Bondholders brace for Venezuelan default
January 17, 2018 | Jason Mitchell
Venezuela is edging closer to default on its foreign debt as vulture funds snap up the country’s bonds and push an acceleration clause for missed coupon payments
Bonds Debt Capital Markets Corporate & Sovereign Strategy Economy & Policy Fixed Income Politics Features Venezuela
Venezuela has sent mixed signals. On November 3, the government, with President Nicolás Maduro at the helm since April 2013, said it planned to refinance or restructure all its foreign debt. But even as it voiced its intentions to rearrange its bond obligations, it also vowed to keep up with coupon and principal payments.
Then on November 13, Vice President Tareck El Aissami presided over a 30-minute meeting with around 100 foreign bondholders and their representatives in Caracas but he did not present a refinancing offer or suggest any terms. The government did, however, hand out gift bags to the attendees with Venezuelan chocolate and coffee.
“People say Venezuela will declare a default,” Maduro said in a televised address in mid-November. “It will never happen. We will not default. We always have a clear strategy, and the strategy is to renegotiate the foreign debt.”
Maduro has put El Aissami and Finance Minister Simón Zerpa in charge of the negotiations with bondholders, but both El Aissami and Zerpa are on a US sanctions list, accused of corruption and drug trafficking, and many US investors are not willing to deal with them, afraid of penalties from the US government.
According to Torino Capital, a broker dealer in New York, Venezuela has around $63 billion in outstanding cross-border bonds. The Central Bank of Venezuela puts the foreign debt closer to $90 billion, but analysts say it rises to between $120 billion and $130 billion if you include what the country owes to China and Russia.
But Russia provided some relief in November, when it agreed to restructure $3.15 billion of debt over a 10-year period with reduced payments in the first six years.
An ongoing economic crisis, exasperated by comparatively low oil prices, has crippled Venezuela’s finances and made it difficult for the government and the state-owned oil company PDVSA to remain up to date on their debt payments. PDVSA said in late November that it was catching up with payments on two bonds, after owing $1.52 billion in late coupons, including $894 million from expired grace periods.
After the meeting with bondholders on November 13, S&P Global Ratings declared Venezuela to be in selective default, due to missed coupon payments. On November 15, it did the same for PDVSA. Fitch Ratings downgraded both the sovereign and PDVSA to restricted default during the same week.
The International Swaps and Derivatives Association (ISDA) agreed that credit default swaps had been triggered and said it would hold two auctions to determine the payout to bond holders on $1.5 billion of contracts tied to Venezuelan and PDVSA bonds.
Banks valued PDVSA bonds at 17.625 cents on the dollar in the auction on December 13, meaning the CDS buyers would receive 82.375 cents on the dollar. In a similar auction the day before, Venezuela’s sovereign bonds were valued at 24.5 cents on the dollar, so CDS buyers would get 75.5 cents on the dollar.
Until now, most bondholders have appeared willing to give the government the benefit of the doubt and avoided triggering an acceleration clause even if payments came after a 30-day grace period. Venezuela has missed payment by up to eight days in some cases, but bondholders have been happy to sit put and reap the massive yields.
At the start of December last year, for example, the return on the investment from the coupon payment — or carry on — on Venezuela’s 11.95% 2031 bond equaled an annual rate of 46%, implying an investor can recoup his original investment in just 26 months, according to Torino Capital.
Gambling on default
Lured by more than steep returns, vulture funds have also swooped in, gambling that Venezuela will fall into default and hoping to make a windfall the same way Argentina’s holdout creditors did in 2016. But in Venezuela’s case, acceleration could prove to be a disaster because it would trigger cross-clauses that could require the country to pay back all its outstanding debt, making its overseas oil assets liable to seizure by creditors.
“Currently, the payments are coming in, if late,” says Jan Dehn, the head of research at Ashmore Investment Management, an emerging markets fund manager that invests in Venezuelan bonds. “Bondholders still have the conviction that the government will make the payments because default is the last thing it would want to do. However, this is all highly subjective. What is a reasonable time to wait beyond the grace period? Vulture funds may not be prepared to wait at all.”
Onslow Capital Management, a hedge fund based in London, sees Venezuelan sovereign bonds and PDVSA notes as buying opportunities. “We already have default,” says the fund’s founder and CEO, Nicolas Galperin. “Bondholders are starting to become organized and will push for acceleration to start. It really is wishful thinking on the part of some investors to believe that Venezuela will not fall into full default.”
