Fixed Income

EMD Relative weekly notes

Week Ending August 25, 2017

08/28/2017

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

If Venezuela is interesting as an investment proposition, it's fascinating as a behavioural finance story.  The overwhelming majority of large emerging market debt (EMD) investors in our estimation have exposure, and many of those have substantial exposure well above that of the benchmark indices.  That's worth thinking about, because with virtually no data to go on and a completely opaque political structure, those who commit part of their capital to managers with Venezuelan exposure may be speculating, possibly gambling, but it's certainly a stretch to call it “investing,” as most investors believe it to be practiced by their manager.

Venezuelan debt consistently yields roughly four times that of other non-investment grade sovereigns.  Under the current and former president the country is maniacally committed to paying its dollar sovereign debt to the obvious detriment of its population which seems unable to manifest a scenario that would remove current officeholders.  That, evidently, is a satisfactory investment thesis for most.  Owning the bonds is a guarantee competitors do not out-perform you should the current situation be maintained indefinitely. However, the probability of a default is rising.  One of the sole pieces of data we have are foreign reserves, which continue to steadily fall (see chart below).  But even here investors can only guess on how much of these reserves are liquid and usable.  Earlier this year protests against the regime picked up and bonds rallied as investors surmised that a regime change would result in a "friendly" debt restructuring from a more market-friendly leadership.  Later, President Maduro managed to hold a sham vote that installed a "constituent assembly" meant to re-write the constitution and replace what was already a toothless Congress.  Afterwards, protests have died out.

Data as of August 25, 2017

Hence we can conclude “regime change” odds were mis-calculated.  A reason to sell?  Hardly.  A large investor was quoted this week in the financial press as arguing that with Maduro more firmly in place investors can rest even more easily given their willingness to squeeze the population.  So the most prominent investment thesis changed from being predicated on potential regime change to being underpinned by regime continuity.  We confess to being a bit troubled by this thesis, hanging as it does on an investor rooting for the population to undergo ever more severe deprivation for the sake of principal and amortization payments promptly rendered. 

With that, and knowing that oil production is declining and reserves falling, investors are hoping for support from the Chinese or Russians.  Venezuela remains indebted to both, exchanging future oil shipments for present day cash, the details of which no one knows.  Investors can only speculate on those potential developments, though they can rest assured that part of the future will be mortgaged for the present, logically increasing the odds of a future default while simultaneously lowering the amount of assets available to public bondholders when that default occurs.  Meanwhile hyperinflation and a failed state status draws closer, as a cursory look at the monetary base demonstrates (see chart below).

Data as of August 25, 2017

Similarly there have been extremely questionable bond issuances in the past two years or so that have been written about in the popular press sufficiently to make them radioactive for most and unlikely to be duplicated at least to US investors.  A further complication is potential US sanctions, another factor that can only be speculated about, though as of this writing most investors seem sanguine--bond prices have risen sharply this week on rumors of additional Chinese support (no details available, of course).

The last refuge is to argue that when Venezuela defaults the recovery value will exceed current market levels due to their vast oil reserves and the urgency to rectify the situation in order to keep oil exports flowing.  Those arguments, like the others, might have merit, but there remains little evidence and lots of unexamined underlying assumptions needed to reach that conclusion.  Much less spoken about is the lack of institutions in the country to negotiate a restructuring, the potential for the current regime to decide to stiff bondholders entirely and sell oil in a black market to countries other than the US, and the incredible legal entaglements that would have to be unraveled on the road to restructuring.

In sum, we would conclude that a speculative case to invest in Venezuela under all available information rests primarily on a hope unsupported by any shred of evidence or a logical chain of defendable assumptions that somehow things will work out.  We choose not to participate.

The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.