The Seductive Allure of Brazilian Bonds.

OK, let’s say that you don’t own bonds, but someone is holding a gun to your head, dangling you by your ankles outside a window on a high floor, or threatening to cut you off their Christmas card list, if you don’t buy some.

Maybe you are sick to death, bashing your head against the wall trying to read this impossible market and want a high-yield place to park your money until you get a better read. Or worse, you offended you boss’s wife at the last Christmas party, and as a result, have been put in charge of running the firm’s bond fund. What do you do?

There is only one place on the planet I would consider owning bonds right now, and that is in Brazil. Investment grader corporate bonds denominated in the Brazilian currency, the Real, are yielding 10.8%. The Real has just suffered a major selloff against the dollar and is poised to bounce back, thanks to the monetary easing efforts of our friend, Ben Bernanke, offering investors a double-leveraged effect that will deliver returns far above and beyond the nominal coupon. Inflation is a somewhat elevated 6%, with the government targeting 4.5%.

GDP growth will come in at a lowly 1.6% in 2012, but should double or more next year, especially if China is on the mend. The Middle Kingdom is the largest buyer of Brazilian exports, including iron ore, coal, oil, and increasingly, coffee. So Brazil has a long and merry series of credit upgrades to look forward to.

Capital is pouring in to take advantage of these lofty, double digit yields, with foreign investors snapping up over $3.2 billion of the $1 trillion market this year. These bonds have become especially popular with investors in low yield countries, like Japan, where ten year bonds pay a parsimonious 0.70% a year (that’s no typo), and increasingly the US, with its 1.70% ten year yield.

Why are yields so high?  Brazil is still laboring under the weight of its own history, when many of its issuing entities defaulted during troubled times in the seventies and eighties. It turns out that Latin American generals aren’t very good at running countries or economies. There is also some concern that growth will become so white hot, that the government would be forced to raise interest rates to cool inflation, burning bond investors.

If you are a major hedge fund with a 24 hour trading desk in Rio de Janeiro you will have no trouble picking up a position here, if you haven’t already done so. If not, you may have a problem finding paper, as these securities are not to be found in your standard online trading account. If anyone knows better, please let me know.

Leery about putting your hard earned money into a bond issued by the State of Paraná? How about bond backed by iron ore? That is effectively what you get buying the 30-year paper floated by Vale SA (VALE), the largest producer in the country, with an 11.03% yield. Still concerned? Morgan Stanley (MS) similarly issued its own Real denominated 30 year paper, which carry an A+ rating. It has never defaulted on its debt.

Keep in mind that buying here could mean top ticking the 60-year global bull market in bonds. If the long forecast collapse of the Treasury bond market starts in earnest next year, it will take Brazilian bonds down as well. However, I am increasingly hearing from a range of high net worth individuals that they could care less. They are picking up this paper purely for the cash flow, which with 30-year maturities, will almost certainly outlive them. They intend to let their heirs worry about pesky things like market-to-market and capital losses, and live high on the hog on the coupon in the meantime.

The only easy way in is through an international bond fund, like the (PCY), which I have been recommending for years, with stellar results (click here for the call). The problem here is that Brazil never accounts for more than 10% of these funds, and your gains are diluted by other positions you would rather not have, such as in Greece and Portugal. You could also learn the salsa, become fluent in Portuguese, and pick up a Brazilian girlfriend to get access to the local market. That strategy might offer other advantages as well.

Check Out Those Double Digit Yields!

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