Bond Trading Shrivels After Lula Tax Increase: Brazil Credit

Trading in Brazil’s longest-maturity bonds is drying up after President Luiz Inacio Lula da Silva tripled a tax on foreigners’ purchases of local debt.

Daily average trading of fixed-rate bonds due 2021 has tumbled 62 percent to 172 million reais ($101 million) since Lula raised the tax for a second time this month on Oct. 18 in a bid to stem a currency rally, according to the capital markets association, known as Anbima. Trading averaged 454 million reais in the first 11 business days of the month and 354 million reais in September.

The yield on the 2021 bonds soared to the highest ever yesterday relative to the country’s interest-rate futures contracts, a sign investors are demanding bigger returns in exchange for buying securities that are becoming harder to sell in the secondary market. Trading in the bonds due in 2021 has been hurt the most because foreigners owned 49 percent of the notes as of April, five times the 10 percent stake they have in local government debt overall, according to the Treasury.

“With foreign investors out, the trend is for very low liquidity,” David Rocha, a trader at Renascenca DTVM Ltda., one of 14 dealers that trade directly with the Brazilian Treasury and central bank, said in a telephone interview from Sao Paulo.

A Finance Ministry official who asked not to be identified in accordance with government policy declined to comment.

Yields on the 10 percent bonds due in 2021 have jumped 66 basis points, or 0.66 percentage point, since Oct. 18 to 12.25 percent, according to data compiled by Bloomberg. Yields on the overnight interbank futures contract due that same year rose 55 basis points over that same time to 11.85 percent.

‘On the Sidelines’

The 40 basis-point yield differential between the two securities is the widest since the government began selling the 2021 bonds in February. The gap was 25 basis points at the end of September, according to data compiled by Bloomberg.

“Foreign investors are still on the sidelines,” said Paulo Rebuzzi, a fixed-income analyst at Corretora Ativa, a dealer in Sao Paulo. “We see some trades with local asset managers selling, but not a normal liquidity throughout the day.”

Lula raised the tax on foreigners’ fixed-income purchases to 6 percent on Oct. 18 after a doubling of the rate to 4 percent on Oct. 4 failed to stem the real’s advance. The currency has surged 33 percent in the past two years as Brazil’s interest rates, the second highest in the world in inflation- adjusted terms after Croatia, lured foreign investors.

Rising Rates

Brazilian central bankers have boosted the benchmark overnight lending rate 200 basis points since April to 10.75 percent to prevent the fastest economic expansion in two decades from fueling inflation. Key lending rates in the U.S., Europe and Japan, by comparison, are no more than 1 percent.

The real’s rally extends its gain since Lula took office in 2003 to 109 percent, curbing exports and helping swell the annual current account deficit to a record $47 billion.

The real weakened 0.8 percent in the past five days to 1.6956 per dollar yesterday, paring its advance this year to 2.9 percent.

Finance Minister Guido Mantega told reporters in Brasilia yesterday that the real’s slide since the tax increase, a move he says was taken in response to countries’ push to weaken their currencies, has been “good.” He said the government isn’t considering applying a tax on foreigners’ income investment from bonds, denying a report in O Estado de S. Paulo newspaper.

“The market almost came to a halt” yesterday on concern the government would implement more taxes, Rocha said.

Extending Maturities

Brazil plans to extend its bond maturities and turn the notes due in 2021 into “the new 10-year benchmark,” the Treasury said in its annual borrowing plan in January. Fixed- rate bonds due in 2015 and longer have accounted for 7 percent of the overall trading in local government debt this year, according to Sao Paulo-based Anbima.

The government extended the average maturity on its fixed- rated debt to 2.4 years in September from less than one year at the end of 2004, according to the Treasury.

The yield on Brazil’s interest-rate futures contract due in January 2012 increased five basis points yesterday to 11.41 percent, indicating traders expect policy makers to raise the rate to about 12.5 percent by then. The extra yield investors demand to own Brazilian government dollar bonds instead of U.S. Treasuries dropped five basis points yesterday to 178.

The cost of protecting Brazilian debt against non-payment for five years with credit-default swaps slid three basis points to 96 basis points, 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.

Treasury officials rejected all bids on the bonds due in 2021 at an Oct. 21 auction for the first time in three months after the tax increase curbed demand. Yesterday’s secondary- market yield of 12.25 percent on the securities was the highest since July. Treasury Secretary Arno Augustin said in an interview on Oct. 21 that the yield bids were “unreasonable.”

“Investors will only bring new money if they know what the final tax rate is that they are paying,” Rocha said.