full -- in other words, it's Brazil's fault for having offered the bonds, not the investors' fault for ignoring the risks when they bought them. Along those lines, I wonder why official sector institutions like the IMF – who know how bleak the latest economic forecasts are -- are not urging sovereigns to take advantage of the market lunacy to put in pandemic clauses. These are clauses that would give the countries like Brazil relief in the future if it turns out that covid-19 causes so much harm to the Brazilian economy that it cannot pay back the debt. After all, if investors are willing to buy any rubbish that is put out there, why not ask for better contract terms for when the party ends?

To reiterate, 2.875% percent is NOT commensurate with the risk of a country in the middle of a pandemic located on a planet in the middle of a pandemic for which there is no cure and no vaccine short of drinking a pint of bleach each morning. 2.875 percent makes sense only in comparison to 0.7 percent for a US Treasury or below zero for a German Bund. 

I’m not done ranting though. Let us now look at the risk disclosures about the impact of covid-19 on the economy in the Brazilian prospectus supplement.

Brazil’s prospectus supplement dated June 3, 2020, at first cut, looks to contain pages and pages of information regarding how the country has been dealing with the covid-19. Unfortunately, for anyone seeking to learn anything meaningful, almost all of information has the quality of the piece of disclosure reproduced below (the first item that appears in the risk factors section of the supplement).  It is hard to describe this disclosure – that some lawyers undoubtedly billed many thousands of dollars to produce -- as anything other than vacuous. But read for yourself. From page S-8 or the prospectus supplement:

Risk Factors Relating to Brazil

Developments relating to the outbreak of the coronavirus may have a material adverse impact on our economy.

The global outbreak of COVID-19, and public health measures to mitigate it, are having a material impact on the economy in Brazil and around the world. The scope, magnitude and duration of the impact on Brazil cannot yet be determined. COVID-19 could increase the risks described elsewhere in this section.

The long-term effects of the COVID-19 and other public health crises on the global financial markets and economy are difficult to assess or predict. They may include risks to citizens’ health and safety, as well as reduced economic activity, which in turn could result in decreased revenue for the government and increased expenditures, among other relevant impacts. It is unclear whether these challenges and uncertainties will be contained or resolved, and what effects they will have on the global financial markets and economy in the long term. We cannot predict the evolution of the disease in Brazil or whether additional restrictions will be required. In addition to measures taken by Brazilian federal, state and local governments, Brazil may be affected by the impact of the disease elsewhere in the region and by measures taken by other countries or organizations, such as orders that suspend travel or that limit trade. The final impact of the COVID-19 pandemic is still uncertain, but it is expected to have a significant adverse effect on our economy.

COVID-19 is also present in Brazil, and the Brazilian government has taken extensive steps to mitigate the spread of the disease and its impact on public health. See “Recent Developments—COVID-19 Developments” in this prospectus supplement. The efficacy of these steps cannot yet be evaluated, and it is highly uncertain how long and in what form they will remain in effect. Since March 2020, the government has introduced several measures to address the COVID-19 pandemic. The measures implemented so far have resulted in a slowdown in economic activity that will adversely affect economic growth in 2020 and possibly 2021, to a degree that we cannot quantify as of the date of this prospectus supplement. Any prolonged restrictive measures put in place in order to control an outbreak of contagious disease or other adverse public health development in Brazil may have a longer lasting material and adverse effect on our economy. While the economic cost of the COVID-19 pandemic is difficult to predict, we expect that our fiscal deficit will increase. The long-term impact of the governmental measures on our economy, and the effectiveness of these measures, cannot be assured. If these measures are insufficient or are not successfully implemented, the effect on the Brazilian economy or on the Brazilian debt sector could be exacerbated.

Brazil’s economy is vulnerable to external shocks and to more general “contagion” effects, each of which could have a material adverse effect on Brazil’s economic growth and its ability to raise funding in the external debt markets in the future.

Emerging market investment generally poses a degree of risk because the economies in the developing world are susceptible to destabilization resulting from domestic and international developments.

Brazil’s economy is vulnerable to external shocks, including adverse economic and financial developments in other countries and market developments. A significant increase in interest rates in the international financial markets may adversely affect the liquidity of, and trading markets for, the global bonds. In addition, a significant drop in the price of commodities produced in Brazil, such as iron ore, oil, soybeans, sugar and corn, could adversely affect the Brazilian economy. A significant decline in the economic growth or demand for imports of any of Brazil’s major trading partners, such as China, the European Union, or the United States, could have a material adverse impact on Brazil’s exports and balance of trade and adversely affect Brazil’s economic growth.

This is what I remember a wise and cynical senior partner at my old firm describing as a "we can't be entirely sure that the sun will rise in the East tomorrow" approach to disclosure. Therefore, it would be reckless for us to speculate about where the sun may in fact be coming up, if indeed it comes up at all, a matter on which we express no opinion and as to which no assurances can be given. 

To be fair, the counter argument is that every damn fool knows what covid-19 means to the world economy. How can our poor literary skills add to what Anthony Fauci has been telling you all for months?


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