A REAL INVESTMENT FOR COMMODITY BULLS / THE WALL STREET JOURNAL ( VERY HIGHLY RECOMMENDED READING )

HEARD ON THE STREET

FEBRUARY 1, 2010, 1:16 P.M. ET.

A Real Investment for Commodity Bulls .

By LIAM DENNING

Looking for the real deal? Brazil's two-year local-currency government bonds are yielding 11.2% right now.

In a world of zero interest rates and jittery stock markets, that sort of return looks tempting. On the face of it, Brazil looks a better bet than, say, Greece, where two-year euro-denominated government bonds yield just 5.2%, despite a fiscal crisis that is raising concerns about the credibility of the euro itself.

Brazil, meanwhile, enjoys healthy government finances along with high real interest rates, both providing scope for further stimulus if the economy weakens. Foreign reserves ended 2009 at almost $240 billion, according to the Central Intelligence Agency. Credit default swap spreads for Brazil's two-year sovereign debt stand at about one percentage point. Greece's are about five times that.

Admittedly, retail investors face difficulties in buying these bonds directly, unless they have a few million to spare. And even institutional buyers should remember that higher rewards tend to carry higher risks.

In Brazil's case, there is also a fairly dismal economic history to live down, not least the hyperinflation of the early 1990s. Inflation is much lower now at just 4.3%, but is expected to rise. HSBC forecasts the central bank target rate to rise from 8.75% today to 11.25% by the end of the year.

Foreign investors holding to maturity, however, care less about Brazilian inflation on such a short horizon. The bigger risk involves currency moves. Brazil's economy is on a sounder footing these days, but commodities markets still exert a big influence.

Maya Bhandari of Lombard Street Research points out that China overtook the U.S. as Brazil's largest trading partner in 2009. A large portion of Brazil's exports to China must be raw materials like iron ore. The real's exchange rate closely tracks movements in commodity prices, so is quite erratic. Annualized volatility in the exchange rate to the dollar since 2000 was 18%, against the euro's 10%.

Factoring in the recently imposed 2% tax on foreign investments in Brazilian securities, the two-year bond's yield-to-maturity for a U.S. investor drops to 10%. Now assume that Chinese monetary tightening pushes down commodity prices over the next two years and the real falls with them. Even a modest 10% leg down would slash the dollar-denominated yield to 5.1% -- about what's available on U.S. triple-B rated corporate bonds right now.

Committed commodity bulls could do worse than Brazilian bonds, although some form of hedge would be prudent. Besides currency swaps, the cheap sovereign CDS contracts might not be a bad place to start.

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