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The Case for Venezuelan Bonds

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

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.

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  Fidelity New Markets Income (FNMIX) and  TCW Emerging Markets Income (TGEIX) have taken a somewhat more cautious tack. Fidelity’s John Carlson has long had an overweighting in Venezuela and hasn’t tried to predict when regime change could happen. He thinks that the country can get through the rest of 2017 if oil prices remain stable because it has found many ways to pay its debts, including bringing gold back from overseas banks and entering into swap agreements with European banks. Still, Carlson has battened down the hatches in the event of a default and accompanying liquidity risk, sharply reducing the fund’s overweighting to an overall stake of 4% at the end of July. He’s also kept exposure focused on long-end PDVSAs, because he thinks short-dated bonds will suffer more in the event of a default given that their prices haven’t been as deeply discounted. In that scenario, Carlson expects his bonds to take a haircut of 50-60 cents.

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  Fidelity Total Bond (FTBFX), are likely to sell their small stakes in near-dated bonds or allow them to roll off.

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.

Karin Anderson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.