Onslow is looking to buy the bonds for around 20 cents on the dollar and earn pass-through interest with the hope of selling them at a profit through a restructuring within three years. In mid-December, the bonds were trading at around 22 cents to 25 cents on the dollar.
Vulture funds prefer Venezuela’s 2027 bonds over all the notes from PDVSA. The sovereign bonds do not have a collective action clause (CAC), which require 75% of bondholders to agree before a restructuring deal can go through. The absence of such a clause means that even a small group of investors has a great deal of power.
“It only takes a bond holder with 25% of a specific bond that the government is late in paying to trigger acceleration,” says Francisco Rodríguez, the chief economist at Torino Capital. “That is not a steep hurdle, and there is a real risk that one of the hedge funds will play this strategy.”
The main risk for the Venezuelan government, Rodríguez says, comes from bondholders pushing for the acceleration clause after missed payments. “Certainly, if the market loses confidence in the government’s promise to continue making payments, the incentives for acceleration would increase,” he says.
Vulture funds also like PDVSA’s 2020 notes because the bonds are backed by a 51% stake in its US-based refiner Citgo as collateral. The equity share is valued at around $2.5 billion.
Venezuela’s sovereign bonds cross-default on both interest and amortization payments. PDVSA bonds and notes from the state-owned electricity company Electricidad de Caracas (Elecar) cross-default only on principal payments.
Analysts think Elecar will likely miss a $650 million bond payment due in April and they are also keeping an eye on what the government does in August, when it owes $1.57 billion in principal and interest payments.
The government and PDVSA must pay a total of $9.51 billion in principal and interest payments in 2018, before the amount rises to $13.5 billion in 2019.
Passing the blame
Market watchers say they cannot decipher Venezuela’s true objectives for restructuring its debt. They question why the government has appointed El Aissami to lead the negotiations when it knows he cannot deal with US investors. It may be a political ruse. The government may want to show voters that it tried to restructure its debt, but the US government blocked its efforts.
“Some 75% of Venezuelans are against the sanctions, according to recent opinion polls,” says Torino’s Rodríguez. “I am not sure if the government realizes that it will not be able to bring a restructuring to fruition. It is not a very sophisticated government, and I am not sure if they know how complicated the whole process would be.”
For Edward Glossop, a Latin American economist at Capital Economics, a London-based consulting firm, the Venezuelan government and its creditors have entered unchartered territory. “The sovereign and PDVSA have been declared in selective default, but only bondholders can really decide if they are in full default. It seems the government would like to see a restructuring without being declared in default, which would be a very hard thing to achieve,” he says.
“If the negotiations fail, the likelihood is that the regime will blame [US President] Donald Trump because his government placed the sanctions,” he adds.
The sanctions do not apply just to senior Venezuelan officials. The US Treasury Department has also banned US citizens from buying or trading new debt issued by the Venezuelan government and PDVSA. The measure protects the holders of existing debt but it makes a restructuring far more complicated. US investors would not be able to agree to a settlement like the one creditors reached with Argentina in 2016 because the restrictions would not allow them to exchange outstanding bonds for new notes. European investors are still free to participate in any refinancing, but most of Venezuela’s debt is held by North American investors.
Some US investment banks had already become wary of dealing in Venezuelan debt before the US government applied the sanctions. Goldman Sachs came in for considerable criticism after its asset management division paid $865 million in May 2017 for PDVSA bonds with a face value of $2.8 billion. Members of Venezuela’s opposition and many Venezuelan citizens living in the United States accused Goldman Sachs of helping to prop up the Maduro administration.
As of November last year, Goldman Sachs Asset Management (GSAM) was still understood to be the largest holder of Venezuelan debt with $1.8 billion worth of bonds. Other major holders of Venezuelan and PDVSA debt include Fidelity Investment with $572 million, T. Rowe Price with $370 million, BlackRock with $222 million and Invesco with $113 million.
Venezuela’s opposition calls the notes “hunger bonds” and accuses the government of prioritizing foreign debt payments over food imports. The country has slashed imports by 93% in the past five years to free up enough dollars to meet its debt obligations. According to Capital Economics, Venezuelan imports totaled $17.3 billion, as the government and PDVSA faced $10.1 billion in principal and interest payments in 2017.
A question of when
Some analysts say it is hard to take Venezuela seriously after El Aissami’s appointment. The government will have to go on roadshows in New York and London for a restructuring to have any chance of success, but such a trip will be impossible with El Aissami in charge. Also, the government has not hired an investment bank with much restructuring experience, and there is a dearth of knowledgeable technocrats in the ranks of the civil service.
