This week we look at investment grade Companhia de Eletricidade do Estado do Bahia (COELBA) bonds denominated in Brazilian Real (R$) and its 11.75% coupon to achieve the difficult task of finding a high quality debt instrument that offers remarkably high cash flow, a near 10% yield and very short maturity, as well as some diversification away from U.S. dollar into the currency of one of the world's better performing economies. We also believe this bond offers sound diversification away from the financial services sector of the global economy, and look to add it to our high yielding Foreign and Global Fixed Income Investments.
Wealth Preservation and Cash Flow Concerns
Wealth preservation continues to be one of the biggest concerns among our clients. In other words, the focus for many people is not necessarily towards making more money, but to preserve the wealth they have already accumulated by taking what we call "intelligent risks" to achieve reasonable returns that can simply outpace moderately rising inflation and/or the devaluation and loss of the greenback's buying power. U.S. Ten-Year treasury yields appear to be slowly recovering, from historic lows near 1.5% to slightly over 2% most recently. This recent rise in rates now outpaces the officially published CPI inflation rates, and the Fed appears content to continue with its QE3 buying program, which is pumping some 85 billion a month into the economy. With the M1 and M2 money supply up 12% and 7.1% respectively year-over-year, and not to mention the four prior years of unprecedented money expansion, this modern marvel of creating trillions of dollars in new liquidity with no inflationary consequences is like alchemy in reverse, gold turning into lead. Or, so it seems, given the recent pummeling of gold. (Although, adjusted for the increase in money supply, gold is now cheaper at $1400 than it was at $500.)
Basic intuition (and the Quantity Theory of Money) leads one to believe that if Fed prints lots of money (QE1, QE2, and QE3), inflation will follow. However, innovations and changes within the financial industry appear to have rendered this line of thinking far from being complete, and thus, obsolete. A newer theory (Singh and Stella) is being presented concerning the effects of Fed money printing. In short, it seems that newer technology and the increased speed at which money changes hands has not only made paper money less important, it also allows people to hold their money in a great many more places than a traditional bank checking or savings account. What this means for fixed income investors waiting for inflation, or for the paltry yields on their bank CDs and savings accounts to go back up, is that they may have quite a long while yet to wait.
While questions arise concerning the integrity of a system where the Fed continues to creates money out of thin air and launder it to the rest of the world simply because it controls the world's reserve currency and can, perhaps one of the most pressing concerns our dollar-based economy has is what might happen should continued advances towards global integration dictate a change in what is acceptable as the reserve currency, or render any need for a reserve currency obsolete. As the reserve currency status of the USD wanes, its repatriation from the world's many cracks and crevices risks causing significant economic dislocation and a much weaker dollar.
We remain steadfast in the effort to protect our client's assets against the persistent risk associated with an ever increasing supply of U.S. dollars and the diminishing need for a reserve currency by scouring the globe in search of sound investments in a basket of the strongest global currencies, and it is why we have chosen this Companhia de Eletricidade do Estado do Bahia high yield Brazilian real bond as This Week's Best Bond.
By far the largest and most populous country in South America, Brazil continues to pursue industrial and agricultural growth and development of its interior. Exploiting vast natural resources and a large labor pool, it has large and well-developed agricultural, mining, manufacturing, and service sectors. It is the world's largest producer of coffee, sugar and orange juice and the second-largest exporter of iron-ore and soybeans. Brazil's offshore oil fields have turned it into a net crude exporter, helping it expand its presence in world markets, and its economy outweighs that of all other South American countries. Currently, Brazil is the world's 11th largest oil producer. Headquartered in Rio de Janerio, the semi-public oil and energy company Petrobras (PBR) is the fourth largest company in the world and the largest in the largest southern hemisphere by market capitalization.
Brazil's economy, the sixth largest in the world, slowed more than was anticipated last year to a GDP growth near 1%, while the first quarter 2013 numbers came in at about 1.9%. While this was below government and economists' projections, it does bolster expectations that Brazil's economy could start recovering in 2013. The official inflation, measured by the Amplified Consumer Price Index (IPCA) closed 2012 at 5.84%. The index was lower than that recorded in 2011, when there was a 6.5% high in the prices, and within the goal established by the Brazilian Government, which varies between 2.5% and 6.5%. However, the result was higher than the mid of that range, which is 4.5%, and more recent results appear to be ticking up. The main item responsible for inflation in 2012 was the food expense group, which recorded an inflation of 9.86% and was responsible for almost half of the total IPCA. Despite the weak growth figures, the central bank surprised markets by raising the base interest rate from 7.5% to 8%, making Brazil the only big economy currently tightening monetary policy, and it appears likely that the bank will have to raise rates again to bring inflation nearer its 4.5% target.
The exchange rate closed 2012 at R$/US$ 2.04, showing a devaluation of the real comparing to the U.S. dollar of 9.4% when compared to 2011, having the European crisis as one of the main factors. More recently, the R$/US$ moved to over 2.12, and on June 4th, the government scrapped a tax on foreign purchases of bonds in order to encourage currency inflows and slow the weakening of the real, which has fueled inflation by making imports pricier. To underline the shift in thinking, Alexandre Tombini, the head of the Central Bank of Brazil, said in an extensive interview published May 31st that the real's weakening reflects a broad strengthening of the dollar, put the bank's focus on inflation and echoed remarks by Brazil's finance minister that investment, not consumption, must become the main driver of economic growth. While the real has tumbled 6.7 percent in the past month (the worst performance among 16 major dollar counterparts) on speculation that the Federal Reserve will curtail a stimulus program that has buoyed emerging-market assets, Vale SA (NYSE:VALE), Brazil's largest exporter, said that further local currency depreciation could counter cost rises and a slowdown in Chinese iron-ore demand as it seeks to regain market share from Rio Tinto Group (NYSE:RIO) and BHP Billiton Ltd. (NYSE:BHP). On Tuesday (June 18th) Brazil's real touched a four-year low, prompting the central bank to intervene for a second straight day as a report showed higher-than-forecast inflation.
