8% Current Yield With Capital Gain Potential Now Available From An Investment-Grade Currency

Aug.29.13 | About: WisdomTree Brazilian (BZF)

We all know about the plight of emerging markets. Recession in Europe, slow growth in the U.S., deceleration of growth in China and other factors have led to weakness in the prices of many commodities. Brazil is somewhere between emerging and "emerged", but more toward the former category. Its history of hyperinflation makes investors wary. The good news is that the commodities cycle may be turning and Brazil's central bank, supported by opinion-makers, is focusing on inflation rather than full employment.

Might the pendulum already have swung far enough to caution from the days not long ago when Paraguay and Rwanda sold multi-year debt in heavily-oversubscribed offerings?

This article makes the case that for adventurous income-oriented investors, the Brazilian real may be a timely and attractive investment.

The simplest way I know to gain direct exposure to the real is through the WisdomTree Brazilian Real Fund (NYSEARCA:BZF). This ETF is liquid enough for most investors, though it is unsuitable for day traders. There are $41 M in assets. As the real is nonconvertible, WisdomTree engages in forward currency contracts and swaps backed by its holdings of U.S. Treasury bills. Its twin investment objectives are to reflect money market rates available to foreign investors in Brazil and changes in the value of the real vs. the U.S. dollar.

The recent actions of Brazil's central bank are encouraging. From Bloomberg.com, Brazil Raises Rate to 9% as Real Undercuts Inflation Fight:

Brazil's central bank raised the key rate by half a percentage point for a third straight meeting, as a plunge in the currency undermines efforts to slow inflation in the world's second-largest emerging market.

The bank's board, led by President Alexandre Tombini, today unanimously voted to raise the benchmark Selic rate to 9 percent from 8.5 percent...

"The committee considers that this decision will contribute to put inflation on a decline and assure that this trend will persist next year," policy makers said, according to their statement posted on the central bank's website...

While annual inflation slowed to 6.27 percent from 6.70 percent in June, the pace of price increases is still high enough to hinder growth, according to Carlos Kawall, the chief economist at Banco J. Safra SA. Brazil targets annual inflation at 4.5 percent, plus or minus two percentage points.

I like this sort of set-up, especially given Mr. Kawall's quote later in the article:

"Inflation reduced consumer's purchasing power and confidence," Kawall said by phone from Sao Paulo before today's decision. "The central bank has to give a sign that the tightening cycle will continue."

Good! I'd like to hear more of that sentiment from Dr. Bernanke and the administration.

The current yield on the fund reflects an embedded income yield of 8.2%, from which fund expenses of 0.45% will be subtracted. The fund generally pays both short- and long-term gains once a year (December), but it had no distributions for 2012. This reflected the collapse in the real vs. the USD last year (per Yahoo! Finance):


Clearly, anyone buying the real here is fighting an ongoing trend. A longer-term look at this currency pair may be more comforting to potential longs:


We have been here before. I'm thinking a nibble might make sense given that the currency pair is trading within an established range.

Brazil is not a disaster area. It continues to experience population and economic growth. It is at peace. It is the dominant country in a continent that has demonstrated strong economic growth that was not much affected by our Great Recession. Out in the ocean, vast hydrocarbon reserves await successful (and difficult) exploitation. It may be true that as the old saying goes, Brazil is the country of the future-- and always will be. However, Brazil now has an investment-grade rating. The last I saw was Baa2 from Moody's. S&P and Fitch also have had the country at low investment grade levels.

Offsetting the above is Brazil's low ranking of #69 globally on Transparency International's Corruption Perception Index for 2012.

Fundamentally, Brazilian short-term interest rates are above the reported rate of inflation, while those of the U.S. have been below the inflation rate for years. The Brazilian monetary authorities are hawkish. Too much has gone right for Brazilian since it moved away from hyperinflationary policies for the central bank to want to scare people into resuscitating those memories. I believe that traders may push the currency pair further on the recent trend, but ultimately the point of foreign currency-denominated investing is to obtain greater real returns than those available "risklessly" at home.

Since U.S. T-bill investing is a loser to inflation, and likely will be for a good while longer, BZF may have an inherent advantage if the central bank delivers on its commitment.

If the USD/BRL pair trades at its 4-year average around 2.0 from today's 2.34, the capital gains upside will be around 15%. Add to this about 8% annual net interest income (which will get paid as a capital gain if it occurs) and one has a reasonable opportunity here. To receive a zero return from BZF, meaning equal to cash, the currency would have to depreciate 8% more in one year against the USD. Could a negative total return be achieved from BZF? Yes, for certain. This investment vehicle is not for the faint of heart.

However, the U.S. is relying on monetary financing of governmental deficits, meaning that there is nothing inherently "strong" about the USD. With the Fed committing to QE at least until next year, taper or no taper this year, and likely holding short rates below the inflation rate for quite some time, the USD may be an asset out of which to diversify.

Personally, I did very well with BZF in 2010 and 2011, then got out in the spring or early summer of 2011. One or two forays into BZF in the past year resulted in more or less breakeven trades. Having just noted the news about the continued hawkishness out of the Brazilian central bank, I consider BZF to be well-suited for self-directed IRA investing. The many fundamental and trading risks of investing in any emerging market in today's environment should be thoroughly understood by anyone contemplating investing in BZF or a similar vehicle.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in BZF over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Not investment advice to purchase or sell any asset. I am not an investment adviser.