While the political and social turmoil in Venezuela has certainly been exacerbated by falling oil prices, its root causes can be traced, in part, to the Venezuelan government's price and currency controls, farm and factory nationalizations, and other populist policies. Although Venezuela has shown an extreme willingness to service its debt (it has not defaulted to date), its ability to do so has become increasingly challenged. However, few bonds mature within the next couple of years and thus far Venezuela has seemingly made the calculation that the country is better served by paying bondholders on a timely basis rather than willingly default (both the Republic and PDVSA have strategic assets abroad and the consequences of not paying would likely be punitive). Importantly, the range of outcomes from a bondholder's perspective is quite wide and, while the situation has certainly worsened, it is possible that the country avoids default over the short-term.
More recently, the Constituent Assembly elections that took place on July 30th represented President Nicholas Maduro's most overt attempt to date to suppress Venezuelan democratic institutions. Due to the worsening humanitarian crisis and the apparent erosion of democracy, the U.S. government announced on August 25th that it would level additional sanctions on Venezuela2. The most important elements of the sanctions are outlined below:
Figure 1: Venezuela Index Spread
While Venezuela was less than a 3% weight in the JP Morgan EMBI Global Index as of July 31st, the yield on the index excluding-Venezuelan bonds is approximately 70 basis points lower (5.5% vs. 4.8%). It is the expectation of most market participants that the bonds will default at some point (with recovery rates likely to be far below par), which suggests that the stated yield to maturity on the bonds, and the index broadly, is unlikely to be realized and therefore may overstate the return potential. As evidenced by Figure 1, spreads on the Venezuela sleeve of the JP Morgan EMBI Global Index have widened significantly year-to-date as its bonds trade closer to the market's perceived "recovery value" in the event of a default.
Importantly, the volatility of Venezuelan bonds has been outsized relative to the volatility of the hard currency index (see Figure 2) as the perception among market participants of the likelihood and timing of default has evolved. While there is a great deal of headline risk and price volatility associated with these bonds, the thesis, among asset managers, for holding Republic or PDVSA bonds is twofold:
It is interesting to note that relative results in 2016 for a number of active emerging market debt strategies were affected positively by holding greater than benchmark positions in Venezuelan debt.
Figure 2: Rolling 30-Day Total Return
While U.S. institutional investors likely do not have exposure to Venezuelan equities, investors with an allocation to emerging market debt hard currency strategies may have exposure to the Republic or PDVSA issues. From a purely investment perspective, we would expect the political turmoil in Venezuela to:
The challenges facing Venezuela underscore the importance of hiring skilled and experienced portfolio managers in the emerging market debt asset class. Investors should be mindful of the potential for tracking error and/or material under- or outperformance by their active emerging market debt strategies. Lastly, from an asset allocation perspective, investors should be aware that the return potential from the emerging market debt asset class may be overstated when looking solely at the index yield, if Venezuela defaults.