Bond analysis for dummies

Guacharaca

A guacharaca (known to our neighbors in Central America as the chacalaca), a type of wild turkey that talks a lot and says nothing. Anything to do with this post? You be the judge.

Roubini Global’s Walter Molino Molano* seems to have forgotten a basic tenet of bond analysis. In his several paragraphs detailing the general crumminess of Venezuela’s economy and the non-recoverability of bond collateral, Molano never explains why exactly people should avoid Venezuelan bonds.

The bonds at issue, mentioned in the prior post, can give investors a theoretical 20% annual yield. That means that lenders (banks, investment funds, and some individuals) can buy a bond maturing in 5 years, for about half of face value, with a 5% annual coupon, and get back about 20% per year on the investment, as well as getting the original investment back upon maturity. However, Molano says everything is going to hell, headlining his article “Run Away.” He says to sell Venezuela holdings. His point seems to be, though he never spells it out, that 20% returns aren’t useful if the underlying country disappears, goes bankrupt, or otherwise defaults on its debt.

It’s a fair point, but Molano never gets around to addressing the probability of default. It’s like he has fun listing the potential downsides of a Venezuela bond holding, without ever estimating either the likelihood of default or the possible recovery value of the bonds — that is, how much money investors would get back in a default.

Nothing in the Bolivarian Republic is predictable. But there are a few principles that can help people make their decisions. First, skip the usual credit metrics. Sadly, our friends at S&P, Fitch and Moody’s frequently city Venezuela’s publicly stated debt-GDP ratio, among other “objective” standards, as evidence of creditworthiness. Both sides of the debt-GDP ratio are suspect: there may be billions of dollars more of off-the-books debt, along the lines of the advance sales of iron and oil to China and of aluminum to Glencore. And coverting GDP estimates to dollars is tricky in a country with four currency exchange rates and purchasing power parity that is subject to on-again, off-again government handouts, price controls and shortages. So let’s forget these guys, as their analysis works great for serious countries, and not so well for places that are run like a slightly more stoned UC Santa Cruz student government.

There is only one risk that really matters in Venezuela: Does President Hugo Chavez want to default? If so, it’ll happen. If not, it’s very unlikely.

The main argument that Venezuela won’t default is the list of projects in the prior post. A default would halt pretty much all of them by cutting off useful sources of financing. Sure, the country can get some money from advance oil sales to China or mortgaging the blood plasma of the unborn, for that matter, but so far even China and Brazil have been unwilling to expand lending to Venezuela to nearly the degree that Chavez has requested. Recent offers have all been for loans that never get to Venezuela, but rather pay for the work of Chinese or Brazilian companies in those countries’ currencies. That won’t work for joint ventures with private companies from Spain or the U.S.

Another argument is that Chavez’s cronies are the ones who are getting rich on the bond issues, and they are going to want to keep the gravy flowing. This is the sort of personalist, situational argument that people who have never lived in Venezuela often ignore. Those of us who must tolerate the daily corruption know how much inertia it can add to any system.

Finally, the country uses the international bond market as a substitute for a currency market, so as to maintain Chavez’s preference for currency controls without cutting Venezuela off completely from international trade. I don’t know if the current official system will last more thana week, but regardless, bonds have long been the only game in town for moving bolivar-denominated wealth into more liquid dollar or euro bank accounts.

I think that over the next 18 months, default is a minimal risk. However, I don’t know. And Walter Molano doesn’t know, or at least he doesn’t give any reason to think he knows. Election season 2012 and beyond? I doubt that anyone knows, including Chavez’s most trusted advisors like Fidel Castro. All we can do is look backward, as crises have come and gone. In a series of tight spots, Chavez has always chosen to remain current on the debt, even backing off plans to pull out of the IMF, for example, when it emerged that such a move would be a technical default. For all the bluster, Chavez has been obsequious to the bond market.

Finally, if you are a small investor thinking of buying PDVSA bonds, it may be that the best, albeit fraudulent, way to do it would be to buy your bolivars at 8 to the dollar on the black market and then tell the Central Bank of Venezuela that you need to buy bonds to get dollars to import food or medicine. If you can get the bonds for 2.3 bolivars per dollar of face value (the going rate at the Central Bank), you are going to get a yield well above 30% a year. I’m sure I’m not the only one who sees the potential profits here.

