Brazilian bonds: heading for junk status?

Not long ago, Brazil was a "motor of the world economy", says Joe Leahy in the FT. Now it's "the sick man of the large emerging markets". It has fallen into a recession that is likely to be the nastiest since the mid-1990s, according to BNP Paribas. GDP could shrink by 2.5% this year.

Credit-ratings agency Standard & Poor's says it is considering downgrading Brazil's credit rating by one grade to "junk", which would put it on the same level as Russia, Turkey and Indonesia. A huge scandal at state-owned oil group Petrobras has put 50 politicians and businessmen under investigation for taking $2.1bn in kickbacks.

To add insult to injury, says Dimitra Defotis onbarrons.com, Brazil's water pollution is so bad that swimmers fear for their health at next year's Olympic Games not ideal for what was supposed to be a showcase for the country's progress.

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So how did the country get into this mess? The first problem was the end of the commodities boom, which dented export earnings, while consumers slowed their spending because they had gorged on debt. So the government tried to "prolong the party" with a stimulus programme, as Leahy points out.

That had little impact on growth but, along with a slumping currency, it helped drive up inflation, while it also led to the first primary fiscal deficit (a shortfall excluding interest on debt) in 14 years.

Fixing the deficit has been harder than expected owing to the cyclical downturn, while the central bank has had to lift its benchmark interest rate to over 14% to squeeze out inflation, exacerbating the downswing. On top of all this, investors began to worry that disarray in the government caused by the corruption scandal could undermine efforts to regain fiscal discipline.

This doesn't add up to a compelling story for investors, but Brazil is hardly a write-off. This downturn is a far cry from the hyperinflationary crises of the past. And once it passes, the focus should be on Brazil's long-term advantages, such as its range of soft commodities, and a young population to power future consumption.

The market is also one of the world's cheapest, on a cyclically adjusted price/earnings ratio of 9.3, implying plenty of potential upside. Two ways to play Brazil are the iShares MSCI Brazil UCITS ETF (LSE: IBZL) and the JP Morgan Brazil Investment Trust (LSE: JPB).