Brazil’s Bond Tax Overhaul to Create Policy Clash for Government

(Bloomberg) -- A year after the pandemic forced Brazil to sell almost nothing but short-term debt to nervous investors, Treasury officials have been pushing hard to ratchet back up auctions of long bonds. For them, like for finance chiefs across much of the developing world, locking in long-term financing works as a safety blanket of sorts, helping protect government coffers from the vicissitudes of global markets.

So when Finance Minister Paulo Guedes proposed last month to slash the tax rate on fixed-income assets held for less than two years, it caught traders and analysts off-guard in Sao Paulo. The move, some of them quickly concluded, is in direct conflict with the government's debt sale plans: By incentivizing the purchase of short-term securities, the legislation would sap demand for longer-maturity bonds.

At a press conference in Brasilia last week, Luis Felipe Vital, the Treasury's public debt coordinator, sought to tamp down these concerns. It's a “good question,” he conceded with a smile when asked about the potential for a policy clash, but he expressed confidence he can stretch debt maturities back out. They fell to an average of 3.3 years in 2020 -- and hit a pandemic low of just 2.1 years in auctions in October -- from 4.8 years in 2019. So far this year, the average has inched back higher to 3.6 years, aided by a nascent rebound in Brazil's economy and currency. “We're not worried,” Vital said.

But as the bill winds its way toward approval later this year -- and by all accounts, the proposal has broad backing in congress -- analysts expect investors will start shifting more money into short-term debt. What's more, a series of aggressive interest-rate increases by the central bank is already fueling demand for short-term securities, a move that's set to intensify ahead of 2022 presidential elections that will add pressure for more spending.

“The higher demand for shorter-term notes arising from the change could impact the debt,” said Reinaldo Le Grazie, the head of the investment committee of Panamby Capital hedge fund.

Le Grazie, a former director at Brazil's central bank, added that it's too soon to estimate the magnitude of the hit and that other factors -- especially Brazil's fiscal outlook -- play a bigger role in the country's debt curve.

Many governments across Latin America are struggling to sell long-term bonds as the coronavirus pandemic continues to take an outsize toll on the region. Investors are also wary of quickening inflation that could bring about higher interest rates and a shift to populism.

Colombia plans to slash the number of long-term debt auctions just nine months after its first ever fixed-rate 30-year notes in pesos, selling more of the medium-term paper investors are still willing to buy. Chile's announcement last week that it will sell more long term debt in the third quarter after scrapping such deals in May and June was met with surprise -- and expectations it will put pressure on yields.

In Brazil, Guedes's proposal to overhaul the country's notoriously complex tax code adds a new wrinkle to the nation's strategy to lengthen its debt.

The bill sets a 15% levy on all financial investments regardless of how long the money is kept in funds. That's a significant change from current rules, which punishes investors who cash their funds earlier with higher taxes. In some cases, levies reach as much as 22.5% if the withdrawal happens under a 180 day period, and can be as low as 7.5% if money is parked for the duration of the investment. The government argues that the wealthy, who can leave their money sitting for a long time, shouldn't have greater benefits.

But some investors worry the change could reduce appetite for longer-term bonds and add pressure to issue short-term notes, the opposite of what the government would like to do.

The proposal would generate “a very large turnover” from long-term to short-term bonds, says Mariana Guarino, a portfolio manager at Truxt Investimentos.

Congress and Guedes want to move quickly with the tax reform, the latest proposal aimed at overhauling Brazil's economy. But there's a short window. The bill would have to clear both houses of congress this year since next year's presidential elections will dominate the political scene. Both Guedes and congressional leaders are optimistic the bill will pass, with most of the initial pushback focused on a levy on dividends.

In an emailed response to questions, the Treasury said the changes will have an impact that needs to be monitored, but dismissed concerns, saying Brazil has a diversified base of investors. “From a structural point of view, impacts on demand are not expected. Nevertheless, the Treasury maintains close contact with the different groups of investors, seeking to adjust its strategy, whenever necessary.”

The Treasury pointed out that despite shortening debt last year, it was able to issue more bonds, which helped increase the country's liquidity cushion. That should help Brazil weather any political turbulence ahead, said Carlos Kawall, former Treasury secretary and director at Asa Investments.

But for Felipe Salto, head of an independent Senate institution created to increase the transparency of public accounts, the change in taxes applied to financial investments is an added source of strain for the Treasury.

Interest rate hikes due to high inflation, fiscal pressure and the elections will already make it more difficult to sell longer-term bonds, Salto said. “Next year won't be the same bed of roses as 2021.”