Analysis: After Brazil ructions, a rethink for investors in emerging market state firms

RIO DE JANEIRO, BRAZIL – Brazil’s shake up of state-run oil firm Petrobras has caused shockwaves at home but may also prompt some bond investors to rethink their US$1 trillion-plus exposure to other government-controlled companies across emerging markets.

From China’s Exim Bank to Mexican oil giant Pemex or South African utility Eskom, companies wholly or partly government-owned make up half of the US$2.4 trillion market in emerging market corporate debt.

Such state-owned enterprises (SOEs) are generally in high demand from investors, first as their bonds carry a yield premium over sovereign debt and second, because of the perception of state backing.

But Brazilian President Jair Bolsonaro’s abrupt sacking of Petroleo Brasileiro SA’s chief executive last Friday in favour of an army general “reminds investors of the risk inherent of investing in SOEs or quasi-sovereigns,” said Eric Ollom, head of EM corporate debt strategy at Citi.

Petrobras shares plunged, wiping out a R$100 billion (US$18 billion) in market value in two days and its bonds tumbled after Bolsonaro announced the CEO change in a social media post, following a spat over fuel price policy.

Emerging SOE debt – concentrated in financials, commodities and energy — comprises around a fifth of the EMBI emerging debt benchmark compiled by JPMorgan. Governance, like at Petrobras, is just one of the concerns.

Utilities and power companies can be subject to politically motivated pricing directives, while financial disclosures and productivity can lag the private sector.

Profitability can take a backseat to political priorities such as creating employment or winning elections.

“First and foremost, investors need to figure out and understand where does this SOE fit into the agenda of the political and socio-and economic landscape of the country… its social importance as employer or as a contributor to the budget,” Sergey Dergachev, a fund manager at Union Investment, said.

He still likes Petrobras but is taking a wait and see attitude for now on a company that regularly catches the limelight. In 2018 the government stepped in to lower fuel prices in response to a crippling nationwide truckers’ strike, while last week’s CEO dismissal came after right-wing populist Bolsonaro said recent fuel price hikes were hurting the Brazilian people.

Other investors such as Citi’s Ollom are more sceptical, noting Petrobras bond spreads versus the sovereign blew out to multi-month highs of near 100 bps, from 30 bps. The move also hit Brazil’s currency and its sovereign bonds.

“If we keep getting bad news, we could maybe get a more permanent repricing,” Ollom said.

DECOUPLING?

Investors aren’t yet rushing to sell out of emerging market SOEs more broadly though. And close government ties can be a boon.

Mexico just extended a US$3.5 billion lifeline to state oil firm Pemex to shore up finances and crude output. Government backing allows Pemex to run a net debt leverage of 8.5 times – well above many other oil firms.

Debt overhauls are rare at SOEs, though recently Chinese bond markets have been spooked by a wave of SOE defaults and Argentina’s YPF this year was forced to overhaul its debt.

“The ‘backing’ of governments behind debt obligations could represent possible ‘coupon buffers’ and a signal of stability,” said Guillaume Mascotto, head of ESG and investment stewardship at American Century Investments.

Nonetheless, the risk of state interference poses a dilemma for investors, especially for asset managers focusing on the environmental, social and governance (ESG) impact of their holdings, Mascotto said.

Corruption poses another headache. State-owned companies in nations with “high levels of perceived corruption” are one third as productive as their private sector peers, according to a recent report by the International Monetary Fund.

Emerging market assets were roiled by the fallout from the pandemic last year, which sparked billions of dollars in outflows. Bonds from fully state-owned companies moved broadly in lockstep with sovereign debt.

Around 90% of SOEs hold credit rating scores in line with their sovereign. Most divergences where the SOE is rated below the sovereign are investment-grade firms, where default probability differentials are negligible, calculates asset manager GMO.

The Petrobras shock may however test that close link.

If investors start questioning the ability and or willingness of the sole shareholder — the government — to support a company, yield spreads between the sovereign and the SOE could decouple. “Increasing leverage on sovereign balance sheets might amplify this development,” Thede Ruest, portfolio manager at Nordea, said.

The feedback loop can work both ways. Morgan Stanley on Monday struck Brazil’s sovereign bonds off its ‘like’ list, citing fiscal concerns and potential spillovers after Bolsonaro’s push.

Investors’ growing ESG focus is another source of pressure, said Ruest, who avoids quasi-sovereigns. “Higher funding costs, as well as a global push to redirect capital towards business models supporting the U.N.’s SDGs (Sustainable Development Goals), might make refinancing more difficult for many of those issuers,” he said.