sábado, 11 de fevereiro de 2017

The 15% per year Govt-backed investment nobody tells you about

During all the periods I lived abroad, I was always intrigued by colleagues and friends who seemed to think there was no better alternative to the low-interest investments offered to retail customers by banks in USA, Australia and Europe, usually not even paying 0.5% in one year, if that much. The few savers who were cunning enough to do some research on the matter either decided to try their luck on the stock market, real state or started their own businesses.

Even though I've been a saver and investor from a young age (16 maybe?), I was never too much of a fan of the stock market. On the few occasions I tried it, it never paid off. Quite the contrary. I felt the information gap was just too wide and that the real opportunities were discussed behind closed doors. Besides, I was never a fan of following the market on an hourly-basis or keeping up with the torrent of news and market data that surround the typical stock trader.

Bloomberg Terminals

So the safety, reliability and rather simplicity of Treasury Bonds was what caught my attention. Although these bonds are, in theory, the safest investment you can make in any particular economy, they're not usually recognized as a high-interest investment, and for good reason. After all, if Risk and Return ride along each other, the safest bet is surely not the one which pays the highest yield. However, that is not exactly the case if you happen to invest in the country that is historically known to pay the highest interest rates for its debt in the World, seldom losing the top position in the ranking.

Surprisingly, this particular country is not a tax-haven island economy. Neither is it a nation with a chronic lack of natural resources which needs to resort to financial markets and speculative money in order to propel the gears of its fragile economy.

Island economy

No, this high-yield paying Country is, in fact, home to some of the biggest reservoirs of natural resources and commodities, including minerals, crops, fresh water and even biodiversity. It hosted both the Olympics and the Soccer World Cup in 2016. Yes, it is BRAZIL. And according to this ranking by The Economist (jan-2017), it ranks first in the World of Government bond interest rates:

Source: The Economist

What are Government Bonds?

Government Bonds are the way to document debt issued by Governments. You, as a person, would issue a bank cheque, or swipe a card, and such actions would be enough to document your debt towards the bank or credit card issuer. Countries, however, issue debt instruments called Bonds, which are usually offered only to Financial Institutions. These banks and brokers compete against one another in an electronic auction to buy them and later trade them (with profit, of course), which can be accomplished by selling to bank customers and investors in general or to other financial institutions.

May the highest bidder win

Nicely enough, in 2002, Brazil started a program (Tesouro Direto, or Direct Treasury) that enables ordinary people to buy Government debt by skipping (in part) the intermediary. You still need a broker or bank to purchase the bonds, but the cost and amounts involved are much lower. With as little as $10 (EUR or USD), a small saver is already able to begin investing in Brazilian Bonds, and the transaction cost is as low as 0.3% in one year, while the rewards (interest) could be higher than 15%!

As of January 24, 2017, the 12-month return on Bonds indexed to Brazil's inflation index (IPCA) were 12,2%, 16,08% and 23,08%, depending on their due date (click to check today's returns).

So what stops everyone you know from investing in Brazilian Government Bonds?

One strong reason is RED TAPE. It is definitely not as simple as opening an account with your local bank. A foreign investor needs basically 4 things to invest on bonds issued by Brazil:
  1. Apply for and obtain a Brazilian Tax ID number ("CPF");
  2. Have a local attorney in the Country for registration, filings, reporting of all sorts and service of process (yes, lots of red tape, as I said);
  3. Open an account with an authorized broker and Bank;
  4. Savings!
Of couse that taking each of these steps can be made a lot easier if you're assisted by the right professional.

If you're a Brazilian living abroad, than you're virtually all set to start, maybe pending the opening of an account with a broker. The brokers (Socopa, XP, Clear, etc) usually charge 1/5 of the fees or even Zero when compared to major banks (BB, Itaú, Bradesco) for the same service.

You may click here for a ranking of brokers and their fees, which vary from Zero to 0.5%, but be reminded you will still need to pay the custodian fees of 0.3% when investing with any them on the Direct Treasury program.

What are the Risks?

