Venezuela — high risk, higher yield
Which bond would you rather buy — one issued by a country with an unpredictable leader but huge oil reserves, or one with a dictatorial president as well as empty coffers? The answer should be a no brainer. Not so. The countries are Venezuela and Belarus, and a basic comparison of their debt profiles shows how strangely risk can be priced in emerging markets.
Venezuela’s 2022 dollar bond yields 15.5 percent while the 2022 issue from state oil firm PDVSA trades at 17 percent yield. Venezuelan debt pays a 1200 basis point premium to U.S. Treasuries, according to the EMBI Global bond index.
Now check out Belarus. Dire public finances, a huge recent currency devaluation, and seeking an $8 billion bailout from the IMF, yet able to pay 11 percent on its 2018 issue. Its yield premium to Treasuries is 900 bps or three percentage points less than Venezuela.
Is such a huge risk premium on Venezuela justified? RBC analyst Paul Biszko says Venezuelan yields should logically be 300-400 bps lower than current levels, given the strong recent track record in servicing debt — it did not miss a payment even when oil prices fell to $10 a barrel a decade back. Oil is well over $100 a barrel now, yet investors seem unwilling to trust in President Hugo Chavez’ willingness to keep up payments.
“People see him as one day saying he won’t pay so there is limited sponsorship externally for the bonds,” Biszko says. “Meanwhile those who do hold it get rewarded with high premiums…it doesn’t make sense that the premium is double that of Argentina.”
Sure, Venezuela’s economy isn’t in great shape. Inflation is running at 30 percent a year. There is an election coming up. Also, PDVSA has a $2.5 billion bond maturing mid-July. But Chavez is a shoo-in for the election while PDVSA has enough money to pay the bond. And no one can doubt Venezuela’s ability to pay — Barclays estimates its trade surplus this year may hit $90 billion.
Exotix economist Stuart Culverhouse suggests buying the 2019 and 2022 Venezuelan bonds, citing the high yield. ”Concerns over willingness to pay…to some extent overstate Venezuela’s default risk,” he says.
Desperately seeking yield
Equities may be having a stop-start kind of month, but investors do seem to be more willing to take on risk than before. The latest numbers from EPFR Global, a tracker of investment flows, show high-yield bond funds raking in the money in the second week of January. A net $766 million flowed into the HY funds tracked by the firm. At the same time, a net $578 million flowed into U.S. municipal bond funds.
The drive behind these flows is a mix of a desperate search for yield and a belief that the risk might well be worth taking. Investment grade corporate debt is considered to be priced at Armageddon levels. That is, the price assumes too much trouble ahead than is likely. This has led, for example, to a monthly record in new bond issuance in January in Europe.
High yield is not pricing in quite as extreme a default rate from a historial perspective. But it is still evidently attractive, hence $3.38 billion in global net inflows over the past seven weeks.
Municipal bonds, meanwhile, may be getting a boost from expectations for the incoming Obama administration. EPFR says U.S. investors are anticipating higher taxes, which would help municipal finances.
The long term problems with Venezuelan debt are aren’t insignificant. The country has used massive amounts of future oil supplies as collateral for loans from China, so long term ability to pay is diminished. Additionally, the underinvestment in the country’s oil infrastructure is starting to reduce output. Granted, proven reserves are immense but twelve years of Chavez rule have turned the country into a basket case. The country imports everything at this point and the government has turned to complete control over the currency market to cover up what I believe is a coming crisis in forex reserves.
Yes, Chavez will play the safe game with the debt until his reelection next year (an almost certitude). After the election, he’ll have much less incentive to pay on good terms. Given the decision to pay debt payments or pay for absolutely necessary improvements in infrastructure I wouldn’t bet on payments. He may not immediately default the bonds, but a threat of nonpayment is not so unimaginable. Here is the real danger in Venezuelan debt, with hightened levels of risk must come higher yields. As yields increase, prices must decrease. Unless you are planning on holding the debt to maturity you will not realize your expected yield if you have to sell the bonds for a discounted price.
I would not invest in Venezuelan debt but I probably would not invest in Belorussian debt either. At minimum, the investment should be hedged with some kind of default swap or option relevant to your holding period.
Joseph Hogue is a Research Economist for the State of Iowa. He is a candidate for the level III CFA exam and sits on the board of the CFA Society of Iowa.