Venezuela has hired Dentons as its legal counsel, but David Syed, the lawyer leading the advisory team, had to leave Orrick to take the case, after the US law firm refused to do business with the Maduro administration.
“I think the government is playing games,” says Daniel Osorio, CEO of the hedge fund Andean Capital Management. “I believe they want to get the price of the bonds down as low as they can, so they can buy them back. Let’s not forget that a quarter of the bonds are owned by people in Venezuela. They would like to pick them up at 15 to 20 cents on the dollar. That is one way carrying out a restructuring,” he says.
“The US sanctions will make it impossible for a proper restructuring to take place. The government must realize this, so I think they will just keep playing this game,” Osorio says.
Experts are torn about whether the government has the financial resources to avoid a full default. The Central Bank has less than $10 billion in hard currency reserves.
According to Siobhan Morden, head of Latin America fixed income strategy at the Japanese financial firm Nomura, Venezuela may muddle through for another six months or so, but it is simply a matter of when, not if, the country falls into full default before the end of next year.
“We are certainly hearing a lot of double speak from the government,” Morden says. “On the one hand, it says it will pay but, on the other, it wants a debt restructuring. The government’s cash flow stress is so great that I believe a full default is inevitable.”
Choosing debt payments over imports is not sustainable, she says. Nomura estimates Venezuela’s imports declined 27% in 2017 from $14.5 billion in 2016, including $11 billion in non-oil imports.
Oil accounts for more than 95% of Venezuela’s exports and is becoming the sole generator of hard currency. But oil production is dropping around 15% per year and has fallen to roughly 1.9 million barrels per day. With optimistic forecasts putting the price of oil at $55 per barrel, Venezuela faces another $5 billion drop in oil export revenues in 2018. The main question, according to Morden, is whether the economy can withstand a 35% year-on-year decline in imports next year, with less than $5 billion in non-oil imports.
“This now forces a reassessment from within chavismo against a status quo that ultimately forces a worse economic crisis from either default and hyperinflation and latent negative shock to governability,” she says.
“The clearly reactive and dogmatic President Maduro will finally have to prepare for the worst. We do not assume a sophisticated response that insulates their petrodollars or prevents a disorderly default.”
Likewise, Morden does not expect the government to advance internal discussions on debt liability management, debt reprofiling, debt restructuring or even economic reform.
Torino Capital, meanwhile, expects Venezuela to run a current account surplus of $4.9 billion, with higher oil prices compensating for the decline in production. In addition, Venezuela will likely face the same external financing constraints in 2018 that it did in 2017, meaning the country can still service its debt requirements if it maintains imports at current levels.
“The fact that it has made principal payments as well as some coupon payments suggests that it does intend to continue paying and that it has the resources to do so,” says Rodríguez from Torino Capital. “It would have made little sense to pay $2.3 billion this quarter if it knew it would end up defaulting.”
Some analysts say Venezuela’s objectives are not aligned with the bondholders who are willing to provide some debt relief if the government enacts economic reforms. The analysis underpins the view that a delayed but disorderly default will take place.
For a debt restructuring to work, advisers and fund managers say two main conditions need to be met: Maduro needs to commit to economic reforms, and the United States must lift sanctions that bar US banks from buying freshly printed Venezuelan sovereign debt.
The possibility that either condition will be met appears remote. The US government is expected to keep the sanctions in place while Trump is in charge, and Venezuela is not likely to make drastic changes to the economic policies first instituted by the former President Hugo Chávez.
“Bondholders need an incentive if they are to agree to any sort of restructuring,” says Raymond Zucaro, chief investment officer at RVX Asset Management, a US asset manager that holds Venezuelan debt. “They need an assurance that if the debt will not be paid off at maturity, then it will be at some point in the future. They are not getting that reassurance, and I think the country is just getting closer and closer to full default.”
Victor Rodriguez, founder and CEO of the US investment advisory firm LatAm Alternatives, agrees. “Unfortunately for the government, if there is no change in macroeconomic policy, no one will give the restructuring any credence. I think the government has just been testing the financial waters with its latest move. It said it wants a restructuring and it just wanted to see how the markets would react.”
Maduro’s political strength appears to have improved in recent months, but the country’s economic situation is increasingly dire. According to a poll from Venebarómetro, Maduro’s approval ratings rose to 31.1% in November from 21.7% in September.
The country experienced violent street protests between April and July, before the government established a Constituent Assembly to replace the opposition-dominated National Assembly and to rewrite the Constitution.
