Regular readers of Credit Slips will know that Mark Weidemaier will often co-post with Professor Mitu Gulati of Duke University. These posts, often on sovereign debt issues, are among our most widely read and commented upon. We are very pleased to announced that Mitu is joining as a permanent blogger. When trying to figure out how to introduce Mitu to our readership, I looked at his faculty bio, which is too good not to share in its entirety:
Mitu Gulati is a professor at Duke University. His research interests are currently in the historic evolution of concepts of sovereign immunity and the role that law can play as a symbol. He has authored articles in the Journal of Legal Studies, the Review of Finance and Law and Social Inquiry. He has won no awards, other than a second place finish in the fancy dress competition in 3rd grade (photo not available).
Characteristically, Mitu's bio is unduly modest. He is a very accomplished and prolific scholar who is well known within the legal academy. It is our honor and pleasure to have him join this often merry band of bloggers. We hope you enjoy his contributions.
History Shows Even Sovereign Bond Default Won’t Unseat Maduro
By
Ben Bartenstein
and
Daniela Guzman
Under 15% of defaults since 1992 spurred government change
Maduro could ‘stay in power through it all,’ Reinhart says
Nicolas Maduro
Photographer: Carlos Becerra/Bloomberg
Venezuela has a dubious backstory when it comes to paying sovereign debt. It’s tied with Ecuador for the most defaults since 1800.
But for anyone betting that a default would catapult President Nicolas Maduro from office even as he holds on in the face of untold economic misery, here’s a more relevant marker: Not once on those 10 occasions, most recently in 2004, did a missed payment spur a change in government.
In fact, defaults around the globe have triggered governmental change less than 15 percent of the time since 1992, according to data compiled by Bloomberg. In Venezuela’s case, Maduro has enough support from the nation’s powerful military to weather any fallout, said Harvard’s Carmen Reinhart, co-author with Kenneth Rogoff of “This Time Is Different: Eight Centuries of Financial Folly.”
“If you don’t have to listen to voters because you’re installed through military might, there’s no reason why a default would mean a change in government,” she said by phone from Cambridge, Massachusetts. “Venezuela is beyond democratic solutions, so Maduro could very well stay in power through it all.”
For most traders, a Venezuelan default is all but certain. The implied probability of one occurring during the next five years has climbed to 98 percent from 91 percent a year ago, according to credit-default swaps data compiled by Bloomberg.
Venezuela’s benchmark dollar bonds due in 2027 rose Thursday to a one-week high of 39.47 cents on the dollar as of 11:30 a.m. in New York.
‘Death Sentence’
Knossos Asset Management, the Venezuelan-dedicated hedge fund known to make big bets on the nation’s debt, parked 90 percent of its portfolio in cash this summer, citing concern that a default would spur regime change. It reasons that investors would seek to seize state-owned assets such as oil, which accounts for 95 percent of the country’s export revenue, making it all but impossible for Venezuela to import basic goods and services that are already in short supply. Danske Capital, the 18th-largest reported holder of Venezuelan bonds, has said a default would be the “death sentence” for Maduro’s administration.
Some $3.5 billion in debt payments come due by November on about $70 billion owed by the government and its state oil company.
“A default will bring about a change in government,” said Francisco Ghersi, co-founder of Knossos. Government officials "would be entering a new territory that is so complex that they wouldn’t be able to manage."
The thinking among some bond buyers is that a new opposition-controlled government could negotiate a restructuring that’s would pay them generously. “Both bondholders and the new government have an incentive on both sides to restructure the debt and also attract investors to the economy,” said Shamaila Khan, the director of emerging markets at AllianceBernstein LP, the ninth-largest reported holder of Venezuelan debt.
Revolving Door
If Ghersi’s right, it wouldn’t be the first time default led to a leader’s downfall.
After Russia defaulted on $40 billion of debt in August 1998, the ruble lost more than half its value in six months. From that economic wreckage emerged a former KGB intelligence officer from St. Petersburg named Vladimir Putin.
Months after Ecuador missed a payment on U.S.-backed Brady bonds in 1999, President Jamil Mahuad was overthrown by the nation’s most powerful indigenous group and military officials. And when Argentina defaulted on its international debt in December 2001, La Casa Rosada became a revolving door, featuring five presidents in 10 days. The last of the quintet’s leaders, Eduardo Duhalde, survived just a year.