*Who’s the dummy now, pal? Thanks to reader DC for the correction, name fixed throughout.

11 thoughts on “Bond analysis for dummies

  1. Quico

    “There is only one risk that really matters in Venezuela: Does President Hugo Chavez want to default? If so, it’ll happen. If not, it’s very unlikely.”

    I think this is as succinct a summation of the case for the “run away” position as you could write! when you talk about default risk in Venezuela, you’re really talking about the risks associated with the absence of effective institutions.

    It’s precisely because Venezuela would default not as the outcome of some complex process of collective decision-making, but rather as the result of a single person swim, that no sane investor can really think about staying there for the long-term, or even the medium term.

    Because all the reasons you give for thinking that venison that will not default makes sense in the context of formalized decision-making: a sane decision-making apparatus would never default considering all that. It’s precisely the sense that no the sane decision-making process need mediate a Venezuelan default that is freaking out investors.

    1. sapitosetty Post author

      Quico – People who want 20% returns when the U.S. treasury is basically giving away money don’t get to choose “PDVSA vs. Mitsubishi.” This is “Hugo Chavez or an equally chaotic roll of the dice,” like General Motors bonds or anything else on this list.

      Unlike Roubini employees, I have neither the interest nor the Bloomberg terminal to find Venezuela’s peers among high-yield emerging-market bonds and write a real analysis. I am just asking this dude to be a little less hysterical. He is getting paid real money to advise people on how to invest billions of dollars, and he sounds like Maria Alejandra Lopez.

    2. Quico

      Hey Mr.,

      I’m glad you don’t mind me using your blog for dictation software trading purposes. It’s oddly difficult to compose your thoughts by speaking them when you’re so used to typing.

      Let me try to revisit your rejoinder.

      Of course there are people looking for extraordinary returns on their bonds. Capitalism can handle that. Professional managers who craft especially complex and speculative business plans that could potentially make lots of money, but are just as likely to collapse spectacularly, that’s just the stuff of everyday money. And that’s the kind of risky investments bond analyst needs to be recommending to clients with a high propensity to take on risk.

      What a bond analyst shouldn’t do, though, is steer clients to bonds whose risks are unmeasurable because they stem not from a speculative business plan, but from a psychological disposition. Because that’s the kind of decision-making practice that makes risk fundamentally unmeasurable. How can you know if Venezuela is a good default risk on 25% yields, but not on 20% you? On what basis can you possibly draw those distinctions? other than a general sense that “wow this is a really risky place”, how can you justify gambling with clients money on bonds whose default risk is fundamentally unquantifiable?

      There is no way you can do that. And you can’t do that because the structure of decision-making in the bolivarian republic makes measuring the risk of default an exercise in psychology rather than financial analysis.

      As a financial analyst, you have plenty of zany speculative bond choices in front of your: why would you go specifically for no one that, should it go bust, you’re going to be unable to justify? Me explico?

      1. sapitosetty Post author

        I think we’re talking past each other here. What makes you think other 20% yields aren’t subject to individual whims of, for example, arbitrary regulators in Argentina, fickle bankruptcy courts in Michigan or the tough-guy complex of a warlord in the Niger Delta? High yields are all about weird unpredictable stuff. All of them have their constraints. Few of them have paid risk analysts who look only at the negative, without even mentioning the constraints on the negativity or what could change their ratings in the future.

        PS: I hold no Venezuela debt.

  2. Quico

    Of course, I meant Venezuela and not venison. I broke my damn arm, and the dictation software I’m using instead of typing is, shall we say, temperamental.

  3. sapitosetty Post author

    I love those dictation typos. I started wondering around “single person swim.” I edited your earlier comment so it would say “Chavismo” and not “Chevy small.” And here I thought you were just trying to be punny.

  4. HalfEmpty

    There is only one risk that really matters in Venezuela: Does President Hugo Chavez want to default? If so, it’ll happen. If not, it’s very unlikely.

