Foreign ownership of Brazil’s local debt hits highest ever level

Brazil is heading for its deepest recession for a quarter of a century, inflation is spiking, the real is plunging, its government is mired in a corruption scandal and even its love of football is threatening to turn sour as the Senate launches an inquiry into bribery allegations surrounding its hosting of the 2014 World Cup.

To top it all, “the security situation in the major cities is deteriorating” and a cut in municipal budgets “will likely raise street violence further”, warns Daniel Tenengauzer, head of emerging markets research at RBC Capital Markets.


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How have foreign investors reacted to this mess? By flocking in record numbers, of course.

Non-residents now own a record 20.5 per cent of Brazil’s local currency government debt, some R$480bn ($153bn) worth, according to ministry of finance data, up from just 11.3 per cent at the end of 2011.

In a world where the hunt for yield is all-encompassing, demand for Brazil’s bonds has been driven by the tempting coupons on offer as the central bank increases interest rates in an attempt to bring inflation, which accelerated to 8.17 per cent in April, back towards its 4.5 per cent target.

Ten-year government bonds yield 12.4 per cent, rendering a real yield of 4.23 per cent, one of the highest rates in the world.

“People recognise that there are issues, but they also think they are getting compensated,” said Jeremy Lawson, chief economist at Edinburgh-based Standard Life Investments, which numbers long-duration Brazilian debt among its £258bn of assets — despite warning that conditions in Brazil have deteriorated in the past six months.

“The risks we have identified are more than priced in. As long as you are confident that there is no actual crisis, then it’s a good place to take duration risk,” Mr Lawson said.

Indeed, there is rising confidence that inflation may be close to peaking, aided by the renewed hawkishness of the central bank, which on Wednesday raised its benchmark Selic rate by a further 50 basis points to 13.75 per cent, cementing a rise of 650bp in two years. The market is pricing in 50 more points of tightening by September, according to Société Générale.


If so, this could push real yields higher still. “Inflation looks like it may have peaked, so in real terms yields are still substantially positive,” said Neil Shearing, chief emerging markets economist at Capital Economics.

Indeed, Jan Dehn, head of research at Ashmore Investment Management, believes inflation could “collapse” in 2016 as price rises driven by cuts in fuel subsidies drop out of the calculation.

Unhedged foreign investors in Brazil’s local currency debt are, of course, at the mercy of further falls in the real, which has plunged from a high of about $1.50 to the dollar in July 2011 to $3.14.

Despite this, Mr Shearing said: “there are reasons to think that at least the big falls in the currency are behind us”, not least the fact that the real has been relatively stable over the past two months and “a lot of the bad news about the economy is priced in now”.

Capital Economics’ central forecast is for a modest further weakening to R$3.20 to the dollar by the end of this year.

Mr Lawson was also optimistic about the currency, provided that Brazil is successful in tackling its twin budget and current account deficits.

He was confident that tighter monetary policy would help narrow Brazil’s external account deficit by reducing domestic demand. As for the government’s finances, much will depend on whether the plans of Joaquim Levy, a Chicago-trained economist helicoptered in as finance minister to balance the books and restore confidence, come to fruition.

Mr Dehn argued Brazil had an “excellent chance” of extricating itself from its slump, given “sound” underlying structural fundamentals, “sustainable” debt levels, “benign” demographics, and a wealth of resources.

To Mr Dehn, the biggest potential risk on the horizon is that Dilma Rousseff, the president, is impeached in connection with the scandal at Petrobras, Brazil’s state-owned oil company.

Ms Rousseff was chairman of Petrobras between 2003 and 2010 when much of the alleged corruption, which is reported to have involved the payment of illicit sums to 54 political figures, is said to have taken place.

Ms Rousseff has said she has no knowledge of any illegal activity, but Mr Dehn said that if any proof emerged, or Ms Rousseff lost support in parliament, “then the outlook changes for the worse”.

Investors do not seem overly concerned about the fallout, though. On Monday, Petrobras successfully issued a 100-year, $2.5bn bond at a yield of just 8.45 per cent, 0.4 percentage points less than bankers initially planned and virtually 4 percentage points above the government’s benchmark borrowing rate.

The timing for the first century bond issued by an emerging market company since 1997 might not have seemed propitious, but the hunt for yield appeared, once again, to win the day.


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