Still, causality is often difficult to prove, according to Martin Uribe, an economist at Columbia University.
“In Latin America, especially, because many democracies are still very young, you see a strong association between a large economic crisis and the demise of political administrations,” he said by phone from New York. “But if the Maduro administration falls, was it the economic crisis or the weakness of the regime? It’s not easy to disentangle.”
Jailed Presidents
Under the majority of defaults, from Nigeria to Nicaragua, heads of state have survived. When a missed payment has coincided with a government change, it’s often been corruption, not default, that brought the leader down, as was the case with Peruvian dictator Alberto Fujimori and Paraguay’s Luis Gonzales Macchi. Both were later jailed.
In Venezuela’s case, if triple-digit inflation, dwindling crude output and eroding foreign reserves can’t unseat Maduro, neither will a default, according to Francisco Rodriguez, the former head of Venezuela’s congressional budget office who is now chief economist at New York-based Torino Capital. Since an authoritarian leader’s survival often hinges on control over resources relative to the rest of society, Maduro may actually come out of a default stronger, he said.
Should Maduro cling to power after a default, traders would be in a challenging position, because sanctions by the Trump administration prohibit U.S. investors from restructuring existing debt. For now, he’s proven resilient.
“The Maduro regime is staying in power through extreme conditions,” said Harvard’s Reinhart. “There’s no reason to expect more extreme conditions being the factor that topples him.”
2000 Steuersünder im VisierSteuerfahnder durchsuchen UBS-Büros
Bei Razzien in UBS-Filialen suchen Steuerfahnder und Staatsanwälte nach Beweisen gegen rund 2000 mutmaßliche Steuersünder. Auf deren Spur hat die Ermittler wieder eine der umstrittenen CDs mit gestohlenen Bankdaten gebracht.
Mit bundesweiten Durchsuchungen bei der Großbank UBS hat die Bochumer Staatsanwaltschaft rund 2000 mutmaßliche Steuersünder ins Visier genommen. Dabei gehe es etwa um den Verdacht, dass Erträge aus Kapitalanlagen in den Einkommenssteuererklärungen, beziehungsweise angelegtes Kapital in den Erbschaftssteuererklärungen pflichtwidrig nicht angegeben worden sein könnte, berichtete ein Sprecher der Staatsanwaltschaft.
Von den Durchsuchungen betroffen seien Konten bei der UBS (Luxembourg) S. A., der heutigen Luxemburg-Niederlassung der UBS Europe, hieß es. An der Aktion seien bis zu 130 Staatsanwälte und Steuerfahnder beteiligt. Eine Sprecherin der Bank bestätigte die Ermittlungen, wollte aber unter Hinweis auf das laufende Verfahren nicht weiter Stellung nehmen. Die Bank werden in vollem Umfang kooperieren, hieß es.
Grundlage der Ermittlungen gegen die Bankkunden sei ein umfassender Datensatz eines Informanten gewesen, so die Staatsanwaltschaft. Nach dem Ankauf durch das Land Nordrhein-Westfalen seien die Daten durch das Finanzamt für Steuerstrafsachen und Steuerfahndung Wuppertal ausgewertet worden.
UBS ist für die Staatsanwälte keine Unbekannte
Nordrhein-Westfalen hat seit 2010 mehrfach Datenträger mit Insider-Informationen über Steuerhinterzieher gekauft, unter anderem bei der Staatsanwaltschaft Köln laufen mit dem Vorgang vertrauten Personen zufolge Verfahren gegen internationale Geldinstitute und deren Niederlassungen. Die Informationen waren Schweizer Banken entwendet worden. Die Schweiz hat diese Praxis kritisiert.
Die Datensätze haben dem Fiskus nach Angaben des damaligen NRW-Finanzministers Norbert Walter-Borjans bis zu sieben Milliarden Euro zusätzlich durch Nachforderungen und Selbstanzeigen eingebracht. Auch die neue schwarz-gelbe Landesregierung hatte den Ankauf neuer CDs nicht ausgeschlossen.
Für die Staatsanwaltschaft Bochum ist die UBS keine Unbekannte. Im Jahr 2014 hatte die Schweizer Großbank wegen Beihilfe zur Steuerhinterziehung 300 Millionen Euro zahlen müssen, das Geldhaus hatte sich mit den Anklägern auf diese Summe verständigt.
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.