I don't mean to be exhaustive on this matter and you should certainly do your own research before making up your mind about it. Still, here are a few of the Risks you should consider:

1) Currency fluctuation

If your income and expenses are in Dollars or Euros and you're making an investment in a foreign currency, the returns on such investments could be adversely affected by the foreign exchange rate.

Let's say you invest US $2,000 on Feb 1st, when the exchange rate was 3.00 (that is, for every dollar, you get 3 Brazilian Reais, or BRL). So, in effect, you invested BRL $6,000. After one year, you get an incredible return of 20%, so your investment is then worth BRL $7,200. However, the exchange rate went up (3.50), so when converted back to Dollars, your balance is worth only US $2,057,14. So your yield was not 20% in fact, but only 2.85%.

[You may want to jump to What is the forecast for the exchange rates? ]

USD BRL 5-year
 USD/BRL 5-year history, by XE.com

EUR BRL 5-year
EUR/BRL 5-year history, by XE.com

2) Difficulty enforcing debt in case the country decides to halt payments

As a sovereign state, Brazil has immunity of jurisdiction and it may not be possible to bring suit against it at your home country's Courts. If you eventually hire a lawyer in Brazil and bring suit against the country, even if you do obtain a favorable decision, which may take years, enforcing it could be slow, as there are currently a number of cumbersome procedures on enforcing judgments against the Federal Government, specially for amounts higher than USD$15,000, not to mention that such procedures could be made worse by future laws.

According to a report filed wih the U.S. Securities and Exchange Comission (SEC) (Sep 2016), halting or restructuring debt is something Brazil hasn't done since 1994, when it issued US$$43.1 billion in bonds to replace previous bonds held by Banks and other creditors. Since then, Brazil has timely paid all its external debt.

By the way, 1994 was the year Brazil changed its currency to Brazilian Real and implemented some of the policies that led to a controlled rate of inflation, a stronger currency and a more stable economy.

3) Economic crisis, internal and external shocks

Remember that when lending to a country, you're relying on that government's ability to collect enough taxes to pay you back with interest. It might be the case that the government investments (new power plants or roads, for example) made with the procedures of your loan do not result in the expected additional revenue due to a number of factors, like the reduced international prices of Brazilian exports, internal or external crises (sub-prime crisis, Brexit, emerging market's financial crisis) or bare and simple mismanagement.

4) Credit ratings

Just as your bank does with you when you apply for credit, countries also get assessed on their credit-worthiness. That is done both by investors and by supposedly independent rating agencies (Moody's, Fitch and S&P, for example), which assess a broad number of countries and assign them grades. Such grades usually affect how high the countries' interest rates must be in order to attract investors and also which institutions can invest in them, as many are restricted to investing on "investment grade" assets.

Is Brazil "investment grade"? Not right now. Since the second semester of 2015, it has been downgraded by all the major rating agencies. That means it is only suitable to those investors who can bear the higher risks.

Before making up your mind about investing, you should click on Risk Factors to know more.

[From the news:]
Brazil finance minister says loss of investment rating is 'serious', CNBC (Dec 2015)
Latam markets enjoy surge of activity, Reuters (Feb 2017)
Moody's downgrades Brazil's Bonds, Moody's Investors Service (Feb 2016)

Let's crunch some numbers

Suppose you had decided to invest $2,000 and held on to your Bonds for one year. Let's see possible scenarios below. Keep in mind, though, that past performance does not assure future performance.

1) Brazilian currency gets stronger

Suppose you made your investment on Jan 29, 2016, when the exchange rate EUR/BRL was 4.3346. I'll assume you used Transferwise to wire the money to Brazil, paying a 1.5% remittance fee. So 2 days later (Jan 31, 2016), with your Brazilian Reais in hand, you bought the full amount of R$ 8,539.16 in government bonds. However, after a 0.4% fee to the Broker and the Clearing institution, you actually invested a little less: R$ 8,505.00. One year later, your bonds are worth R$ 9,541.75 (up 12.19%).

