The Case for Venezuelan Bonds

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

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.

The team behind Ashmore Emerging Markets Total Return EMKIX has been on the more-aggressive end of the spectrum, holding high-single-digit stakes in Venezuelan debt at points in 2017, though those positions have come down some. That team believes the market had already priced in a default by 2016 and that the country has the ability and high willingness to pay its debts into early 2018. The high willingness to pay hinges on a need to keep PDVSA running, because in a default, there could be a halt on exports and the country would fall even deeper into crisis. Ashmore also believes the government and citizens of Venezuela will do whatever it takes to avoid U.S. military intervention, which also means that bond payments would be met for both PDVSA and sovereign bonds. Ashmore’s stake is focused on PDVSA bonds maturing in 2020, where the team expects the best recovery values if the country were to run out of cash. In a default, the team estimates that a price haircut on the bonds could range from 30 cents on the dollar, with the promise of structural reforms, to a much larger haircut with no reforms.

The teams behind

Penny Foley and David Robins of TCW had a smaller overweighting in Venezuela earlier in the year and have been reducing theirs as well on concerns over potential recovery values and liquidity. They’ve also favored long-maturity, lower-dollar-priced bonds with the expectation that longer-dated bonds will offer better upside in the event of a regime change. As a result, Foley and Robbins have kept about half of their exposure in PDVSA 2027s with the balance in three long-dated Venezuelan sovereign bonds. They believe that a credit event is likely to occur, but that it will take longer than originally anticipated because of Maduro’s tighter grip on the country’s legislative body.

Advice for Fund Investors

This complicated situation could become even more so as time goes on, especially if oil prices start to slip or there is some unexpected political change. Another wrinkle comes from U.S. sanctions: As long as they are in place, U.S. business entities can’t be involved in any restructuring. That said, investors in core funds needn’t be concerned, as most of them never owned Venezuelan debt to begin with, and others, including

For more-intrepid bond investors, this situation is a reminder of the stark political and economic risks that come with emerging-markets debt. There have been several sovereign defaults since the late 1990s, including Ukraine, Ecuador, Argentina, Jamaica, Belize, and Russia. Among countries that have gone through debt restructuring, Ukraine’s haircut was on the low side, at around 20 cents, whereas typical outcomes have been closer to recoveries in the 60 cent per dollar range.

That makes a strong case for active management when it comes to investing in these countries’ bonds. Managers can form creditholder groups to negotiate restructuring terms along with help from their firms’ legal teams. Veteran emerging-markets bond managers, including Carlson, Conelius, and Foley, have seen these situations play out before and have had seats at the table during restructurings. They’ve experienced waves of illiquidity and price shocks, giving them insight to size and position their current stakes accordingly. Venezuelan bonds have reportedly held decent liquidity throughout the recent turmoil, but that could dry up if the regime collapses or if oil prices plunge.