"Investors may well view initial downgrades not as isolated events but as the beginning of a new trend," BofA said.
Index Ejection Risk
Russian, Turkish, Brazilian and South African local bonds - among the handful of emerging market names included in the Barclays Global Aggregate index - risk ejection from the $2 trillion benchmark if they are downgraded.
Falling angels which lapse into junk status will also drop out of the investment grade portion of the EMBIG index which has up to $7 billion benchmarked, JPMorgan says.
"The big worry is for countries in the low investment grade range, such as Russia and Brazil. Falling into the junk bond range cuts you off from the largest segment of bond buyers," said Peter Marber, head of emerging debt at Loomis Sayles.
That's especially so in the case of big insurers and banks which are extremely sensitive to ratings due to tighter regulations on capital reserves and asset quality, he noted.
Also, company ratings tend to be constrained by the sovereign, Marber said, adding: "So if we see countries downgraded into high-yield status, it may trigger automatic corporate downgrades which would dramatically restrict access to international capital."
All this will raise capital costs for borrowers, adding to pressures caused by the possibility of higher U.S. interest rates and Treasury yields which will suck funds out of emerging markets.
Exactly how much emerging bond yields will rise is impossible to calculate. But BofA/Merrill reckons a one-notch downgrade to junk tends to produce a 40-60 basis point increase in yield and credit default swap spreads.
BNP's Spegel calculates that for every 10 falling angels, spreads over U.S. treasury bond yields on the CEMBI EM corporate debt index will widen by 125 basis points and sovereign spreads will blow out 241 bps.