Brazil Bonds to Drop If State Debt Rules Change, Citigroup Says

  • Debt-calculation change would cost government $89 billion
  • Ruling in favor of change to worsen Brazil's fiscal concerns

Citigroup Inc. analysts are warning investors that Brazil’s sovereign bonds may fall should the country’s Supreme Court uphold its earlier ruling that changes the way state debt loads are calculated.

The top court is set to rule Wednesday on a government appeal of its decision this month that changed the terms of three states who sought to calculate simple rather than compound interest on their debts. Should all 25 states that owe the federal government money seek similar rulings, it would cost the Treasury 313 billion reais ($88.7 billion), according to the Finance Ministry.

A ruling against the federal government threatens to damp Brazil’s recent sovereign rally. The nation’s dollar-denominated bonds returned 14 percent this year, more than twice the average for emerging markets, on speculation that President Dilma Rousseff will be impeached, ushering in a more investor-friendly government led by Vice President Michel Temer.

“A negative ruling could bring forward the timing of a steeper bond curve, which we believe will happen in the medium term as an easing cycle starts and/or Temer’s honeymoon ends,” analysts Kenneth Lam and Dirk Willer wrote in the report to clients on Tuesday.

States, struggling in a two-year recession that has slashed revenue, owe the federal government 463 billion reais, including compound interest, according to the Finance Ministry. The debt was previously restructured in 1997 to be paid in installments through 2027. Rio Grande do Sul, Brazil’s southern-most state, missed a payment in August.

"States are facing true calamity and are clearly getting desperate. It’s absurd that situation could cost the country a fortune and pressure Brazilian assets," said David Beker, chief Brazil economist and fixed income strategist at Bank of America Merrill Lynch in Sao Paulo. "In a scenario dominated by political headlines, we forget the country’s main problems are still out there."

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