Archive for July 5th, 2011

Understanding the bet on Venezuelan bonds due to a possible change in economic strategy

July 5, 2011

Some people are a little surprised that someone would buy Venezuelan bonds because of Chavez’ illness. It is simply a bet on Chavez not being around or even much simpler, on something as simple as Chavez changing his team, including the economic team.

You see, it was not that long ago (2008), under Chavez, that Venezuela’s risk premium was 500 basis points or 5%. This is simply the extra yield that investors demand from Venezuelan bonds over the equivalent US Treasury bond or expressed in another way how much it costs to insure against default (They are similar). Today that number stands around 1050 basis points or 10.5% for Venezuela (For comparison, it stood at 105 basis points for Colombia, 107 for Brazil, 1.05% and 1.07% respectively, that is what good management does and could do in Venezuela). The historical graph is shown below:

Above you can see the value of the 5 year CDS, the cost of insuring against Venezuela’s default in five years, which is the most common benchmark used. As you can see in 2008 this was around 500 basis points, it rose to over 3000 points during the financial crisis and now settled down around 1060 in the graph.

Why didn’t it go back down to 500 basis points?

Easy, just look at graphs in this post a couple of weeks ago and you will see that it was around this time that Venezuela and PDVSA started increasing debt issuance in both local and foreign currency. Here is the change in total debt (Warning since that date of the post two weeks ago, it has already increased by US$ 1.7 billion (or maybe more…)):

This creates two problems for investors: First, there are too many new bonds around that have to  be absorbed by the markets. Second, it is in the long run an impossible strategy as there is a limit to how much Venezuela can issue. As long as there is no alternative strategy in the long term something has to give some day.

Thus, if there was a possibility that the economic team would change with Chavez’ illness, that the Government itself could change, or the actors could change, then there is the possibility that this crazy rhythm of issuance will end and Venezuela’s debt will improve and maybe even go back down to the 500 basis points or 5% value it had in 2008.

What is critical to understand is that small changes in yield lead to large changes in bond prices, particularly of bonds that trade at discount like all Venezuelan bonds.

For example, if the yield to maturity of Venezuela’s benchmark bond Global 2027 went down by 3% (from 13% to 10%), the price of the bond would change (increase!) by almost 25%. Or if the yield to maturity of the PDVSA 2022 dropped by 3% (from 14.7% to 11.7%), the price of that bond would jump up by almost 18%.

So, if you are a foreign investor who thinks there may be change in Venezuela, it becomes a very asymmetrical bet. If you think there will be change in the next 18 months, you buy the bond. If there is change, the strategy changes for whatever reason and Venezuela stops issuing like there is no tomorrow, the bonds go up by 18-25%.

What if nothing changes?

Well that is why it is so asymmetrical and attractive. If nothing changes in those 18 months, you collect a year and a half of coupons, which range from 18% for the 2027 to roughly 26% for the PDVSA bond. As long as Venezuela and PDVSA pay and the bonds don’t drop so much in price, it is a nice return either way.

Of course, investors are attracted by the possibility of the upside, which they believe would occur if something as a simple as a change in the country’s economic team takes place. The possible downside in the same time frame, looks reasonable.