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Viewpoints

February 2010

The Brazilian Economy and Investment OpportunitiesBrigitte Posch

Executive Vice President, Portfolio Manager

Ms. Posch is an executive vice president in the Newport Beach office and amember of the emerging markets portfolio management team. Prior to joiningPIMCO in 2008, she was a managing director and head of Latin Americansecuritization and trading at Deutsche Bank. Ms. Posch was previously adirector with Ambac, responsible for developing asset- and mortgage-backedsecurities in emerging markets. Before joining Ambac, she was a vicepresident and senior credit officer with Moody’s Investors Service in New York,responsible for rating asset- and mortgage-backed securities in Latin America.She also worked in Sao Paulo, Brazil at Banco Inter-Atlantico/Credit Agricole,Citibank and ABN AMRO. She has 15 years of investment experience andholds an undergraduate degree from Mackenzie University of São Paulo.

Brazil has been a bright spot in the global economic recovery, rewarding bond investors as government and corporate credit quality improved. In the following interview, PIMCO Portfolio Manager Brigitte Posch discusses the firm’s outlook for the Brazilian economy and investment opportunities.

Q: What’s your view on local interest rates in Brazil?Posch:

Brazilian local interest rates are attractive on both a nominal and a real basis, asthey are still considerably higher than those in comparably rated countries. Because ofthis as well as the strength of the country’s macroeconomic policies, we expect Brazilianlocal rates to continue to trend lower and converge with interest rates in the developedworld. For now, however, the disconnect between Brazilian rates and rates in otherinvestment grade countries makes Brazil one of the world’s most attractive markets foryields.This is true despite certain transaction costs for international investors, such as the IOFtax (Imposto sobre Operacoes Financeiras) that applies to the conversion of foreigncurrency related to debt and equity investments, as well as a considerable degree ofvolatility, particularly as you go further out the local yield curve. In longer local maturities,liquidity provided by offshore investors plays a significant role in the market, making itmore sensitive to changes in risk appetite.Additionally, Brazil’s robust economic recovery caused the local curve to suggest a veryaggressive tightening cycle is in the offing by policymakers. While we agree that thecentral bank will likely tighten rates this year, we believe the market is ahead of itself, andthe tightening already implied by the long end of the local bond curve is sufficient toaccommodate both higher policy rates and the so-called convergence trend. We may, ofcourse, see some volatility due to concerns regarding monetary and fiscal policy exitstrategies in the U.S. and Europe as well as some unease regarding the fiscal accounts.With rates in Asian economies generally much lower and emerging market (EM) Europefacing fiscal constraints that are affecting policy, Brazil is the rare case of a solid andimproving EM credit with credible monetary policy and the offer of outsized local yields onboth an absolute and relative basis.

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February 2010

Q: How is liquidity in general in the Brazilian sovereign fixed income market?Posch:

The Brazilian fixed income market is relatively large and liquid for an EM country.In November, for example, one of the most recent months for which data are available,there was just under 7 billion Brazilian real (BRL), or 3.8 billion U.S. dollars, in turnoverper day for fixed rate bonds. That trading was largely concentrated in the short end of thecurve. In the same month, another 1.4 billion real per day traded in inflation-linked bonds,according to the Brazilian Treasury. Brazil provides additional liquidity through regularbuyback and debt swap auctions and is improving access for individual investors throughthe Tesouro Direto program (which allows residents in Brazil to buy government bondsthrough the internet).

Q: What is PIMCO’s view on local Brazilian corporate bonds?Posch:

The market for locally issued corporate debt in Brazil remains underdeveloped.To a large extent, this is simply because interest rates in Brazil are still high, making itvery expensive for local corporations to leverage themselves domestically.Corporations often find it more attractive to raise capital abroad or by selling equity, asillustrated by the large number of initial public offerings in the last several years. WhilePIMCO expects interest rates to decline in the long run, the rate situation is not likely tochange in 2010, when, if anything, the overnight rate is expected to go up, not down.Corporate credit in Brazil’s local fixed income markets would be more attractive if therewas more liquidity for most issues. Currently, the best values are in primary issues, ratherthan the secondary market, but since most international fixed income investors are activemanagers, the lack of liquidity makes buying local corporate debt a difficult proposition. Inaddition, foreign investors need to take the 15% withholding tax into account.Since local corporate bonds are currently trading with only a small premium to thesovereign curve – and because of the potential credit, liquidity and interest rate risk aswell as the aforementioned tax issues – we don’t think it makes sense for either local orforeign investors to get aggressively involved. PIMCO has been focusing on names onthe defensive side of industry. These bonds tend to have lower durations and lessinterest rate sensitivity.

Q: Are the new infrastructure projects in Brazil creating investment opportunities?Posch:

Absolutely. Proactive public policies and strong support for expansion ofinfrastructure studies and projects are at the core of Brazil’s plans to boost growth. In thepast year, the Brazilian government has placed particular emphasis on public works as ameans to offset the effects of the global economic recession.Numbers also help to tell the story: Over the last several years, investment ininfrastructure has increased by 12 billion real to 75 billion real in 2009. Such investmentshould reach 100 billion real by 2011, independent forecasters suggest. Another 550billion real should flow from the public and private sectors from 2010 to 2014, accordingto these forecasts and project commitments. This includes transportation infrastructure ofnearly 400 billion real. An additional 136 billion real is projected for the energyinfrastructure sector. Water infrastructure projects, including sanitation, are expected toaccount for approximately 22 billion real during this period.

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February 2010To meet the needs of a growing population and engender economic expansion, annualinfrastructure spending will need to average some 100 billion real to 110 billion real.However, investment in infrastructure has been just 2.1% of GDP for the period of 2001to 2007. That figure will need to be closer to 3.0% going forward to bridge the gap.In addition to government support, the private sector is becoming involved in engineeringand project management as well as financing new infrastructure private equity funds.Another happy development: Brazil recently won the right to host the World Cup of 2014and the Summer Olympics in 2016, an event that should brings billions in freshinvestment.

Q: Securitization is still a small market in Brazil. Do you see any opportunities forthat market to grow in 2010?Posch:

Although the volume of securitization in Latin America dropped in 2009, in Brazilit increased 20%, according to the total volume of asset-backed securities (ABS)registered. Collateralized debt obligations (CDOs) and multi-assets, which invest incorporate debt instruments, were the most active sectors.This year, we expect volumes to be similar to 2009, potentially with more government-ledsecuritizations and fewer private sector issues. This is due to the large increase inlending activities by state-owned banks in the second half of last year, which wasprimarily a consequence of the administration’s efforts to boost consumption and lendingfor housing acquisition and construction.If interest rates move lower – converging with other investment grade countries as weexpect – pension funds in Brazil will find it hard to meet the 6% real return that most ofthem target and will likely look to add more risk to their portfolios to capture higher yields.Securitization products, corporate debt issued by companies involved in the infrastructuresector or debt issued to fund specific infrastructure projects could all see more interest.The goal would be to have sovereign-like credit volatility but with an enhanced liquiditypremium. Over time, as the market develops and more issuers tap the capital markets,liquidity and credit premiums will likely fall.

Q: Does the presidential election pose a risk to the country’s fixed incomemarkets?Posch:

We do not expect a repeat of the volatility associated with the 2002 election.After all, eight years ago, there was concern about the continuity of the basic foundationsof macroeconomic policy (inflation targeting, floating exchange rate and prudent fiscalpolicy). This time around, whoever wins the election will likely remain committed to theseprinciples.