Brazilian policy makers have signaled economic pragmatism in recent days, which we see as an encouraging development. Addressing inflation by hiking interest rates aggressively and removing capital controls on foreign bond investors should all be supportive of the real, which, the authorities are also signaling, will be subject to a less-managed, that is, freer float.
Companhia de Eletricidade do Estado da Bahia Coelba (COELBA) is a Brazil-based company engaged in the electrical energy sector. Founded in March of 1960 and privatized on July 31, 1997, it is 87.84% owned by Brazil's Neoenergia Group, which in turn is 39% owned by Spain's Iberdola SA. The Company operates as an electrical energy utility concessionaire, aimed to project, construct and explore systems of sub-transmission, processing, distribution and commercialization of electrical energy and related services. It is also involved in other activities associated to electrical power services, such as technical services in the energy sector and export and import operations. COELBA supplies 415 of the 417 municipalities of the state of Bahia, in the municipality of Delmiro Gouveia in the state of Alagoas and in Dianapolis in the state of Tocantins, covering a concession area of 563,000 square kilometers and serving over 5.08 million clients, primarily in the residential sector. COELBA is the largest distributor of the Northeast region and third largest concessionaire in Brazil in number of clients.
In 2010, investments made by the company amounted to R$ 976.6 million, 21.3% over the value invested in 2009, intended mainly to implement, expand and improve the electrical energy distribution system. Such resources enabled the execution of 181,100 new urban and 75,637 rural connections, besides 16,270 km in new distribution networks and expansion of 03 substations, always focusing on service and the quality of services rendered to its consumers. COELBA received Investment Grade ratings from the international credit-rating agency Standard & Poor's, with a rating of "BBB-" on the Global Scale and "AAA" on the Brazilian Scale.
COELBA ended 2012 with a net operating revenue of R$ 5.81 billion (US$ 2.72 billion), 17% higher than 2011. The cash operating generation, measured by the EBITDA, reached R$ 1.31 billion (US$ 612 million), 2.2% higher than the previous year, while finance costs for 2012 were R$ 497 million (US$ 232 million.) The gross margin in 2012 was 30.8% and the EBITDA margin reached 22.5%. The net income also increased to R$ 805.5 million (US$376 million) in 2012, 7.3% higher than the result for 2011. In 2012, the company applied R$ 1.4 billion (US$654 million) to expand and modernize its electrical system, and added 494 thousand new connections of clients in the rural areas of the State of Bahia.
This COELBA Brazilian real bond indicates a yield pickup of about 5% when compared to the debt of U.S. corporations of similar maturity and credit ratings. As long as any appreciation of the greenback averages less than 5% annually against the real, we see this bond as outperforming comparably ranked U.S. corporate bonds of similar maturity. However, should the U.S. currency weaken instead of strengthening against the Brazilian real, it potentially could end up yielding even more than the already very high 9½% rate that's currently indicated.
The default risk is COELBA's ability to perform. Given its fundamentally solid financial condition, its high credit rating (AAA on the Brazilian scale), and its key economic role within the Brazilian economy, it is our opinion that the default risk for this short-term bond is very minimal relative to the currency risk of the Brazilian real.
The currency risk of the Brazilian real could and will affect the returns of these bonds and possibly in a negative way as it exposes investors to the Brazilian economy and the policies of its central bank.
We acknowledge that a strengthening of the U.S. dollar would directly reduce the total returns of this Brazilian real denominated bond. On the other hand, should the world's waning need for a reserve currency result in a sudden or unexpected weakening of the dollar against a basket of other stronger currencies, the returns of this bond are likely to increase substantially.
Considering Brazil's prominent position as a leading emerging market economy, its relatively stable political system, and reasonably good prospects for economic recovery in 2013, we view the gaining of nearly twice the yield of comparable U.S. dollar denominated corporate bonds as a very attractive reason in and of itself for recommending this Brazilian real bond from COELBA for a client's fixed income holdings. When we add to this the sound diversification and possible lowering of overall risk that it might offer should one's total wealth be too overweight in U.S. dollar denominated assets, the very high cash flow that its 11.75% coupon offers, and its short 34 month maturity, it quickly moves from merely attractive into being both logical and compelling. Consequently, we have chosen it for inclusion in our Foreign and World Fixed Income holdings.
Yield to Maturity: ~9.94%
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Durig Capital and certain clients may have positions in COELBA 2016 bonds.
Please note that all yield and price indications are shown from the time of our research. Our reports are never an offer to buy or sell any security. We are not a broker/dealer, and reports are intended for distribution to our clients. As a result of our institutional association, we frequently obtain better yield/price executions for our clients than is initially indicated in our reports. We welcome inquiries from other advisors that may also be interested in our work and the possibilities of achieving higher yields for retail clients.