Pimco Love Affair Ends Decade After Lula Bond Bet: Brazil Credit

Jan 17, 2014 8:11 am ET

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Jan. 17 (Bloomberg) -- Bill Gross is souring on Brazil.

After the country’s real-denominated debt plunged 13.6 percent last year, more than the 9 percent average decline for developing nations, Pacific Investment Management Co.’s chief investment officer said Jan. 15 that Brazil was no longer a preferred market. His $237 billion Total Return Fund cut Brazilian assets to 3.27 percent in December from 4.18 percent three months earlier, its most recent investment report showed.

Pimco is turning away from Latin America’s biggest economy more than a decade after the firm bought Brazilian bonds as they plunged before presidential elections in 2002, a bet that proved prescient and burnished the reputation of Chief Executive Officer Mohamed El-Erian. Gross’s comment, coming a year after he said the real was a better use of cash than buying junk bonds, shows how investors are losing confidence in President Dilma Rousseff as economic growth slows and Brazil lifts its interest rate above 10 percent to contain inflation.

“It emanates from bad economic policies of the current administration,” Peter Lannigan, a managing director at CRT Capital Group LLC in Stamford, Connecticut, said in a telephone interview. “Rates this high in that kind of growth environment -- it’s a challenging macro backdrop.”

Pimco still holds Brazilian debt but is not overweight on the country, Mark Porterfield, a spokesman for the firm, said in a response to questions. Brazil’s Finance Ministry didn’t respond to telephone and e-mailed requests seeking comment after market hours.

Fund Losses

Pimco’s investments in Brazil backfired last year after the nation’s local-currency bonds posted their second annual loss since 2003. The country’s dollar-denominated notes lost 11.2 percent, the most since 1998, JPMorgan Chase & Co. index data show.

The real, which is little changed this year, fell 13 percent against the dollar last year, while global speculative- grade bonds climbed 6.4 percent, based on index data compiled by Bank of America Corp. Gross, the 69-year-old co-founder of Pimco, touted the real over junk bonds in a Twitter message on Jan. 16, 2013.

“Modest exposure to Brazilian local interest rates as yields rose on inflation concerns” resulted in negative or neutral returns for the Total Return Fund in 2013, according to Pimco’s Dec. 31 quarterly investment report.

The fund has lost 1.57 percent in the past year, trailing 75 percent of like funds over the period.

Most Aggressive

Brazil’s central bank this week lifted its benchmark rate to 10.5 percent, marking the sixth straight half-percentage point increase as the country’s policy makers seek to contain inflation that’s forecast to accelerate to 6 percent in 2014. Last year’s rate increases were the most aggressive of any nation tracked by Bloomberg.

While the cost of living accelerates, Latin America’s largest economy will expand just 1.99 percent this year, a central bank survey of about 100 economists published this week showed, from an estimated 2.3 percent for 2013.

Brazil had the outlook on its BBB credit rating from Standard & Poor’s and Baa2 from Moody’s Investors Service cut last year as the bond raters cited a surge in state-bank lending and sluggish growth. Thirty-nine percent of analysts, investors and traders surveyed in a Nov. 21 Bloomberg Global poll said the country’s rating will probably or certainly be cut, versus 10 percent who said the nation will avoid a downgrade.

“They’re walking a very difficult path of trying to engender growth and also contain inflation,” said Michael Roche, an emerging-market strategist at Seaport Group LLC. “The model they’re using, state-directed growth and state involvement in the economy, is really starting to stumble.”

OGX Default

Pimco also suffered losses on its investment in OGX Petroleo & Gas Participacoes SA bonds. The oil company, now known as Oleo & Gas, missed payments on $3.6 billion of dollar debt last year in Latin America’s biggest corporate default.

As the largest holder of the company’s dollar-denominated securities according to third-quarter filings, Pimco is helping to lead reorganization discussions with the company.

OGX’s 2018 bonds currently trade at about 6 cents on the dollar, versus 98.1 cents a year ago.

In 2002, Pimco boosted its holdings in Brazil as its dollar-denominated bonds due in 2040 traded as low as 42.7 cents on concern Luiz Inacio Lula da Silva would default on the nation’s obligations after assuming the presidency. Within two years after the firm increased its stake to about $1 billion by mid-2002, the bonds traded as high as 119.5 cents on the dollar as Lula, who took office in January 2003, cut state spending.

Soros, Mobius

Brazil’s dollar bonds returned 70 percent that year, more than double the average 26 percent gain for emerging-market debt, according to data compiled by JPMorgan.

El-Erian managed the emerging-market funds during the 2002 elections, and his strategy that year put him at odds with investors including billionaire George Soros and Templeton Asset Management Ltd.’s Mark Mobius.

Soros, chairman of Soros Fund Management LLC, said in October 2002 that he saw more than a 50 percent chance Brazil would “have to reorganize its debt.” Mobius put the odds of default at 90 percent that September.

With Brazil’s emergence in the past decade, the economy is stronger than most developed countries, according to Jan Dehn, the head of research at Ashmore Group Plc, which oversees $78.5 billion in emerging-market assets.

The Latin American country has $376 billion of foreign reserves, 113 percent more than Mexico.

Bull Case

At the same time, Brazil’s local-currency bonds provide 10.18 percentage points more in yield than similar-maturity U.S. Treasuries.

“It has lower debt, stronger reserves and faster growth than most European countries,” Dehn said in an e-mailed response to questions. “Brazil’s bonds also pay investors far more than investors get paid in bond markets in developed economies. I am not nearly as negative as Pimco.”

For CRT’s Lannigan, Brazil’s inability to tame inflation as growth slows means there are few reasons to be bullish.

“They’ve got an environment where activity is weakening, but they’re still hiking policy rates to contend with inflation,” he said. “It hinders their ability to respond to the weakening growth. I’ve been pretty bearish on Brazil for a year now, and nothing is happening to change that.”

--With assistance from Matthew Malinowski in Brasilia, Veronica Navarro Espinosa in New York and David Biller in Rio de Janeiro. Editors: Lester Pimentel, Bradley Keoun