Safer Than Connecticut Signals Rally ‘Overdone’: Brazil Credit

Traders have more confidence in Brazil honoring its debts than the wealthiest U.S. states including Connecticut and New Jersey, a sign to Citigroup Inc. and DoubleLine Capital LP that the country’s debt is overvalued.

The cost to protect Brazil’s notes against non-payment for five years fell 12 basis points, or 0.12 percentage point, last year to 111, according to CMA. The swaps trade 54 basis points below Connecticut’s, the most since at least May 2009, and are priced 51 percent less than New Jersey’s. Brazil’s BBB- rating at Standard & Poor’s is seven levels lower than the U.S. states.

International investors poured a record $53.1 billion into developing-nation bonds in 2010, according to Cambridge, Massachusetts-based research firm EPFR Global, driving down default swaps from Brazil to the Philippines to the lowest in at least two years. Brazil’s swaps and dollar debt “priced in” almost all “good news,” leaving the securities vulnerable to rising U.S. Treasury yields and contagion from Europe’s debt crisis, according to DoubleLine.

“Brazil has very good fundamentals, but valuation falls short to us,” Luz Padilla, who helps manage $6 billion in assets at Los Angeles-based DoubleLine, said in a telephone interview. “We can look at other places to make money.”

Padilla said she’s avoiding Brazilian government bonds while holding 13 percent of the money she manages in the country’s corporate debt.

Real Advances

Brazil’s dollar bonds returned 9.7 percent in 2010 as its average yields fell to a record 4.72 percent in October, according to JPMorgan Chase & Co.’s EMBI+ index. Emerging-market government dollar debt gained 11.8 percent on average last year.

The real rose 5 percent against the dollar last year, following a 33 percent surge in 2009, as the government tripled a tax on foreigners’ purchases of local fixed-income assets to stem the rally. It touched a two-month high of 1.6454 per dollar today.

Yields on Brazil’s interbank rate futures due in January 2012 rose 18 basis points last year to 12.04 percent. They fell one basis point today to 12.03 percent. That level suggests traders are betting the central bank will raise the benchmark borrowing cost by about 200 basis points to 12.75 percent by December 2011, according to data compiled by Bloomberg.

Brazil’s swaps were 108 basis points lower than the average of 50 U.S. municipal issuers tracked by the Markit MCDX index on Dec. 31, compared with 12 basis points at the end of 2009. They were 179 higher in February 2009.

Sinking Revenue

Brazil’s default swaps declined last year as Latin America’s biggest economy expanded at the fastest pace in two decades, and followed a 176 basis-point drop in 2009. The swaps fell within four basis points of those protecting debt from France, which is rated at AAA, or nine steps above Brazil, by S&P. The gap was 340 basis points in March 2009.

In the U.S., default swaps from California to New Jersey are climbing after the deepest recession since the 1930s caused the biggest nationwide decline in state tax receipts on record. The five-year swaps for Connecticut, the second-wealthiest state, have doubled to 165 basis points since April, while those for New Jersey, the fourth richest, increased to 219 from 155 at the end of 2009.

The median household income of Connecticut averaged $65,213 in the past three years, the second highest after New Hampshire, according to the U.S. census. CMA doesn’t track default swaps for New Hampshire, which has average income of $66,654.

The outperformance of emerging markets relative to U.S. states has left default swaps in developing nations, including Brazil, so expensive that credit ratings appear to “mean nothing at all,” said Mikhail Foux, a New York-based credit strategist at Citigroup.

Market ‘Darling’

Citigroup is recommending its clients buy protection against default by developing nations, including Brazil, while selling insurance policies against the U.S. municipals, according to Foux.

Developing countries are “the darling of the market, and it’s very common for the market to trash the munis,” Foux said. “It’s overdone.”

Most U.S. states will survive the recession without defaulting on debt because they can cut or delay funding to local governments and shift costs for services to the municipal level, S&P said in a report on Nov. 8.

Adam Liegeot, a spokesman for Connecticut Governor Jodi Rell, didn’t respond to a telephone call and e-mail message seeking comments. Sean Conner, deputy press secretary for New Jersey Governor Chris Christie, didn’t respond to an e-mail.

Brazil’s Finance Ministry didn’t return phone calls and an e-mail.

Trading Volume

Default swaps are higher for the states than Brazil in part because they are less actively traded, according to Matt Dalton, chief executive officer at Belle Haven Investments Inc. in White Plains, New York. The states are unable to print money, as countries can, to pay off their debts, contributing to a higher default risk, he said.

The swaps for a sovereign country are “vastly different” from those for a U.S. state, said Dalton, who oversees about $550 million in municipal bonds.

The net notional value of default swaps outstanding on Brazilian debt totaled $15 billion as of Dec. 24, according to data compiled by the Depository Trust & Clearing Corp., which runs a central registry for the market. By comparison, there were $806.7 million of swaps outstanding on California debt and $372.9 million on New Jersey bonds, the most actively traded contracts among U.S. states. DTCC doesn’t publish data for Connecticut.

Rating Upgrades

The extra yield investors demand to hold Brazilian dollar debt rather than U.S. Treasuries narrowed to 189 basis points on Dec. 31 from 192 at the end of 2009 and 428 at the end of 2008. The yield gap dropped to 180 today.

The yield gap fell to a record 138 basis points in June 2007 before jumping five-fold during the global financial crisis in 2008. In November, Brazilian dollar debt lost 3.1 percent, the most since January 2009, when stronger-than-forecast economic data drove up U.S. Treasury yields and prompted investors to demand more compensation for owning emerging-market debt.

“Will Brazil and other emerging markets become the safe port in the storm of global dislocation? My gut feeling is no,” said Alfredo Viegas, a strategist at Knight Libertas, a fixed- income broker-dealer in Greenwich, Connecticut. “For investors who are worried, buying credit default swaps makes logical sense.”

‘Good News’

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’s default swaps have dropped by 70 percent since November 2004 as former President Luiz Inacio Lula da Silva reduced the budget deficit, slowed inflation and helped the country win an investment-grade rating over his eight years in office.

Further rating increases depend on the ability of President Dilma Rousseff, who succeeded Lula on Jan. 1, to withdraw fiscal stimulus measures implemented during the global financial crisis, Regina Nunes, the head of S&P in Brazil, said at a conference in Sao Paulo last month.

“Potential good news has already been priced in,” said DoubleLine’s Padilla. “Can the spread tighten further? Probably not much.”