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Saturday, October 2, 2010

Brasil's Red Hot Bond Market

Feature | SATURDAY, OCTOBER 2, 2010
Brazil's Red-Hot Bond Market
By KENNETH RAPOZA | MORE ARTICLES BY AUTHOR
With double-digit yields, Brazil's government bonds are drawing strong interest from investors around the world. Time to jump in?



BRAZILIAN STOCKS have been something of a disappointment this year, up just 1% and lagging behind the Dow Jones Emerging Markets Index. But the country's bonds are another story. They have been sizzling, helping to keep Brazil a favorite of global investors.

International bond-fund managers this year put at least $5.2 billion into all classes of Brazilian bonds as of Sept. 22, up from the previous record of $2.05 billion set in 2009, according to investment data firm EPFR Global in Cambridge, Mass. Brazil accounts for a little more than 10% of the record $34 billion inflow into dedicated emerging-market bonds.

And here is the best part: There is no sign that the market is overheating. Demand remains especially strong from investors in countries like Japan, where interest rates are below 1%.

Within Brazil's fixed-income universe, the $900-billion local government-bond market is a favorite, with a yield of about 11.33% for one-year bonds. With a little cooperation from the economy, these securities could deliver double-digit returns for some time.

Brazil's government debt is investment grade, with relatively little credit risk. The greater dangers would be a rise in inflation—now at about Brazil's targeted annual level of 4.6%—or a drop in the value of the real.

If investors in the U.S. and other countries with weak economies pull back from investing in projects in Brazil, the currency clearly would take a hit.

Some savvy investors think the risks are manageable. They see a stable local economy growing at 7%, and a strong financial position, with the country's cash reserves exceeding what it owes in interest on its debt to foreign countries.

"Our investors are very happy buying 11% government bonds and taking the risk on the real," says Alexander Gorra, head of international sales of BNY Mellon ARX in Rio de Janeiro. "The risk could mean a bigger payout if the real strengthens or stays steady."

The risk of a steep devaluation is low, says Sara Zervos, manager of the $13.4 billion Oppenheimer International Bond Fund (ticker: OIBAX). She expects the real to end the year stronger, at the equivalent of $1.65, up from a recent $1.67.

"My thinking on Brazil bonds is that everybody likes them, everybody wants them, and there's a food fight whenever there's an issue," says Zervos.

Record Breaker

International bond-fund managers are pouring money into Brazil's bonds


In fact, the market easily absorbed a recent $550-million issue.

The easiest way for individual investors to buy Brazil bonds is through a growing number of emerging-market bond funds and some dedicated offshore Brazil bond funds, such as Deutsche Bank's Brazil Bond Basket 2014 for high-net-worth individuals.

Oppenheimer launched its first emerging-markets bond fund, the Oppenheimer Emerging Markets Debt fund (OEMAX) on June 30 for the retail market. Brazil accounts for 15% of Oppenheimer's emerging-market debt, with real-denominated bonds accounting for around 60%, nearly all of it government issues. A month after that fund launched, Van Eck unveiled its latest exchange-traded fund for emerging-market bonds, the Market Vectors Emerging Markets Local Currency Bond (EMLC).

BlackRock has its three-year-old ETF called the iShares JP Morgan Emerging Markets Bond Index fund (EMB). EMB is up 9.3% through Sept. 30. Outside of the retail sector, institutional investors and sovereign-wealth funds from Europe to Japan have their own Brazil-dedicated bond funds.

"There is a lot of appetite these days for local bonds," says Olivier Ginguene, portfolio manager at Pictet Asset Management in Geneva. "There's value there and the currency risk is stable."

THE OVERSEAS MARKET for Brazilian government bonds— offering the country's bonds in the U.S. and elsewhere— may be almost fully valued. Yields have fallen close to those of U.S. Treasuries, as investors scramble for a piece of the action.

Brazil's 2021 overseas bond was yielding around 3.78% recently, with a spread of 129 basis points, or 1.29 percentage points, over Treasuries. A year ago, the same bond yielded 183 basis points above Treasuries.

The Bottom Line

With the Brazilian economy growing at 7% and inflation at target levels, locally traded government bonds look attractive. But Brazil bonds traded overseas look pricey.

On the corporate-debt side, mining company Vale (VALE) sold $1.75 billion in overseas bonds Sept. 8, yielding just 4.6% with a spread of 210. Two days later, Vale's 10-year was lower at 4 5/8% with a spread of 175 over Treasuries. Demand for Brazilian bonds has kept up with supply.

"This market becomes a bubble when you start seeing corporate-debt spreads closer to what we are seeing for the sovereigns," says Michael Roche, an emerging-markets strategist at MF Global in New York. The spread on Brazil corporate debt over Treasuries, as registered by the JP Morgan Corporate Emerging Markets Bond Index, was recently 330 basis points.

As a result of all this, foreign investors account for nearly 10% of Brazil's local government bond market, says Paulo Valle, the sub-secretary of public debt at the Brazilian National Treasury. That's up from 0.7% in 2005, leaving some investors to wonder if it might be getting too late to get in on the action, especially in light of the jump in stocks just this past week.

Take heart, it probably isn't too late, at least in the local government-bond sector. Those double-digit yields look unlikely to vanish anytime soon.

KENNETH RAPOZA, a free-lance writer, covers Brazilian markets.

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