Creating the new assembly struck a major blow to the opposition, which has fizzled out in many ways since then. The protests, which claimed the lives of 125 people, alienated many ordinary Venezuelans because they were not able to get on with their daily lives. Most opposition parties participated in the gubernatorial elections of October 15, but their voters appeared to stay away, and the governing socialist party, or PSUV, won 18 of 23 races.
Mayoral elections also took place in 335 cities and towns on December 10. Most of the opposition parties boycotted the vote, so the PSUV won 295 races with a turnout of 47%. Maduro then declared that only the parties that took part in the mayoral elections could contest the presidential ones, scheduled for December this year.
Maduro has indicated that he will run for reelection but this latest measure means that the leaders from the three main opposition parties — Justice First, Popular Will and Democratic Action — cannot stand. Speculation also exists that the government will move the presidential elections forward to spring.
“There is no doubt that Maduro will now be the government’s candidate,” says Rodríguez from Torino Capital. “He has been in a more powerful position since the gubernatorial elections.”
At the start of December, Maduro's government began fresh talks with the main opposition coalition in the Dominican Republic to try to put an end to the political crisis. Analysts are not optimistic that any progress will be made because the political chasm between the two sides is so vast, but the imploding economic situation could put even greater political pressure on the government.
According to the International Monetary Fund (IMF), Venezuela’s economy shrank by 26.4% between 2014 and 2017. It declined another 12% in 2017 and is predicted to drop by 6% in 2018, a prolonged economic collapse that dwarfs the Great Depression in the United States in the 1930s.
As the economy sinks, inflation, in turn, has risen precipitously, the IMF says. Inflation climbed 254% in 2016, before leaping 652% in 2017. The IMF expects inflation to soar 2,349% in 2018, while some analysts think it will surpass 4,000%.
As a result, Venezuela’s currency, the bolívar, is fast losing value. According to the official exchange rate, 9.98 bolívares equal one dollar. But on the black market in December, one dollar fetched 100,000 bolívares, a sharp rise from 7,000 bolívares in July last year.
The minimum wage in Venezuela stands at 456,000 bolívares per month, including 279,000 bolívares in lunch vouchers. At the official exchange rate, it amounts $45,700 a month, but it comes to just $4.50 a month at the black-market rate.
“We cannot ignore the optionality from the domestic shock of the worsening economic crisis,” Morden says. “This is particularly relevant considering the recent military takeover in Zimbabwe, after the difficulty of paying soldiers and civil servants. These are specifically the same reasons that may undermine the core support for the Maduro administration on the difficulty of insulating core constituents from the worsening economic crisis.”
Whether Venezuela defaults next year, hyperinflation and falling imports pose serious threats to the government, she says. Nomura expects purchasing power in Venezuela to drop another 20% in 2018. “There are multiple potential shocks to the economy that will undermine financing for the chavista constituents of public sector workers and rank-and-file military and ultimately threaten governability,” Morden says.
Maduro appeared to clean up the oil ministry and PDVSA in late November, when the oil minister, Eulogio del Pino, and the head of PDVSA, Nelson Martínez, were detained on charges of embezzlement and joined 63 other oil-industry managers and officials under arrest. Maduro appointed Major General Manuel Quevedo, a military general with no prior experience in the oil industry, to run the oil ministry and PDVSA.
He also sacked Rafael Ramírez, who had been the ambassador to the United Nations until December. Ramírez, a top rival to Maduro within the PSUV, also ran PDVSA from 2002 to 2014. The government has opened a corruption investigation into Ramírez’s time at the oil company. It is understood that he has fled the country.
“The crackdown on corruption in the oil industry, with recent changes at the top of PDVSA, represents the government’s latest target for its economic ails,” says Stuart Culverhouse, head of macroeconomic and fixed-income research at Exotix Capital, a London-based specialist emerging market investment bank.
“While a cleanup is no doubt needed, this is another distraction from proper political and economic reform and is unlikely to deliver any rebound in the oil sector or help to stave off default,” he says.
Bond buyers are confident that they can recover their investments if there is a change in government and economic policy. Venezuela, after all, sits on top of the world’s largest oil reserves with 301 billion barrels, compared to 266 billion barrels in Saudi Arabia.
Some investors are encouraged by the example in Ukraine, where a debt restructuring in 2015 led to just a 20% haircut for creditors and awarded bondholders a 7.75% coupon and extra payments linked to future economic recovery.
In Venezuela, however, the government will likely find a way to make bond payments through the second half of the year, but either a full default or an eventual restructuring appears to be inevitable sooner or later. LF