Citigroup Sounding Alarm on $13 Billion of Bank Bonds in Brazil

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To Citigroup Inc., traders in Brazil’s bank-bond market are being far too complacent.

The country is in danger of having its rating cut to the cusp of junk by Moody’s Investors Service, and that means the nation’s biggest lenders are also in the crosshairs. That’s because banks’ credit grades typically are aligned with those of their home country, given the lenders’ importance to the local economy.

A Brazil downgrade will be especially damaging for the riskiest corner of the market, says Citigroup’s Eric Ollom. Banco do Brasil SA, Itau Unibanco SA and Bradesco SA have issued $13 billion of subordinated notes, which already are rated lower than senior notes that give bondholders stronger protections in a default. And their prices don’t yet reflect the pain that’s in the offing, says Ollom, the head of global emerging-market corporate debt strategy at Citigroup.

“Is that cut priced in? I don’t think it is,” he said by telephone from New York. “There should be ratings pressure.”

Ollom, who recommends selling the notes, points to Banco do Brasil’s $750 million of subordinated bonds due in 2023, which yield 0.9 percentage point more than the state-controlled bank’s senior debt. Investors should be getting a yield premium of as much as 1.5 percentage points given the prospect of a rating cut, he said.

Moody’s Outlook

Speculation is mounting that Moody’s will be the second rating company to lower Brazil’s grade to the precipice of junk as the economy suffers its biggest contraction in a quarter century and a bribery scandal frustrates the government’s efforts to restore its finances.

Moody’s, which met with officials in Brazil last month, cited the country’s economic woes and deteriorating finances when it put the Baa2 rating on negative outlook in September. Things have only gotten worse since then, with Moody’s predicting in a July 16 report that gross domestic product will shrink 1.8 percent this year.

Brazil’s real declined 0.5 percent to 3.4885 per U.S. dollar at 4:24 p.m. in New York. The currency declined 24 percent this year.

Just last week, Standard & Poor’s also revised its outlook on Brazil’s rating to negative. An S&P downgrade would plunge Brazil back into junk since the company rates Brazil BBB-, one level below Moody’s.

“Banks are a leveraged macro play and as such, given the recession, I see the bonds expensive,” Jorge Piedrahita, the chief executive officer of New York-based brokerage Torino Capital LLC, said in an e-mail.

Bonds Drop

The $13 billion of subordinated bonds from Banco do Brasil, Bradesco and Itau have slumped 3.8 percent in the past month. That compares with an average 0.3 percent gain for emerging-market banks.

Banco do Brasil and Bradesco declined to comment on the performance of the bonds and a potential downgrade.

Itau’s press office said in an e-mailed statement that the bank’s rating can’t be above the sovereign’s due to Moody’s own methodology, and that its funding is mostly composed of deposits from local clients denominated in reais. Therefore, a rating cut should not significantly affect the conglomerate’s average cost of funding, the bank said.

To Babson Capital Management LLC, the likelihood of a Moody’s downgrade isn’t enough of a reason to get out of the subordinated bonds.

‘Relatively Sound’

“The major private banks have weathered the current downturn pretty well, and their balance sheets remain relatively sound,” money managers Brigitte Posch and Kristine Li said in an e-mail.

Still, with the economy getting progressively worse, it’s hard to see Brazil’s biggest banks avoiding the pain.

“In an economic downturn, banks are the most affected,” Patrik Kauffmann, who helps manage $11.2 billion at Solitaire Aquila in Zurich, said by e-mail. “With nonperforming loans going up, they need to write down credits and may need capital injections. As a subordinated holder, you are one of the first in line to get hit if things turn difficult.”

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