Will Brazilian Debt Go Green?
Brazilian President-elect Luiz Inácio Lula da Silva has vowed to be a climate leader, scaling back deforestation, setting new emissions targets, and helping developing nations get the money they need to deal with the effects of climate change. But what’s rhetoric and what’s reality, and what does it mean for emerging markets (EM) debt investors?
New Hope—and Concern
It is likely that Lula will enact greater environmental protections than did outgoing Brazilian President Jair Bolsonaro, and Lula’s more environmentally focused government could drive stronger trade relationships with other countries, including those of Europe.
And while its very early to tell whether investors are changing their allocations based on Lula’s victory, Lula’s pro-climate comments are likely to attract the attention of global green investors.
One must be cautious, however. Presidential rhetoric in Latin America is often tempered by legislative pushback or inaction, and that is yet to work itself out in Brazil. Improvements in climate policy could be offset by a deterioration in fiscal policy. In addition, recent statements by Lula could be viewed as less than market friendly.
Presidential rhetoric in Latin America is often tempered by legislative pushback or inaction, and that is yet to work itself out in Brazil.
So, although there is great potential and dedicated capital exists, we must also consider Lula’s policies holistically in order to assess the appropriate risk premium. We do think that if enacted, Lula’s environmental policies will make corporate level pledges more effective through higher public/private cooperation and support.
Potential Winners—and Losers
Given the differences in Lula and Bolsanaro’s position on the environment, it’s reasonable to think that certain types of debt could outperform under Lula. For example, we could see more green bonds issued and former ESG laggards outperforming.
If rate volatility continues to moderate, we expect primary issuance of corporate debt to improve but more than likely not until 2023.
But Brazilian corporates have actually underperformed the broader market rally since Lula’s election. Duration more than structure or labelling has been the main differentiator in performance. There has not been any issuance in hard currency corporates since the election. If rate volatility continues to moderate, we expect primary issuance of corporate debt to improve but more than likely not until 2023.
The Outlook—Sovereign Bonds
From a sovereign perspective, we think investors would need to see some concrete action from Lula before changing allocations.
Broadly speaking, however, we are constructive on local currency sovereign bonds, but less constructive on hard sovereign currency bonds given valuations and the outlook for monetary policy.
Brazil has finished its rate-hiking cycle ahead of the curve, and will be in a position to cut sooner than many other Latin American and developed countries. However, we believe valuations in hard currency debt are a bit stretched.
What is emerging as a potential risk—but not part of our base case—is the possibility that Lula is significantly more fiscally profligate than what we thought he would be. Overly expansionary fiscal policy would counteract the contractionary monetary policy and increase uncertainty about the outlook for rates and inflation. If Brazil loses the fiscal anchor, we could see a weaker Brazilian real and higher local interest rates.
The Outlook—Corporate Bonds
Brazilian corporates, on the other hand, offer a diversity of investment options. Indeed, Brazil is one of the few countries with a full spectrum of sectors in our universe. When looking at labeled bonds—whether they are green, sustainable, or sustainability-linked—the diversity is smaller but still good relative to other countries.
Brazil is one of the few countries with a full spectrum of sectors in our corporate debt universe.
In this case, we think investments should be more issuer/bond-specific than top-down, but expect companies, particularly in directly impacted sectors such as protein processors and pulp/forest products, to explore market access.
Brazilian corporates currently offer historically attractive yields, but so do most corporates in other EMs. So we think corporate investors will be cautious on allocations until Brazil’s macroeconomic path is more visible.
Readers are probably sensing a theme at this point: While there is much speculation that Lula’s more environmentally focused government could drive changes in allocations, there is risk when it comes to the macroeconomic environment and potential impact of any changes on fiscal dynamics.
It’s wise to consider all factors in order to appropriately gauge a risk premium. Viewing an investment through only one lens—in this case an improvement in environmental policies—is insufficient. Investors should consider Lula’s recent non-climate-related comments, the naming of cabinet members, the macroeconomic outlook, and the microeconomic aspects of the investment, in addition to environmental, social, and governance (ESG) considerations and their materiality to Brazil.
Jared Lou, CFA, is a portfolio manager on William Blair’s emerging markets debt (EMD) team.
Luis Olguin, CFA, is a portfolio manager on William Blair’s emerging markets debt (EMD) team.
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