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The Case for Venezuelan Bonds

As default looms, some emerging-markets bond managers are cautiously hanging on. 

Karin Anderson, 09/26/2017

Venezuelan President Nicolas Maduro’s mismanagement of state-run oil company Petroleos de Venezuela (PDVSA) has led to a crippling recession and shortages of food and medicine that have sparked massive protests this year.

During the summer, Maduro's takeover of the legislature led to U.S. sanctions on trading newer bonds and dividend payments from Citgo (PDVSA’s U.S. oil refinery arm) back to Venezuela. In addition, a U.S. court’s decision to allow a Canadian company to seize Venezuelan assets at BNY Mellon further constrains the country’s access to cash and may spur further lawsuits that could chip away at its reserves.

Venezuela continues to service its sovereign and PDVSA bonds against an increasingly dire economic and political landscape, but it’s not clear how much longer they can keep it up. Reports indicate that the government and PDVSA face payments of at least $4 billion this fall with a pile of reserves that has been cited at roughly $10 billion.

Within the mutual fund space, Venezuelan debt is most common in emerging-markets bond funds, which typically use the JPMorgan Emerging Markets Bond Index, or EMBI, as a benchmark. That index focuses on hard-currency (USD or EUR) denominated sovereigns and quasi-sovereigns and had a 2.6% stake in Venezuelan debt as of August 2017, down from 3.9% at the end of 2016. All six emerging-markets bond funds rated by Morningstar had at least a 0.5% exposure to Venezuela as of mid-2017 with higher weightings coming in around 5%-6%. Venezuelan debt pops up in some multisector, core, and nontraditional bond funds too, but in most cases it amounts to less than 0.5% of assets.

The country was the best performer in the EMBI in 2016, though its 53% return was off of low bond prices. The latest sell-off in bonds began earlier this year and worsened through the summer. The benchmark bonds slid by 10% in aggregate for the year to date through August, and Venezuela was the only country in negative territory for the period. PDVSA and Venezuelan sovereign bonds have been trading at 30-45 cents on the dollar, by far the cheapest bonds in the index, with a yield of 33%.

Default or Muddle Through? 
Some longtime Venezuela investors have found ample reason to stay the course and even add to their positions on weakness. Their investment theses hinge on the country’s oil resources, the management of them (whether under current or new leadership), and oil prices. The country’s crude oil accounted for 3% of global exports in 2015 and 2016, with a dollar value of $20-$30 billion.

Mike Conelius, manager of T. Rowe Price Emerging Markets Bond PREMX, has had an overweighting in Venezuela with an emphasis on PDVSA bonds. He’s been comfortable with liquidity and holding a bigger stake (5% at the end of August) given that there are so many different views in the market. Conelius thinks there is a good chance the country can muddle through into 2018 by further squeezing imports and offering oil assets to Russia in exchange for cash and credit. Conelius does believe that a default could occur in the event of a regime collapse. But he also thinks that an administration replacing Maduro would also likely undertake reforms that would benefit PDVSA. Conelius doesn’t necessarily think bondholders would be forced to take a price haircut in the event of a restructuring, either, as that would be too time-consuming to resolve and would put the government in too weak a position to invest in PDVSA. Rather, if the country doesn’t ask for a haircut and moves toward a cooperative agreement, Conelius thinks Venezuela might get more concessions from creditors.

Sergio Trigo Paz, manager of BlackRock Emerging Markets Flexible Dynamic Bond BEDIX, had a 7% stake in Venezuelan bonds, mostly PDVSA, as of mid-2017. His view is shared by many emerging-markets bond managers: You don’t know when the regime change will happen, but you need to have a position when it does, because one would be too hard to establish in a more volatile and illiquid market and you could miss the potential bounceback. Trigo Paz sees three scenarios, one of which he likens to “Cubanization,” in which the United States maintains sanctions while Russia and China keep the country afloat. Another scenario is default, which he thinks is less likely to happen than the former and assumes a 40%-60% investor recovery on the bonds. Paz believes the best, but least likely, scenario is a military coup or U.S. military intervention, which would result in the lifting of sanctions, improvement on the outlook for oil exports, and a near-full recovery for debt investors. Given these views, Paz is focused on longer-dated PDVSA bonds (2027s) because they’d be likely to benefit most under any of these scenarios, and because Citgo could easily be sold to free up cash.

Karin Anderson is a senior mutual fund analyst with Morningstar.

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