Monday 4 February 2013

The surge in the Brazilian real versus the US dollar marks the return of the "Double-Decker" funds.

"If you ain't just a little scared when you enter a casino, you are either very rich or you haven't studied the games enough." — VP Pappy

As we indicated in October 2011, in our conversation "Misery loves company", the reason behind the large depreciation of the Brazilian Real that specific year was because of the great unwind of the Japanese "Double-Decker" funds. These funds bundle high-return assets with high-yielding currencies. "Double Deckers" were insignificant at the end of 2008, but the Japanese being veterans of ultralow interest, have recently piled in again.

These funds represented 126 billion USD in asset in 2011. Following the great unwind we discussed back in 2011, these funds have recently surged back to 106.4 billion USD last month from November according to a Bloomberg article from Jun Yang from the 25th of January - Double-Decker Funds Grow Most in 10 Months in December on Real:
"The total net asset value of the so-called double-decker funds -- designed to first invest in high-yielding assets like junk bonds and then buy into currencies to further increase returns -- rose 7.9 percent to 9.63 trillion yen ($106.4 billion) last month from November, the steepest increase since February, according to data compiled by Thomson-Reuters unit Lipper. Created in 2009, the products now account for more than 15 percent of the world’s eighth-largest mutual-fund market. The Brazilian real was among the 10 best-performing currencies against the yen last month, gaining 9.5 percent as the central bank intervened to stem the currency’s decline against the U.S. dollar. Products tied to the real accounted for 46 percent of double-decker fund assets last month, as Japanese individuals looked to beat the country’s low interest rates by looking overseas for higher-return investments. The gain in the real helped boost demand for the funds, Shoko Shinoda, a Tokyo-based analyst at Lipper, said by phone. Net sales jumped 31 percent in December from the previous month, according to the research company’s data." - source Bloomberg

The surge in the Brazilian Real versus the US Dollar, with the Japanese investors once again playing their favorite high-yielding currency - source Bloomberg:
In blue the Brazilian real versus the US dollar, in red the Australian dollar versus the US dollar, as one can see the correlation between the Australian currency and the Brazilian real broke down spectacularly in 2011!

From the same Bloomberg article:
"Double-decker products use non-deliverable forward contracts for foreign exchange to leverage returns and pay monthly dividends, catering to Japanese individual investors who want a regular income, such as retirees. The real has been preferred by Japanese funds to other emerging-market currencies because it’s more actively traded in the global foreign-exchange market, Shinoda said. Nomura Asset Management Co.’s real-linked “U.S. High Yield Bond Fund,” is a double-decker fund investing in U.S. dollar- denominated industrial bonds. Its net asset value increased 6.8 percent in December, after falling 1.4 percent a month earlier, according to data compiled by Bloomberg. Total returns on the fund were 21.8 percent in 2012, compared with a 5.4 percent loss the previous year, the data show. The real’s drop over the past two years, amid a series of interest-rate cuts in Brazil, and subsequent fluctuations in returns on double-decker funds, have prompted Japan’s financial regulator to require more disclosure about the products’ risks, making sales more difficult, said Sadayuki Horie, a Tokyo-based researcher at Nomura Research Institute." - source Bloomberg

At the same time Brazilian companies have sold the most junk bond on recort since May 2011 last Month according to Boris Korby from Bloomberg in his article - Junk Bond Frenzy Poised to Spill Into February: Brazil Credit from the 1st of February:
"Brazilian companies led by Banco do Brasil SA sold the most junk debt since May 2011 last month as unprecedented global demand for high-risk securities enabled the neediest borrowers to chop their financing costs. State-owned Banco do Brasil sold $2 billion of junior subordinated perpetual bonds rated BB by Standard &Poor’s in the nation’s second-largest high-yield sale on record, pacing $4.25 billion of speculative-grade offerings in January. Junk- bond issuance accounted for 81 percent of Brazil’s corporate debt sales, versus 34 percent globally and 18 percent in the country last year, data compiled by Bloomberg show. 
With U.S. Treasury yields touching a nine-month high, debt investors are turning to the riskiest emerging-market bonds as they face diminishing returns on their safest holdings. That’s allowed junk-rated companies in developing nations to cut their borrowing costs to a record 6.56 percent last month." - source Bloomberg

According to Bloomberg, the amount of Brazilian junk bonds sold was second only to China among emerging markets last month. High-yield issuance in China reached at least $5.3 billion, data compiled by Bloomberg show.

The heat is on...

"The gambling known as business looks with austere disfavor upon the business known as gambling." - Ambrose Bierce

Stay tuned!


  1. Brilliant piece !

    Based on your article, can we conclude that Brazilian Financial Institutions have lowered their cost of capital (thanks to Junk bonds) to a level which will enable them to increase their ROE ? I try to formulate a thesis that would support investors`appetite for this particular sector.

    Due to the latest inflation figures, interest could be hiked further down the road, and thus keeping the real on its upward trajectory vs. the US dollar. What is the implications for the Brazilian banks? The correlation between the real and the Brazilian banks equities have been very correlated.

    1. Hi Anonymous reader!
      The Brazilian Central Bank has reduced more than six times its overnight Selic rate since August 2011 from 12.5% to less than 9.00%. Rapid consumer credit growth has been very impressive in recent years as well as a cause for concern.
      The issue with Brazil and as displayed by the recent GDP figures is that you cannot expect such a rapid growth in GDP anymore as in previous years.
      Remember that at Macronomics we argue that banks are the second derivative of an economy (high beta play).

      To offset the slack in growth (+2.7% in 2011 and only +0.9% in 2012), recently state banks are lending more than non-state financial companies for the first time ever. President Dilma Roussef is expanding credit faster. This lending has been spear-headed by Banco do Brasil SA, Caixa Economica Federal and Brazil's development bank to the tune of 560 billion USD in 2012 (+27% according to Bloomberg), more than triple the 8% increase to 1.2 trillion reals (roughly 600 billion US equivalent) by commercial banks Itau Unibanco Holdings SA and Banco Bradesco SA. Private lenders were stung by rising delinquencies in 2012 FYI.
      So yes private banks will see an improvement in their ROE because public banks are picking up the credit slack while putting their own balance sheet at risk.

      To answer your question, delinqencies at Itau have been trending down. Itau's 4Q12 EPS was Ro.78 per share, meeting consensus estimate. Credit metrics are improving with lower delinquencies across the board if you want to use Itau as a proxy for the Banking sector (private) as a whole. Itau's ROE in its 4Q12 was 18.4%, with NPLs at 4.8% (much healthier than Italian banks...but that's another story).

      While ROE will no doubt be above what you can expect from European banks, given GDP in Brasil is expected to be way above 2012 around 3% in 2013 according to median estimates.
      So the not so robust growth will be supported by public banks putting their balance sheet at risk and they might need a recapitalization or will have low credit growth.

      As far as the private banks are concerned, nonperforming loans are falling so, yes the picture is better.

      I'd be happy to see the results of your thesis on the subject!




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