Thursday, January 20, 2011

"What About Brazilian Bonds?"

Earlier this week I received a call from one of my clients.

This client - who's a retired accountant executive, and a pretty savvy guy - had a couple of CD's maturing, and was searching for better yields than the local banks are offering.

I gave him my opinion: Longer maturity U.S. bonds, especially higher quality municipals, offer very attractive yields in a disinflationary world. Given that AA-rated municipals in the 10-year maturity range are offering yields that are 120% of comparable Treasurys, I suggested that at least a portion of his fixed income money be moved into this sector.

No, that wasn't what he wanted - my client is convinced that U.S. interest rates are going to be headed considerably higher in the next year or so, and so wants to stay on the shorter maturity end of the U.S. bond market.

But then he startled me with a question that I really hadn't expected from a relatively conservative investor:

"What about Brazil? Aren't rates pretty high down there? Is there any way I can get some Brazilian bonds?"

I confessed to my client that I really wasn't too well-versed on the bond markets of South America, so we're not going to invest in that region, but it got my curiosity going.

I turned to one of my favorite columnists - Ambrose Evans-Pritchard of the London Telegraph - to see what he could offer. And sure enough, Mr. Evans-Pritchard had just written a column about Brazil.

According to his article, Brazil is struggling with high inflation rates, largely due to the flood of foreign capital coming into the country. It seems that global investors - especially those in the United States - are frustrated with the low rates in their own countries, and look at countries like Brazil as attractive alternatives.

Problem is, Brazil doesn't really want the foreign money, since it drives up the value of the Brazilian real, which moves inflation higher and makes Brazilian exports less competitive globally:

Brazil’s trade deficit doubled last year to $71bn, and there is evidence that the strong real is letting Asian exporters eat into Brazil’s industrial base. The government has already adopted 28 anti-dumping measures against China, covering steel, tyres, synthetic fibres, chemicals, shoes and toys. China’s annual exports to Brazil have jumped from $5bn to $26bn in five years.

Still, the central bank in Brazil just raised short term rates to 11.25% to combat inflation, which is running at an annual rate of about 6% (i.e. real Brazilian rates are above 5%, which is among the highest in the world).

So how does this all turn out? Mr. Evans-Pritchard continues:

Marcelo Ribeiro from the Pentagono Asset Management said Brazil is repeating its age-old pattern of boom and bust. "Brazil is wrongly perceived as the world’s best investment play. Fiscal policy is ultra-loose and sooner or later the fiscal vigilantes will force dramatic changes," he said.

Mr Ribeiro said Rio’s richest district, Leblon, is now more expensive than New York’s Upper East Side, and Brazilian tourists find London cheap. There has been an explosion of derivatives contracts on the real. "These are all signs of a gigantic bubble," he said.