Pimco Rocked by Real to OGX Bonds Shows No Sign of Easing
Brazil is threatening to turn into a sinkhole for the world’s biggest bond-fund manager.
Pacific Investment Management Co.’s $13.4 billion Pimco Emerging Local Bond Fund (PELBX), which had real-denominated assets as its biggest allocation in July, has lost 13.5 percent in the past three months and underperformed 83 percent of peers as the currency weakened the most in emerging markets and the nation’s local bonds fell 28 percent in dollars. Pimco is also leading a creditor committee seeking to recover money from Eike Batista’s OGX Petroleo e Gas Participacoes SA (OGXP3), whose bonds sank 77 percent after the firm raised its stake in the fourth quarter.
While Michael Gomez, Pimco’s co-head of emerging-markets portfolio management, said last week that Brazilian debt still offers value, the Newport Beach, California-based firm’s investments in the country are faltering as sluggish growth fuels speculation Brazil will have its ratings cut and the 16 percent currency slide fans inflation. Yields on Brazil’s notes due 2017, the second-biggest holding in Pimco’s local debt fund as of March 31, surged 2.54 percentage points in the past three months to 11.88 percent, twice the jump in emerging markets.
“Brazil is clearly included in a group of countries most vulnerable to headwinds,” Luis Costa, an emerging-markets bond and currency strategist at Citigroup Inc., said in a telephone interview from London. It has to do with issues such as “economic deceleration and sticky inflation. If you put it all together, it doesn’t bode well” for Brazil.
The Pimco Emerging Local Bond Fund, which is managed by Gomez, has also fallen more in the past three months than the 11.4 percent decline in its benchmark, the JPMorgan Global Bond Index-Emerging Markets Global Diversified Index, which is unhedged, according to data compiled by Bloomberg.
According to the monthly commentary on Pimco’s website, the fund had 12.3 percent of its market value allocated to real-denominated assets in July, the most of any country.
“We continue to think that local Brazilian interest rates look attractive,” Gomez said in an e-mailed response to questions on Aug. 14. Brazil has “inflation falling below 6 percent by year-end, a credible central bank that has a well-defined and managed inflation targeting framework, and among the highest real and nominal interest rates in the world.”
While the annual inflation rate fell to 6.27 percent in July from a 20-month high of 6.7 percent in June, central bank economic policy director Carlos Hamilton said Aug. 12 that price increases will probably accelerate this month as the real plunges. Brazil seeks to keep inflation at 4.5 percent, plus or minus 2 percentage points.
The central bank has raised interest rates by 1.25 percentage points in 2013, the most in the world, from a record low 7.25 percent. At 2.23 percent, Brazil’s inflation-adjusted interest rate is the second highest in Latin America.
Standard & Poor’s reduced its outlook on Brazil’s credit rating to negative on June 6, citing weakening growth and an expansionary fiscal policy. The country is rated BBB, the second-lowest investment grade.
Analysts surveyed weekly by the central bank have cut 2013 economic growth forecasts by more than one percentage point this year after gross domestic product expanded 0.9 percent in 2012, the least in three years. As part of her effort to revive economic growth, President Dilma Rousseff prompted state banks to boost lending to six times the rate of privately owned lenders in the first half of 2013.
Alejandro Urbina, a money manager at Silva Capital Management LLC, which oversees $800 million in emerging-market assets, says he’s staying away from Brazilian bonds after selling his holdings about six months ago as growth deteriorated. He said the selloff may create a buying opportunity in the future if concern the Federal Reserve will taper stimulus subsides.
“We noticed Brazilian fundamentals were deteriorating, with a slowdown in the economic activity and inflation problems,” Urbina said in a telephone interview from Chicago. “When we realized volatility was increasing, we decided we were only going to stay in a market with better fundamentals.”
Pimco is also facing potential losses on its investment in OGX debt. OGX’s notes due in 2018 are leading the declines in Brazil’s bond market as the oil producer missed output targets. The company is set to run out of cash as soon as this month, data compiled by Bloomberg show.
Pimco, which increased its Brazilian holdings in the first quarter, is leading the OGX bondholder committee that hired Rothschild to advise on a debt restructuring, a person with direct knowledge of the matter said this week.
Michael Reid, a spokesman for Pimco, declined to comment on Pimco’s holdings of OGX bonds. An official at Rothschild also declined to comment.
“What we’ve seen is unfortunately something this government created, a negative bubble, for the last two to three years,” Citigroup’s Costa said. Brazilian corporates are “like the poor cousin. If you’re an investor, you don’t want to be loaded up on corporate risk.”
Marcelo Assalin, who oversees $3 billion of local-currency, emerging-market debt, including real-denominated notes, at ING Investment Management Holdings NV, said Brazilian debt securities are attractive.
“I like the idea of holding these bonds with a medium-term outlook,” he said in a telephone interview from Atlanta. “In the short term, there is a good chance that we still see higher yield levels. This is because the market has been driven by technical, poor sentiment towards emerging-market countries in general and in Brazil particular.”
Speculation U.S. policy makers will curb stimulus has eroded demand for higher-yielding emerging-market assets.
The extra yield investors demand to own Brazilian government dollar bonds instead of U.S. Treasuries rose three basis points, or 0.03 percentage point, to 247 basis points at 4:02 p.m. in New York, according to JPMorgan Chase & Co.
Brazil’s five-year credit-default swaps, contracts protecting holders of the nation’s debt against non-payment, fell 17 basis points to 197 basis points.
The real climbed 3.5 percent to 2.3535 per dollar a day after the central bank stepped up efforts to arrest the biggest three-month decline in emerging markets, announcing a $60 billion intervention program involving currency swaps and loans. Yields on interest-rate futures contracts due in January decreased 12 basis points to 9.16 percent.
While Pimco’s Brazilian investments have underperformed this year, its bets on the country in the past have paid off.
In 2002, Pimco added to its Brazil holdings as the country’s dollar-denominated bonds due in 2040 traded as low as 42.7 cents on the dollar on concern Luiz Inacio Lula da Silva would default after taking office. The firm increased its stake to about $1 billion by mid-2002. The bonds traded as high as 119.5 cents on the dollar two years later as Lula cut government spendng after taking office in January 2003.
The Pimco local bond fund’s underperformance this year is also a reversal from its longer-term performance. The fund has returned an average of 5.1 percent annually over the past five years, beating 93 percent of like funds, data compiled by Bloomberg show.
Rousseff met with central bank president Alexandre Tombini and Finance Minister Guido Mantega on Aug. 21 to discuss the weakening real, according to a government official who asked not to be identified because he isn’t authorized to comment on the issue publicly.
“The risk of policy mistakes in Brazil has risen substantially and that continues to create a lot of noise for Brazilian bonds,” Citigroup’s Costa said.
To contact the reporter on this story: Veronica Navarro Espinosa in New York at email@example.com