Two months before its due date, the USD 2.1bn PDVSA bond maturing in April 2017 was trading at 36 cents to the dollar, a sign that Venezuela was about to default. However, against all odds, on April 6th, PDVSA paid and bondholders got their hopes up again. Just two months later, investors renewed their concerns over Venezuela’s ability to pay. Fund managers are swapping their short dated bonds for longer ones and most of them see a debt restructuring as an unavoidable outcome. So what has changed?
In recent weeks, Venezuela increasingly appeared like it is having a going-out-of-business sale. The engineering of unorthodox financing methods led by small and little-known financial institutions are signs of desperation. The sale of USD 2.8bn worth of bonds to Goldman Sachs at 31 cents to the dollar appeared like its most desperate move, until it outdid itself by trying to sell NY-based investors USD 5bn worth of non-regulated debt at 20 cents to the dollar. Analysts are no longer debating whether Venezuela will default. The question is when and how?
To answer these questions, analysts often think of the sovereign and PDVSA separately. This is because there are no cross-default clauses in the bond documentation between the two issuers. The government doesn’t guarantee the oil company’s debt, and one default does not automatically trigger the other to default. So who would go first? And does it even matter?
It is our view that both issuers will default. The annual combined cost of servicing the debt amounts to USD 10bn a year, which is equal to the total foreign reserves held by the Central Bank. The country simply does not have enough cash to simultaneously meet its debt service and import basic goods. PDVSA exports are the main source of foreign exchange revenues, but the company is struggling to produce enough oil to meet its contractual obligations. While PDVSA is sitting on some of the largest oil reserves in the world, it needs vast investments to function effectively. This is something it cannot undertake under existing conditions.
In our opinion it is likely that the Sovereign will default first for two reasons. The current government, if it remains in office over the next weeks, will run out of cash but will not wish to be seen to trigger complete financial chaos at PDVSA, its only source of revenue. It will also be easier for the government to attempt a restructuring of the sovereign bonds, which have Collective Action Clauses, enabling restructuring by agreement of the majority (rather than unanimous) consent of all bondholders.
PDVSA bonds do not have such clauses, making a restructuring more complicated. Once PDVSA defaults, the long and complicated legal process may undermine its ability to operate and to generate much needed income. We would caution investors, however, that these facts provide little additional protection to investors. Because the restructuring of PDVSA bonds is complicated, it is likely that the resolution of the default will take considerably greater time.
The prospect of Venezuela’s default is taking centre stage in the country’s current turmoil. Protesters, outraged at the government’s decision to prioritise payments to bond holders over importing basic needs, are effectively demanding a default. If and when the opposition comes into power, a default is inevitable. Julio Borges, head of the opposition-led National Assembly threatened, in a heated comment after Goldman Sachs Asset Management’s purchase of sovereign bonds, to renege on the debt should he win power.
For all these reasons, attempting to profit from the current situation is a rather complex task. Some distressed debt as well as retail investors are buying Venezuelan and PDVSA bonds at a large discount hoping for reasonable recovery values. Some press articles cite fund managers that expect recovery values to range from 40 to 70%. Such recovery values will imply that there is a considerable upside to investors from current market prices.
We believe these views are far too optimistic. For both political and economic reasons, the recovery value of Venezuelan debt is likely to be far lower. There is a risk that the opposition would renege on part of the debt issued by the former regime. While this is uncommon, they consider, for example, that the USD 5bn debt issued in December 2016 illegal, as it wasn’t approved by the National Assembly.
The level of haircut that investors in the sovereign bonds should expect is a function of two factors: the country’s ability to pay as well as the willingness of the international community (in particular the IMF and World Bank) to provide emergency financing to support an economic reform program. The two factors are interrelated. More ambitious reform programs will garner a higher level of support. At present, however, there is little visibility on what reforms might look like, and what shape a new government will take.
Venezuela’s economy is in freefall, and the depth of economic hardship suggests that any external support will be aimed at minimising further hardship. In other words, bondholders will be nowhere near the priority list of the Venezuelan government or the international financial community. Additionally, because Venezuelan sovereign bonds includes collective action clauses, restructuring this debt at a very steep haircut is possible without a drawn-out legal challenge.
The haircut that investors in PDVSA bonds should expect may or may not be smaller in nominal terms. In real terms, however, it could be the same given the long legal process that is likely to ensue. Furthermore, the absence of any transparency on the company’s finances suggest that it is virtually impossible to estimate it.
The current situation brings Baron Rothschild’s famous quote to mind “the time to buy is when there’s blood in the streets”. While there literally is blood in Caracas’ streets, for all the reasons above, we believe that Venezuelan bonds are not an asset to buy. Meanwhile, traders recommending switches between various Venezuelan bonds at this time, are like staff rearranging chairs aboard the Titanic.
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