Lula Falters in Bid to Cut Floating-Rate Debt as Rates Increase
Brazil’s bid to wean itself off floating-rate debt, a legacy of 1990s hyperinflation, is faltering as the central bank boosts benchmark borrowing costs from a record low.
The percentage of the government’s 1.59 trillion reais ($894 billion) of debt that was issued at yields tied to the overnight lending rate, known as Selic, climbed to 33.6 percent in May from a record low of 30.7 percent in 2007, according to the Treasury. The increase snaps a decade-long decline that cut the percentage from 62 percent in 1998 and helped the country win investment-grade credit ratings.
The rise in floating-rate debt, which became popular two decades ago when annual inflation climbed above 1,000 percent, may slow Brazil’s efforts to win further rating increases, said Mauro Leos, who heads the Latin America sovereign ratings group at Moody’s Investors Service.
“There’s a reversal, it’s clear,” Leos said in a telephone interview from New York. The question is “when will they be able to push it below 30 percent,” he said.
Moody’s raised Brazil’s rating to Baa3, the lowest investment-grade ranking, in September, matching moves that Standard & Poor’s and Fitch Ratings made a year earlier. Moody’s and Fitch have positive outlooks on the rating.
“Small increases in the debt linked to Selic don’t jeopardize rating upgrades,” Otavio Ladeira de Medeiros, Brazil’s debt strategic planning coordinator, said in a telephone interview from Brasilia yesterday. “The rating agencies look at the whole debt composition and recognize that there was a lot of progress made.”
Demand for floating-rate bonds, known as LFTs, is picking up as central bank President Henrique Meirelles raises the benchmark overnight rate to cool the fastest economic expansion in 15 years. Meirelles lifted the target rate to 10.25 percent from a record low of 8.75 percent in April. Traders expect it will reach about 12 percent by year-end, according to futures contracts.
“The problem is that they’re seeing a lot of demand,” said Henry Stipp, an emerging-market fund manager at Threadneedle Asset Management in London, which has $98 billion of assets under management. “If interest rates are going to rise, investor demand for floating-rate bonds is going to increase.”
Brazil is more vulnerable to rising rates than its regional peers. In Mexico, Latin America’s second-biggest economy after Brazil, floating-rate securities represent about 8 percent of government debt. Mexico is rated Baa1 by Moody’s, or two levels above Brazil. In neighboring Colombia, which is rated Ba1, or one step below Brazil, floating-rate notes account for about 4 percent of debt.
The improvement in Brazil’s debt mix “has lost momentum,” Luis Fernando Lopes, who helps manage 1.1 billion reais as a partner at Patria Investimentos in Sao Paulo, said in a telephone interview. “Credit-rating companies are going to be cautious because it’s going to take more time,” he said.
Leos said that Brazilian officials would have to cut floating-rate debt to less than 30 percent to have a “significant impact on improving their credit profile.” He said Moody’s is looking for improvement in the government’s debt ratios and is monitoring how it manages the increase in tax revenue as growth quickens.
Shelly Shetty, a Fitch analyst in New York, said it would be “desirable” for Brazil to reduce the amount of debt linked to the overnight rate. Fitch is more focused on whether Brazil can prevent its economy from overheating and if the next administration will maintain policies that “ensure fiscal restraint,” she said.
The high percentage of floating-rate debt is one of the “fiscal issues” that Brazil confronts, said Sebastian Briozzo, an S&P analyst in Buenos Aires.
“Investors continue to demand this floating paper,” Briozzo said in a telephone interview. “The structural issue that needs to change in Brazil is high interest rates.”
Brazil’s overnight rate amounts to 5 percent after adjusting for inflation, making it the third-highest among 53 economies tracked by Bloomberg behind Croatia and Latvia.
The 10.25 percent overnight rate on floating-rate debt compares with a 12.26 percent yield on government bonds due in 2021, the longest fixed-rate maturity in Brazil. The yield on the 2021 bonds rose five basis points, or 0.05 percentage point, today.
The cost of credit-default swaps to protect against a default on Brazilian debt for five years was unchanged at 139, according to data compiled by CMA DataVision. Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a government or company fail to adhere to its debt agreements.
The real fell 0.1 percent to 1.7796 per dollar at 5:32 p.m. in New York, extending its loss this year to 2 percent.
Lula’s push to move investors into fixed-rate and inflation-linked bonds has also been weakened by the global financial crisis. As the crisis deepened in 2008, foreign investors pulled out of Brazilian fixed-rate bonds, Lopes said.
“There was a significant capital outflow,” Lopes said in a telephone interview. “So when the Treasury had to roll over this debt again, they couldn’t. There were no buyers of long- term, fixed-rate bonds.”
Fixed-rate securities accounted for 31.7 percent of government debt in April, down from 35.1 percent in 2007, according to the Treasury. The government has struggled to sell fixed-rate bonds since the European debt crisis emerged in April. Officials canceled three auctions of bonds due in 2021 in the past two months.
S&P’s Briozzo said many local investors have too much of a “short horizon” to buy long-term bonds. International investors held 61 percent of the fixed-rate bonds due in 2017 and 49 percent of securities due in 2021 as of April.
Brazilians learned during hyperinflation, which peaked in April 1990 when the annual rate reached 6,821 percent, that buying debt with interest rates that re-set daily was the “way to make money,” said Paulo Vieira da Cunha, a former central bank director who is a partner at Tandem Global Partners LLC in New York. Inflation was 5.2 percent in May.
“There’s a legacy there,” da Cunha said in a telephone interview. “It’s diminishing, but there’s always demand” for floating-rate debt, he said.