When selling it, you may be subject to income tax if you're considered a resident of Brazil for tax purposes (20% on profits for a one year investment). So the net amount after sale would be R$ 9,334.40. However, the exchange rate has gone down: 3.4017 (that means less Reais are needed to buy the same amount of Euros).

When converted back to Euros, you'll have $2,675.42 (after a 2.5% Transferwise fee - yes, the fee is higher than for the inbound transfer). That would mean a profit of +33.7% in one year.

Show me the money! (The Wolf of Wall Street, 2013)

Calculations step-by-step

2,000x 4.3346= 8,669.20[conversion to BRL]
8,669.20- 1.5%= 8,539.16[TransferWise fee deduction]
8,539.16- 0,4%= 8,505[Broker fees]
8,505+ 12.19%= 9,541.75[balance after one year]
(9,541.75 - 8,505)x 20%= 207.35[Income tax]
9,541.75- 207.35= 9,334.40 [Net income in BRL]
9,334.40÷ 3.4017= 2,744.03[conversion to EUR]
2,744.03- 2,5%= 2,675.42[TransferWise fee deduction]
2,675.42÷ 2,000= 1.3377
1.3377- 1= + 0.3377[profit in proportion]

2) Brazilian currency gets weaker

Let's keep the same fees, amounts and interest, but change the dates of investment and withdrawal. When wiring your money on Feb 15, 2015, the exchange rate EUR/BRL would have been 3.2310. On Feb 17, 2016 (one year later), it was 4.4338. So the same amount invested ($2,000), even at 12.19%, would have resulted in just $1,530.03, a loss of -23.5% in one year.

Calculations step-by-step

2,000x 3.2310= 6,462.00[conversion to BRL]
6,462- 1.5%= 6,365.07[TransferWise fee deduction]
6,365.07- 0,4%= 6,339.60[Broker fees]
6,339.60+ 12.19%= 7,112.39[balance after one year]
(7,112.39 - 6,339.60)x 20%= 154.56[Income tax]
7,112.39- 154.56= 6,957.83 [Net income in BRL]
6,957.83÷ 4.4338= 1,569.27 [conversion to EUR]
1,569.27- 2,5%= 1,530.03[TransferWise fee deduction]
1,530.03÷ 2,000= 0.765
0.765 - 1= - 0.235[loss in proportion]

What is the forecast for the exchange rates?

As much as we'd like to know for sure, foreign exchange rates are not like the weather and, thus, are mostly unpredictable due to the fact that they can be influenced by too many factors, both economical and psychological. The amount of money in circulation, the amount of credit in the economy, the goods and services produced by the country, the price of exports and imports, the political environment, the trust and expectations among investors and business people, government spending, all these affect the value of a currency.

Forecasting is never simple

Nevertheless, economists still try to (guess)timate what the future exchange rate will be, not because they enjoy passing as fortune-tellers, but merely because they're asked to. In that sense, the Central Bank of Brazil does periodical surveys with local Banks to know what the expectations in the market are.

According to this survey (Jan-2017), known as Focus Report, the expectation for the USD/BRL rate is 3.40 for 2017 and 3.50 for 2018. That would mean an increase of only $0.26 on the current rate of 3.14 to 1 dollar (Jan 28, 2017). Nothing like the one described above, when it rose from 3.23 to 4.32 (difference of $1.09). But again, these are mere expectations.

For the Euro x BRL, I couldn't find a similar survey, but I did find projections by the European Central Bank. The Dec 2016 issue assumes that the USD/EUR rate will be 1.09 for both 2017 and 2018, which means a small appreciation of the Euro against the Dollar (1 Euro buys a few more cents of dollars than before).

How about you? What do you think?

Is the USD/BRL or EUR/BRL rate going up or down an year from now?

Can you calculate how high Brazilian bond's return rate must be to make the investment worthwhile?

Disclosure: The author is a Brazilian lawyer not associated to any of the banks, brokers or to the Direct Treasury program mentioned above, other than as a client. This article is not and shouldn't be interpreted as a recommendation to invest in any asset. It is neither an offer to purchase or sell assets, nor a legal opinion on your particular situation. So please take it for what it is: an article of informative nature with the goal of promoting discussion.