Mantega Trumps Serra as Tax Fuels Bond Rout: Brazil Credit

Brazil’s longest-maturity fixed-rate bonds are tumbling the most on record this week as a tax increase on foreigners squelches a surge in demand sparked by opposition candidate Jose Serra’s advance in presidential polls.

Yields on the government’s bonds due in 2021 rose 48 basis points, or 0.48 percentage point, the past two days to 11.97 percent after Finance Minister Guido Mantega boosted a tax on foreigners’ purchases of local fixed-income assets for the second time this month to curb gains in the currency. The rout reverses a rally last week sparked by polls showing that Serra, who has pledged to be fiscally “responsible,” was gaining ahead of an Oct. 31 vote.

Mantega, joining what he described as a global “currency war” to protect exporters, raised the tax on foreigners to 6 percent on Oct. 18, two weeks after a doubling of the rate to 4 percent failed to arrest a two-year rally in the real. Foreigners tripled local bond holdings over the past three years to $89 billion in part on speculation Brazil would cut the budget deficit and lower the second-highest inflation-adjusted interest rates in the world after Croatia.

“Brazil is sending a big message to us foreigners holding the bonds: They want us out of the Brazil curve,” Jeremy Brewin, who manages $2 billion of emerging-market assets at Aviva Investors in London, said in an interview. “This is a currency war for them, and Mantega has reinforced the view that he’d keep on going if necessary. Serra may create an environment for further unwinding fiscal stimulus, but when the market begins to sell, it tends to overwhelm any positive thoughts.”

Serra Gains

Brewin, who put on a wager in the futures market last week that a victory by Serra would lower Brazilian interest rates, said yesterday that he may “review” the bet in coming days.

Yields on bonds due in 2021 surged to 11.97 percent yesterday, the highest since Aug. 6, while yields on bonds due in 2017 jumped 44 basis points in the past two days to 11.88 percent. The price of the bonds maturing in 2021 tumbled 25 centavos in two days to 920.77 centavos.

The rout erased all the gains from last week when a Sensus poll released Oct. 14 showed Serra, 68, narrowed his deficit with Dilma Rousseff, President Luiz Inacio Lula da Silva’s handpicked successor, to 4.6 percentage points. Rousseff, a former energy minister and cabinet chief under Lula, won 47 percent in a first-round vote on Oct. 3 while Serra took 33 percent, setting up the Oct. 31 runoff election.

Serra, who carried out spending cuts as governor of Sao Paulo, Brazil’s biggest state, has pledged to trim government payrolls and renegotiate prices on public contracts. Those moves will offset plans to boost the minimum wage and payouts to pensioners, he said in September. While Rousseff, 62, has vowed to control the budget, she said in an interview with TV Globo network on Aug. 31 that promoting spending cuts was a “crime.”

‘Little Panic’

“There’s a little panic in the market and the rates are blowing up,” Ram Bala Chandran, a Latin American currency and rates analyst at Citigroup Inc., said in a telephone interview from New York. “If Serra starts to lose votes, we could see a further sell-off at the back end of the curve.”

Serra’s campaign staff didn’t respond to e-mail and telephone messages seeking comment yesterday. The Finance Ministry declined to comment in an e-mailed statement.

Mantega is working to stem the real’s 38 percent gain since the end of 2008, a rally that helped push the shortfall in the current account, the broadest measure of trade, to an all-time high of $45.8 billion in the 12 months through August. Mantega, 61, said last month that governments around the world are waging a “war” to weaken their currencies as Japan sold the yen for the first time in six years and Colombia bought dollars in the foreign-exchange market.

Real Declines

Brazil’s central bank has bought $2.8 billion in dollars this month through Oct. 8, after tripling the purchase to $10.8 billion in September from August. The purchases have pushed its foreign reserves up 18 percent this year to a record $282 billion.

The real slid 0.5 percent yesterday in its fourth straight decline, the longest losing streak in two months. Before yesterday, the real had gained 1.4 percent since the Oct. 4 increase in the tax, while the yield on bonds due in 2021 dropped 27 basis points as record-low rates in the U.S., Europe and Japan kept fueling demand for higher-yielding emerging- market assets.

Mantega’s move may be more effective this time in weakening the currency because he’s signaling he’ll do “whatever it takes to stop the inflows,” said Julian Jacobson, an emerging-market debt manager at Fabien Pictet & Partners Ltd. in London.

“If you change it from 4 percent to 6 percent within a couple of weeks, who knows they won’t take it to 8 or 10 percent next week?” Jacobson said in a telephone interview. “If the government wants to make it unattractive to foreign investors, they will succeed.”

‘Temporary Relief’

With yields at 11.97 percent on the bonds due in 2021 yesterday, investors can earn an annual return of 10.94 percent by holding the securities to maturity after paying the 6 percent tax, according to data compiled by Bloomberg. That compares with a 2.48 percent yield on 10-year U.S. Treasuries, 6.1 percent on Mexican debt and 7.1 percent on Indonesian securities.

The tax “may provide a temporary relief, but won’t do the job” because Brazilian rates are so high, Arminio Fraga, a former central bank president, said in an Oct. 18 interview in Naples, Florida.

“Brazil will have to create the conditions for its interest rates to go down,” said Fraga, who’s now chairman of BM&FBovespa SA, the owner of Latin America’s biggest securities exchange. “It will have to cut government spending and credit growth.”

Budget Gap

Lula’s government boosted spending 18.2 percent in July from a year earlier, helping push the budget deficit to 3.4 percent of gross domestic product from 1.2 percent in October 2008 and boost inflation above its 4.5 percent annual target. Brazil’s gross debt equaled 60 percent of GDP last year, compared with 38 percent in Mexico and 46 percent in Colombia.

Yields on Brazil’s interbank rate futures contract due in January 2012 rose four basis points yesterday to 11.32 percent, suggesting traders are betting the central bank will raise the benchmark lending rate to about 12 percent by the end of 2011 from 10.75 percent.

Policy makers have boosted the rate 200 basis points from 8.75 percent in April to contain inflation as Latin America’s biggest economy expands at its fastest pace in two decades. Benchmark rates in the U.S., Europe and Japan are no more than 1 percent.

The extra yield investors demand to own Brazilian dollar bonds instead of U.S. Treasuries rose 10 basis points yesterday to 191, according to JPMorgan Chase & Co.

‘Punishing Investors’

The cost of protecting Brazilian bonds against default for five years rose three basis points to 104 yesterday from a two- year low of 89 on Oct. 13, according to CMA DataVision prices. 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.

Brazil plans to extend the maturity of government bonds and turn the notes due in 2021 into benchmark securities, the Treasury said in its annual borrowing plan in January. International investors owned 49 percent of the bonds maturing in 2021 as of April, according to the Treasury. They held 61 percent of government debt due in 2017, up from 50 percent at the end of 2008.

“They’re punishing investors that really help you extend duration,” said Pablo Cisilino, who helps manage $14 billion in emerging-market debt at Stone Harbor Investment Partners in New York. “They have to be mindful that it’s not cost free for them and the kind of investors that they hurt by doing this. When they want to issue longer-term bonds, they’re going to have to pay an extra fee for it because of this tax.”