Brazil is a country full of contrasts. The biggest Latin American country is not only known for its sunny beaches, vast Amazon jungle, samba and passion for football, but also for poverty and social inequality, mostly seen in places like the country’s famous favelas.
The Brazilian economy has long benefited from the world’s, and particularly China’s, strong appetite for Brazil’s abundant natural resources, such as soya, oil and iron ore. The commodity boom led to strong economic growth. From 2000 to 2012, brazil was one of the fastest-growing major economies in the world with an average annual GDP growth of over 5%. However, the economy started to slow down in 2013 and entered a recession in late 2014 that lasted until 2016, driven by an economic slowdown in China that caused a sharp decline in commodity prices. The Brazilian economy shrank by more than 7% in two years, which made it the longest and deepest recession in its history.
The recovery process after the recession has been desperately slow, held back by political uncertainties, corruption scandals and external shocks (crisis in Argentina, global trade war). However, the current president, Jair Bolsonaro, has started to push through an ambitious reform agenda that should improve structural growth in Brazil. More importantly, there is still a lot of overcapacity and slack in the economy, which has helped to keep inflation under control. The central bank’s policy rate has come down from 14.25% in 2016 to 5.5%, and additional cuts are likely. Structurally lower rates and economic reforms should improve Brazil’s competitiveness and stimulate economic growth.
Investors can get access to Brazil via its stock market, the Bovespa. But investing in Brazilian stocks has proven to be a very volatile ride with massive ups and downs, and typically concentrated exposures to some large stocks with political influences, such as Petrobras, Itaú Unibanco, Bradesco, AmBev and Vale.
But there is a much more conservative way to invest in Brazil via receivables-backed funds called Fundo de Investimento em Direitos Creditórios (FIDCs). FIDCs are mutual investment funds that apply the majority of their financial resources in receivables. They offer relatively high yields and huge diversification benefits. Brazil is a fantastic example for the deficiency of the traditional banking sector with a concentration of almost 80% amongst the top four banks. These banks tend to focus on mortgages and long-term loans for larger corporates. Small- and medium-sized enterprises (SMEs) are often struggling to get access to traditional sources of funding. Also, bank spreads in Brazil are much larger than in any other major country. While interest rates have come down, banks are still widely lending at rates above 30%.
Alternative financing options, such as accounts receivable factoring, may provide the working capital SMEs need. Accounts receivable factoring is financing that comes from a business selling its accounts receivable to a factoring company. Given the lack of lending provided by traditional banks, the Brazilian authorities implemented an investor friendly regulation for the factoring industry. In Brazil, FIDC are fully regulated and monitored by the Brazilian Securities Commission (CVM). The concept was first introduced in 2001 but since then, the transparency and accountability has been improved significantly. Today, FIDCs must comply with a number of rules that guarantee strong governance and independent controls through regulated fund administrators, independent auditors, registered managers, custodians, etc., which gives investors a very high level of transparency and accountability. Brazil is probably the country with the highest standards in terms of the regulation of the factoring industry, a real factory paradise, and definitely a positive aspect to be added to the list of contrasts. The strong regulatory framework that protects the interest of investors paved the way for sizable capital inflows, that helped to meet the strong demand from SMEs. Currently, there are around 800 different FIDCs with a total asset size of around B$ 120 billion (around USD 30 bn).
Investors have many advantages if they invest in FIDCs compared to corporate bonds or equities, for example. First, receivables portfolios usually contain receivables from a diverse group of debtors, which means that there is much less concentration compared to traditional corporate bond or equities portfolios. Second, investors mainly face the credit risk of the buyer (obligor), which tends to be a bigger, more established company, typically multinationals, that have a much lower credit risk. What is more, the credit risk of the obligors can be insured against default at relatively low costs. Third, FIDCs can also get guarantees from the suppliers, such as real estate and personal guarantees of key executives. This gives a strong incentive for suppliers to buy back the receivables in the rare case that the buyer does not pay the invoice to the factor. Therefore, expected default rates are below 2% and expected loss rates (after renegotiation and recovery) are below 1% in the Brazilian factoring industry. Interestingly, loss rates remained below 1% even during the deep recession of 2015/2016, which has been an excellent stress test of the resilience of the Brazilian factoring industry. And last but not least, the expected performance for international investors is highly attractive. Even if we deduct hedging costs (that have come down a lot thanks to the lower rates in Brazil) and any other costs related to the origination, management and administration, net returns for USD investors should be in the 8-10% range.
Opinion by Pascal Rohner, CIO at Katch Investment Group