Brazilian Government Bonds Plunging

Investor skepticism about the nation's prospects leads to the biggest quarterly bond losses since 2002.

Brazilian government bonds are suffering the biggest quarterly losses since the run-up to former President Luiz Inacio Lula da Silva’s election in 2002 led to speculation that the nation would default.

Dollar-denominated bonds from Brazil, Latin America’s biggest nation, plunged 7.55 percent since the end of March, the biggest slide since a 16 percent drop in the third quarter of 2002 before Lula’s October election that year. The loss this quarter exceeds a decline of 6.15 percent for countries with triple-B ratings, according to Bank of America Corp.

Investors are becoming concerned that President Dilma Rousseff’s administration is undoing the progress of her mentor and predecessor, who overcame bondholder skepticism to win the nation’s first-ever investment grade in 2008. Brazil is now grappling with inflation above its 6.5 percent target, the prospect of a credit downgrade and the biggest street protests in more than two decades as speculation increases that the Federal Reserve will reduce its unprecedented bond buying, which had pushed investors into higher-yielding emerging markets.

“The street protests are really exposing a lot, the many levels of weaknesses that the administration put into the economy,” Italo Lombardi, an economist at Standard Chartered Plc, said in a telephone interview from New York. “If they don’t take actions and we continue to see low growth, then we could see a downgrade.”

The Finance Ministry declined to comment in an e-mailed response to questions about the nation’s bond performance.

The average yield on Brazil’s dollar-denominated bonds has soared 106 basis points, or 1.06 percentage points, to 5.09 percent since Fed Chairman Ben S. Bernanke said May 22 that signs of a sustained improvement in the U.S. jobs market could lead the central bank to scale back its monthly bond purchases, according to data compiled by JPMorgan Chase & Co.

“Things weren’t good, and then, when the Fed came in, that just did it,” Paulo Vieira da Cunha, partner at Tandem Global Management LP and a former central bank director, said by phone from New York. “All of a sudden, you got this perspective that you would have to pay a lot more to borrow abroad. It caught Brazil completely on the wrong foot.”

Outlook Cut

Lula ran for president unsuccessfully as head of Brazil’s Workers’ Party three times before winning in 2002 amid pledges of revived growth and job creation. The former union leader’s party had advocated a renegotiation of Brazil’s international debt and investors were concerned he would boost deficit spending and default.

Once in office, Lula ordered a record 14.1 billion reais in spending cuts as part of a $30 billion loan agreement with the International Monetary Fund and accumulated a then-record $289 billion in international reserves as prices for food and mineral exports soared.

Brazilian bonds due in 2040, which traded as low as 42.5 cents on the dollar in the third quarter of 2002, tripled in value during Lula’s presidency.

On June 6, Standard & Poor’s cut its outlook on Brazil’s rating to negative, citing sluggish economic growth, weakening fiscal accounts, and a loss of investor credibility. S&P raised the country to BBB-, the lowest investment-grade rating, in 2008. The rating climbed to the current BBB in November 2011, toward the end of Rousseff’s first year in office.

Slowing Growth

Mauro Leos, senior credit officer at Moody’s Investors Service, said in a June 19 interview that his firm’s positive outlook on Brazil is “difficult to support” amid lackluster growth and rising debt levels. Brazil’s gross debt was equal to 59.2 percent of gross domestic product in March, compared with 53.35 percent at the end of Lula’s term in December 2010.

Rousseff’s administration is trying to revive economic growth that slowed for two straight years to 0.9 percent in 2012 from 7.6 percent in 2010. The central bank yesterday cut its forecast for growth this year to 2.7 percent, from a March projection of 3.1 percent.

Annual inflation through mid-June reached 6.67 percent, the fastest pace since November 2011, even after officials cut energy tariffs. Brazil’s central bank targets annual inflation at 4.5 percent, plus or minus two percentage points.

The price increases prompted central bankers to raise their benchmark interest rate twice this quarter from a record low 7.25 percent.


Budget Deficit

Street protests that began three weeks ago against an increase in bus fares have swelled as demonstrators voiced complaints about corruption and the quality of health care and education.

The president vowed to boost spending to placate the protesters while urging fiscal restraint among policy makers. In April, the government posted the biggest budget deficit in almost four years of 132 billion reais ($60 billion).

For John Welch, a macroeconomic strategist at CIBC World Markets in Toronto, the bond sell-off has created a buying opportunity.

“You have some value in Brazilian bonds where you’re actually being compensated for the risk,” Welch said in a telephone interview. “Brazil’s been the big underperformer and probably deservedly so, but now it’s starting to go too far.”

The extra yield investors demand to own Brazilian government dollar bonds instead of U.S. Treasuries has surged 52 basis points this quarter to 242 basis points as of 11:54 a.m. in New York, according to JPMorgan’s EMBI Global index.


Default Swaps

The cost to protect Brazilian bonds against default for five years has climbed 49 basis points since the end of March to 186 basis points, the biggest quarterly jump since 2011. Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent if a borrower fails to adhere to its debt agreements.

The real has plunged 8.5 percent this quarter to 2.2084 per dollar, the second-biggest drop in emerging markets after India’s rupee. Since taking office in January 2011, Rousseff has implemented dozens of measures to try to boost demand and protect industry from imports. Brazil removed taxes on currency derivatives in March and foreigners’ purchases of bonds earlier this month.

None of the actions has been successful in stimulating growth, according to Ricardo Hausmann, a professor at Harvard University in Cambridge, Massachusetts, and former planning minister in Venezuela.

“Brazil is a country that had been dealt a fantastic hand, and has played it very poorly,” Hausmann said in a telephone interview.

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