[Practical Finance] Should You Jump on the 'Running' Brazilian Bonds Now?

Slowing Pace of Interest Rate Cuts... Hold the Bat Shorter for Investment
Brazil Credit Rating Up... Defending the Value of Real Currency

Last year, Brazilian bonds, which recorded high returns, have attracted the attention of investors. This is because Brazil has started cutting interest rates, causing bond prices to rise. The international tax treaty between Korea and Brazil, which exempts both interest income and capital gains from taxation, has also been an attractive factor. However, experts recommend focusing on short-term interest income investments, as the interest rate cut cycle has progressed to some extent.

According to the financial investment industry on the 27th, investors who invested in Brazilian 10-year bonds at the beginning of last year are estimated to have recorded an annual return of about 38%. This is attributed to the stabilization of inflation, the Brazilian central bank's interest rate cuts, and the Brazilian government's initiation of fiscal reforms. With such high returns, domestic investors also invested large sums in Brazilian bonds. The scale of Brazilian bonds sold by five domestic securities firms is known to be about 2 trillion won.

Earlier, in September 2020, the Brazilian central bank lowered the benchmark interest rate to 2%. As COVID-19 spread rapidly, the real economy contracted, and advanced countries like the U.S. drastically lowered interest rates, Brazil also cut rates. Subsequently, as inflation surged due to the side effects of low interest rates, the Brazilian central bank rapidly raised rates from March 2021 to September 2022. During this period, rates were raised 12 times, maintaining a high rate of 13.75% until August last year.

Brazil's high interest rate trend reversed from August last year. The Brazilian central bank unanimously decided at the Monetary Policy Committee (COPOM) to lower the benchmark interest rate by 0.5 percentage points to 13.25%. This was based on the judgment that while the real economy was recovering due to the COVID-19 endemic, inflation was slowing down due to the Russia-Ukraine war. At that time, Brazil's Consumer Price Index (CPI) was around 4.6%, within the central bank's target range of 1.75% to 4.75%.

The interest rate cuts that began then have continued until recently. On the 20th, the Brazilian central bank set the benchmark interest rate at 10.75%. This marks a total of six rate cuts since August last year. The Brazilian central bank also hinted at a 0.5 percentage point cut at the upcoming monetary policy meeting in May. When interest rates fall, bond prices rise. This is why investors have recently earned high returns from Brazilian bonds.

The market expects Brazil's benchmark interest rate to fall to around 8% by the end of this year. However, the pace of cuts is expected to slow down starting in May, as Brazil's consumer price inflation has been decreasing recently. Accordingly, experts recommend taking a cautious, short-term investment approach.

Jeon Byung-ha, a researcher at NH Investment & Securities, said, "The Brazilian central bank is expected to signal a slowdown in the pace of rate cuts starting from the June meeting, so the decline in long-term bond yields will be limited after June," adding, "Short-term bonds are preferred over long-term bonds."

One factor limiting profits in this favorable interest rate environment is the weakness of the Brazilian real. If the real depreciates, the value of Brazilian bonds denominated in reals also falls. The real has been devalued due to Brazil's chronic fiscal deterioration and increasing debt. Brazil's government debt-to-GDP ratio was about 88% last year, higher than other emerging countries. Especially since the inauguration of the Lula administration last year, the government debt ratio has been rising again.

Kim Eun-gi, a researcher at Samsung Securities, analyzed, "The Lula administration announced a new fiscal rule last April to limit the fiscal deficit to -1% and pledged to maintain a balanced fiscal budget this year and a surplus thereafter. However, the fiscal deficit last year was -1.2%, failing to meet the target, and the deficit is expected to continue this year, making the achievement of the new fiscal rule very unlikely."

Researcher Kim pointed out, "As the rise in bond prices due to interest rate cuts is limited, yield volatility caused by the real's value may increase. Despite the dollar weakening due to U.S. interest rate cuts, capital outflows from bond investments may occur as the interest rate gap between the U.S. and Brazil narrows. Attention should also be paid to factors weakening the real exchange rate, such as China's economic growth slowdown and the decline in iron ore prices, one of Brazil's major exports."

However, some analyses suggest that the risk of real depreciation has somewhat decreased as Brazil's sovereign credit rating has improved. In December last year, the global credit rating agency Standard & Poor's (S&P) upgraded Brazil's credit rating from 'BB-' to 'BB' (stable). Brazil's credit rating has been gradually recovering since it fell to junk status in 2015.

Park Min-young, a researcher at Shinhan Investment Corp., said, "Since Brazil's credit rating upgrade last year, the KRW/BRL exchange rate has shown downside rigidity around the mid-260 won range, confirming higher resilience compared to other currencies," and forecasted, "The relative strength centered on South American countries is continuing, so concerns about the real's weakness are unlikely to expand."

Park Jun-woo, a researcher at KB Securities, analyzed, "The steep interest rate cut cycle has entered its final phase," adding, "Rather than actively investing in long-term bonds expecting rate declines, a strategy focusing on short-term bonds to earn interest income, backed by a stable real value, is necessary."