Viewpoints

February 2010

The Brazilian Economy and Investment Opportunities

Brigitte Posch
Executive Vice President, Portfolio Manager
Ms. Posch is an executive vice president in the Newport Beach office and a
member of the emerging markets portfolio management team. Prior to joining
PIMCO in 2008, she was a managing director and head of Latin American
securitization and trading at Deutsche Bank. Ms. Posch was previously a
director with Ambac, responsible for developing asset- and mortgage-backed
securities in emerging markets. Before joining Ambac, she was a vice
president 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 and
holds 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, as
they are still considerably higher than those in comparably rated countries. Because of
this as well as the strength of the country’s macroeconomic policies, we expect Brazilian
local rates to continue to trend lower and converge with interest rates in the developed
world. For now, however, the disconnect between Brazilian rates and rates in other
investment grade countries makes Brazil one of the world’s most attractive markets for
yields.

This is true despite certain transaction costs for international investors, such as the IOF
tax (Imposto sobre Operacoes Financeiras) that applies to the conversion of foreign
currency related to debt and equity investments, as well as a considerable degree of
volatility, 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 it
more sensitive to changes in risk appetite.

Additionally, Brazil’s robust economic recovery caused the local curve to suggest a very
aggressive tightening cycle is in the offing by policymakers. While we agree that the
central bank will likely tighten rates this year, we believe the market is ahead of itself, and
the tightening already implied by the long end of the local bond curve is sufficient to
accommodate both higher policy rates and the so-called convergence trend. We may, of
course, see some volatility due to concerns regarding monetary and fiscal policy exit
strategies 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) Europe
facing fiscal constraints that are affecting policy, Brazil is the rare case of a solid and
improving EM credit with credible monetary policy and the offer of outsized local yields on
both an absolute and relative basis.

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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 turnover
per day for fixed rate bonds. That trading was largely concentrated in the short end of the
curve. 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 regular
buyback and debt swap auctions and is improving access for individual investors through
the Tesouro Direto program (which allows residents in Brazil to buy government bonds
through 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 it
very expensive for local corporations to leverage themselves domestically.

Corporations often find it more attractive to raise capital abroad or by selling equity, as
illustrated by the large number of initial public offerings in the last several years. While
PIMCO expects interest rates to decline in the long run, the rate situation is not likely to
change 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 there
was more liquidity for most issues. Currently, the best values are in primary issues, rather
than the secondary market, but since most international fixed income investors are active
managers, the lack of liquidity makes buying local corporate debt a difficult proposition. In
addition, foreign investors need to take the 15% withholding tax into account.

Since local corporate bonds are currently trading with only a small premium to the
sovereign curve – and because of the potential credit, liquidity and interest rate risk as
well as the aforementioned tax issues – we don’t think it makes sense for either local or
foreign investors to get aggressively involved. PIMCO has been focusing on names on
the defensive side of industry. These bonds tend to have lower durations and less
interest rate sensitivity.

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

Posch: Absolutely. Proactive public policies and strong support for expansion of
infrastructure studies and projects are at the core of Brazil’s plans to boost growth. In the
past year, the Brazilian government has placed particular emphasis on public works as a
means to offset the effects of the global economic recession.

Numbers also help to tell the story: Over the last several years, investment in
infrastructure has increased by 12 billion real to 75 billion real in 2009. Such investment
should reach 100 billion real by 2011, independent forecasters suggest. Another 550
billion real should flow from the public and private sectors from 2010 to 2014, according
to these forecasts and project commitments. This includes transportation infrastructure of
nearly 400 billion real. An additional 136 billion real is projected for the energy
infrastructure sector. Water infrastructure projects, including sanitation, are expected to
account for approximately 22 billion real during this period.

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To meet the needs of a growing population and engender economic expansion, annual
infrastructure 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 2001
to 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 engineering

and 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 2014
and the Summer Olympics in 2016, an event that should brings billions in fresh
investment.

Q: Securitization is still a small market in Brazil. Do you see any opportunities for
that market to grow in 2010?
Posch: Although the volume of securitization in Latin America dropped in 2009, in Brazil
it increased 20%, according to the total volume of asset-backed securities (ABS)
registered. Collateralized debt obligations (CDOs) and multi-assets, which invest in
corporate debt instruments, were the most active sectors.

This year, we expect volumes to be similar to 2009, potentially with more government-led
securitizations and fewer private sector issues. This is due to the large increase in
lending activities by state-owned banks in the second half of last year, which was
primarily a consequence of the administration’s efforts to boost consumption and lending
for housing acquisition and construction.

If interest rates move lower – converging with other investment grade countries as we
expect – pension funds in Brazil will find it hard to meet the 6% real return that most of
them 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 infrastructure
sector 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 liquidity
premium. 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 income
markets?
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 foundations
of macroeconomic policy (inflation targeting, floating exchange rate and prudent fiscal
policy). This time around, whoever wins the election will likely remain committed to these
principles.

Thank you, Brigitte.

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Past performance is not a guarantee or a reliable indicator of future results. Investing in the
bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation
risk; investments may be worth more or less than the original cost when redeemed. Investing in
foreign denominated and/or domiciled securities may involve heightened risk due to currency
fluctuations, and economic and political risks, which may be enhanced in emerging markets.
Sovereign securities are generally backed by the issuing government; portfolios that invest in such
securities are not guaranteed and will fluctuate in value.

This article contains the current opinions of the author but not necessarily those of PIMCO and
such opinions are subject to change without notice. This article has been distributed for
informational purposes only. Forecasts, estimates, and certain information contained herein are
based upon proprietary research and should not be considered as investment advice or a
recommendation of any particular security, strategy or investment product. Information contained
herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this
article may be reproduced in any form, or referred to in any other publication, without express
written permission of Pacific Investment Management Company LLC. ©2010, PIMCO.

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