[Originally published on May 1, 2014.]
The U.S. is in a strange situation of economic uncertainty despite what the markets have been saying over the last five years. This is apparent in feeble employment figures, steady but slow economic growth, contracting corporate earnings, and the relatively overvalued equities market. Brazil is also in a strange and uncertain environment with contracting economic growth and a flailing currency. But after all this data has been thrown at us from all directions, investors always ask the same question, "What can I get without taking any risk?"
Brazil and the U.S. are countries with similar financial systems but hyperbolically differing environments. When I tell Brazilians that the U.S. target federal funds rate is near 0 and that the annual rate of return on the U.S. 2 Year Government Note is approximately 0.375%, their jaws drop as they say, "Nossa senhora! Que é isso?", which means "What? What the heck is that?"
It's also hard for me to believe as a professional coming from the U.S. that the Brazilian interbank rate, the Selic, was just increased last month by 25 basis points to a target of 11%. This is much higher than our current target interest rate environment of 0 in the U.S., which the Fed has held to stimulate the economy by providing cheap access to credit and by stimulating the equity and debt markets by not allowing Americans to save.
Once again, the Brazilian system is similar to the U.S.'s but the environment is very different. In Brazil, the CDI, which trails approximately 25 basis points behind the Selic, is the interest rate by which Copom, or the Brazilian Fed, uses to stimulate or slow down the economy, similar to the federal funds rate in the U.S. or the Libor in Europe. It is also the benchmark by which the Brazilian treasury structures annualized returns on government issues, the lowest risk investment in Brazil backed by the Brazilian government.
Why is the Brazilian interest rate so high compared to the U.S's? It's because Brazil is a high growth, emerging economy. Given this environment, industrial production, incomes, and gross domestic product may grow at very high rates at times. When this happens, prices grow at very high rates which is why Brazil has such high inflation relative to developed economies, along with a history of hyperinflation in the late 80s and early 90s. 6% is a healthy level of inflation in Brazil whereas 2% is the U.S. inflation target set by the Fed. Given the high inflationary environment, Brazil must have high interest rates set by their central bank to continuously cool down the blazing growth in prices. Since 2009, the Selic has fluctuated from a high of 14% to a low of 7% and is currently at 10.9%.
By purchasing the CDI indirectly via government bonds, Brazil's government guarantees these high interest annualized returns of more than 11.77%. This is not a risk free investment, but it is a extremely low risk investment depending on your faith in Brazil's ability to pay its bills. Relative to the AA sovereign debt rating of the U.S., Brazil's BBB- stable rating does not seem so risk-free. But, we rest assured that Brazil is a high growth developing economy with limited political risk, especially compared to other developing countries, and is not likely to default on its government debt.
What does all this mean?
This means that right now, you can demand upwards of 11.77% of low risk annual return in Brazil. Our analysts project 2014 inflation, measured by the IPCA, the Brazilian CPI, to be around 6.4%. This means that Brazil is currently offering a domestic government guaranteed real rate of return of 5.37% whereas the U.S. is offering a domestic risk-free, real rate of loss of -1.12% given the current U.S. inflation is at 1.5% year-over-year and the U.S. Treasury Note is paying 0.375%. If you're an American investor with your currency denominated in U.S. dollars, you can demand upwards of 10.5% depending on your costs of hedging the value at risk of Brazilian currency exposure and the cost of access to this investment, which is very easily attainable.
There are a lot of names for this investment: LCA, LCI, CDB, CDI Referenciado, Referenciado, Prefixado, and Posfixado.
But, it all boils down to Posfixado and Prefixado Renda Fixa. Posfixado Renda Fixa is a floating-rate government fixed income security linked to the CDI. Prefixado Renda Fixa is a predetermined fixed-rate government fixed income security linked to the CDI. With the latter, when the CDI increases, the par value of the bond decreases, which creates some risk unless you want to hold them until maturity, which are short term starting at around 3 years if you buy the bonds directly. Imagine being able to lock in definite rates of 11.77% for only 3 years? Plus, if interest rates decrease back down to 7% you can benefit from an early redemption and a hefty capital gain. Investors in the U.S. engage in highly risky private equity investments with a lock up period of a minimum five years just to get 10%.
On the other hand, the rate of return with the Posfixado Renda Fixa increases or decreases with the CDI and from the perspective of an average American investor, they can be rest assured that their returns will always float in high interest rate territory between 7 and 14%. Or, you can always let funds manage these risks for you such as the BTG Pactual DI Referenciado Fundo, a floating-rate, CDI-linked fund.
Past year performance of CDI shown by BTG Referenced DI (102% of CDI), currently at a forward expected return of 11% plus considering the CDI holds or is voted up. If the CDI decreases, the loss in return is incremental. If you're uncomfortable with this, Prefixado Renda Fixa may be a better decision for you:
10 year performance of BTG Referenced DI compared to Brazil's Ibovespa Index and the S&P 500. CDI largely outperforms both on an incredible scale on both a risk and return basis:
Data as of April 15, 2014
Sources: WSJ, BTG Pactual Research, Banco Centro Do Brasil, US Bureau of Labor Statistics, MSCI, IMF, Bloomberg, Yahoo Finance, Morningstar, Tesouro Nacional
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Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.