NEW YORK, April 6 (IFR) - Investors with a stomach for volatility are reaping hefty rewards for taking risky bets on Brazilian debt, with the sovereign's bonds clearly outperforming other emerging market credits.
Mired in its worst recession in decades and racked by a widening corruption scandal, Brazil has become the high risk but high return play that once typified EM investments of the past.
Investors are buying the debt amid expectations that President Dilma Rousseff will likely be impeached, shortening the unpopular head of state's term in office and opening the way for fiscal reform.
That, combined with renewed risk appetite for emerging markets - thanks to Fed Chairman Janet Yellen's dovish comments in late March, fading worries about a hard landing in China and a more supportive oil market - have spurred a dramatic turnaround in Brazilian bond prices.
"All the woes that were plaguing EM are somewhat diminished," said Sean Newman, a senior portfolio manager at Invesco Fixed Income who oversees emerging market and government bonds. "You could call it the JOC principle - Janet, Oil and China."
Year to date, the Brazil component of JP Morgan's EMBI Global Diversified Index, which tracks sovereigns' hard currency bonds, takes the lead spot with a 12.88% return, putting it ahead of Ecuador at 12.49%, but way ahead of its other EM peers whose returns are still in the single digits.
As in the sovereign universe, Brazilian corporates were also top performers during the first quarter, providing a 7.5% return over that period versus 3.6% for EM corporates overall, according to a recent Citigroup report.
Investors playing local currency government bonds have enjoyed the greatest dividends in Brazil.
Franklin Templeton's Michael Hasenstab, is one of a number of big name fund mangers seeking yield in the country's government bond market.
He is confident Brazil will emerge from its political and economic crisis without a debt default.
"It is clear that the administration's legitimacy of pro cyclical and overly expansive monetary and fiscal policy are over. A change is inevitable," he said.
Invesco's Newman, who looks at both local and dollar markets, said: "(Brazilian) markets have been on a tear on the back of impeachment expectations.
"If there is an impeachment we could see the Real rally from current levels and that would be good for rates."
The Real - one of the best performing currencies of the year - hit 4.156 against the dollar on January 21, but strengthened to a recent low of 3.55 on April 1, marking a 17.07% return over that period.
That would account for much of the 22.36% year-to-date return seen on the Brazil Broad component of JP Morgan's local currency GBI-EM Global index, also making it by far the best performer in this asset class.
The second highest return over that period on the GBI-EM came from Indonesia with 14.43%, followed by Malaysia at 12.48% and Russia at 12.05%.
That stands in contrast to the same period last year when the Brazil Broad was the worst performer at a negative 11.72%.
The high yields on government debt are also a big attraction thanks to the central bank which has kept the benchmark Selic rate at 14.25% as it seeks to keep inflation in check.
More upside could be on the horizon if monetary authorities decide to cut rates now that the exchange rate has stabilized.
"The currency is reaching a plateau in terms of performance, and it is shifting towards a carry trade," said Siobhan Morden, head of Latin America strategy at Nomura, noting that local government debt is still offering double digit coupons.
"From a yield basis, Brazil still stands out," said Chia Liang, head of emerging markets investments at Western Asset, whose local currency EM fund recently moved to overweight on local rates.
"Brazil is the only double digit yield country within the GBM-EM complex and to the extent the Fed is not in a rush to normalize policy we see decent tailwinds."
Citigroup, which is overweight Brazilian corporates, believes their debt could tighten another 55bp with a reduction of political risks and perhaps up to 200bp if a rally in commodities is sustained.
"All things being equal, we feel we are probably closing in on some sort of shift in the power base of the government," Liang said.
Some are, however, doubting the sustainability of this impressive rally.
After all, Brazil to a certain degree has ridden on the coattails over the broader EM rally, which could be fleeting if commodities take another leg down or rate expectations in the US change.
"We have seen a rally in part due to global macroeconomic factors but we have (yet) to alleviate the idiosyncratic risks in Brazil," said Adrian Helfert, senior portfolio manager at Amundi Smith Breeden, which manages more than US$1trn in assets and has positions in Brazil.
"The rally has been strong relative to peers and this has made me think twice about relative value, but in certain areas there is still some value." (Reporting By Paul Kilby; editing by Shankar Ramakrishnan and Sudip Roy)