    I worry that you have found the paradox. President HC cannot default and stay President for more than 12 months, but to stay President he must lead the nation to default and devalue.

  5. Marcus

    Setty,

    You are confusing two issues. The “ability to pay” and “the willingness to pay.” Both are necessary and jointly sufficient to assure debt repayment, but neither is individually sufficient.

    You are correct that HC is very scrupulous about paying certain elements of his debts — sovereign debts. However, he’s rather cavalier about paying other debts. He started running up huge arrears to PDVSA’s suppliers when oil was still $120/bbl. And when he couldn’t pay them, he nationalized them. He’s been in no hurry to pay for all the companies that he has nationalized.

    Why does he do it that way? Who knows? It’s probably something that he learned from the Cubans who learned it from the Soviets. The Soviets were known to be pretty scrupulous about paying certain external debts.

    However, the capacity to pay debts is eroding. Yes, he has enough oil revenues to pay all the debts as long as oil still is over $20, but he has other pressing needs: Needs that we can see and needs that we can’t (repayments in oil to China or payments for Russian weapons or Cuban advisors).

    The official exports statistics are a joke. The real volume of oil exports could be anywhere between 500 million to 700 million barrels. At current prices that probably $30 – $40 billion annually, just enough to cover the imports that we can see.

    If oil prices stay stuck where they are, he may have a choice: “keep imports above a certain critical threshold or cut something else.” In a year, if oil prices don’t rebound, the “something else” could be government or PDVSA bonds.

  6. otto

    We get:

    Some stopped-clock expert saying that Venezuela oh! noes! we’re! all! gonna! die! which is the samo we’ve seen for the last seven years.

    Someone with the common sense to point out the typical glaring omissions in said ‘expert’s’ article which could have been written on any of the last seven years.

    That someone is greeted with the same scripted comments we’ve seen for the last seven years.

    Au suivant!

  7. sapitosetty Post author

    Yeah, you never know which crisis will be The Big One. I can understand why people think that This Time It’s Different. But I also remember the goodbye party for a reporter friend who was here like four years before heading off to New York, who said that as a journalist, he was disappointed to have missed the final crisis for Chavismo. I don’t know if there will be one. Who would ever have expected the longevity of Mugabe, Qadafi or of course Castro? Hell, even George W Bush. It turns out that you can pull off a lot of tricks by force of will, no matter how bad things get.

    That said, yes, Marcus, you make some good points. Roubini should hire you instead of their current clown. But none are 100% determinant either. Sure, Venezuela owes lots of companies lots of money. As I’ve said before, they’ll lose Citgo. But they’ll suck it dry before they lose it. Companies are preparing to try and seize vessels. Maybe that’ll happen. But beyond that? What is there to seize?

    As far as the export numbers, I don’t know, man. One of these days I’ll post my opus on export figures, but there is a case to be made that the country is exporting a lot more than you think. I just don’t see that things have changed all that much, as Otto says, since 2003. I think the current cash crunch comes from massive spending on power plants, not from a shortage of income. I see no reason to think that a default is more likely now than in the oil strike, or after oil prices collapsed, or after Mobil and ConocoPhillips filed for what, like 1% of GDP in their arbitration claims, etc etc etc.

  8. carne tremula

    Mark my words, no default before 2014. Want to get in a sweet deal, buy pdv 2011 or venz 2011. Yields = 15%. 2010 and 2011 debt service and debt repayment around 11B usd. There is enough cash flow to pay all that. Also there is lot of room at the end of the curve >2025 to keep borrowing. And all venezuelan foreign assets are worth around 70B enough to pay the 60B bond debt completely. Yes it could be that chavez does not want to pay but I doubt it. Moral grounds ? most of the debt was issued by chavez. Economic grounds ? none, it would isolate venezuela from debt markets, venezuelan assets could be forfeited (citgo).

    but from 2014 forward: caveat emptor, here be dragons. Would not touch it with a 10 ft pole. For me the good stuff is in 2023. also very sure oil prices would go up (my prediction 2013=150 usd)

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