Bolivarian Bond Arbitrage for Dummies

February 13, 2011

I- The Question

I have been getting some emails asking about why it is that the PDVSA bond issued last week, the so called PDVSA 2022, has a price that is so much below the identical Global 2022 Venezuela bond issued by the Republic last summer.

II.-Bonds in general

But to understand why this is relevant, let me start at the beginning: Typically, when a country or a company issues a bond, it has a price and a yield to maturity which depends on the perceived “risk” associated with the issuer. Such a bond is simply a promise that I will pay the annual payments, the coupon, and at maturity, the day the bond ends, you will get 100% of the nominal or face value of the bond.

III.- Venezuela’s bonds and risk

Venezuela currently is perceived as being high risk, in fact, very high risk. There are two reasons for that, one is simply political, the feeling that one day Hugo may wake up and decide not to pay the country’s debt. The second one is that Venezuela has been issuing more and more debt and at some point this can’t go on, the country has to pay at maturity, as well as the increasing annual or coupon payments to the bond holders, which are already near US$ 5 billion per year.

As this risk has increased over the last few years, this coupon has gotten higher, meaning that the country or PDVSA has to pay more to convince someone to buy your bond. As an example, in 2009, PDVSA issued bonds maturing in 2014,2015 and 2016 with coupons around 5%. That means that if you hold $100,000 of the bond PDVSA has to pay you $5,000 per year and then at maturity give you back your money.

IV.- How Venezuela issues bonds

This is where things get complicated. Because of exchange controls, these bonds are not issued internationally, where they would trade very close to each other, but instead are sold to Venezuelan individuals or companies for Bs. That is, you pay so many Bolivars for each dollar face value of the bond at Bs. 4.3 per US$, but you know based of the coupon, that the bond will not trade at 100%, but at a lower value.

Why?

Because Venezuela would have to pay coupons of 14-16% for the bond to trade near 100% if issued in US$ directly. Instead, what the Government or PDVSA do, is to set a lower coupon, knowing that the bond will trade below 100%. Thus, if you are a Venezuelan and you pay say Bs. 4,300 per $1,000 of a bond that should trade around 70%, you buy it, sell the bond for 70% of its face value (You get $700) and then you are simply buying dollars at Bs. (4,300/700) or Bs. 6.14 per US$.

Since exchange controls are so strict now, people love these bond issues, because other than what the foreign exchange control office sells you at Bs. 4.3, there is no way for an individual to buy dollars as it is completely illegal to do so since last May. The same applies to companies. If the Government does not give them dollars for imports, they have to either use their own money or simply stop importing, it is illegal to buy foreign currency other than from the Government.

V.- The Venezuela Global 2022 bond

Last summer, Venezuela issued a bond maturing in 2022 (It actually matures in three parts, one third in each of 2020, 2021 and 2022) with a coupon of 12.75%. This is a very high coupon, very few companies or countries in the world issue at such high coupons. Even worse, these bonds trade at a discount in order to equilibrate with what investors expect from Venezuela. Last week, for example, this Global 2022 bond, as it is called, was trading at 88% of its face value just before PDVSA announced its bond. At that price it was yielding around 15.3%. The difference between coupon and yield is that coupon is what you get paid every year over the face value, yield to maturity is what your annual return will be if you keep the bond until it matures.

VI.- The PDVSA 2022 bond

And here is where the Bolivarian arbitrage and the topic of this post begins. You see, this week PDVSA announced an issue of a bond also maturing in 2022, also having a coupon of 12.75% and also having maturity in three parts in 2020,2021, 2022. That means the two bonds are identical. Given that PDVSA and Venezuela are so inter twinned, you would think they should have very similar prices and very similar yields. Right? Well, yes and no, because of all of the artificialities in the Venezuelan economy due to the controls, at the beginning of the trading of a bonds this does not happen. In time they will be very close, but it will take time.

In fact, last Thursday when the PDVSA 2022 began trading, it was being sold at 74% of its face value, while the Global 2022, essentially the same risk, same yield, same coupon, was trading at 86.4%, a full 12.4 points above the new PDVSA 2022 issue. Illogical. right?

VII.- The Bolivarian Arbitrage

You would think these two prices would become the same immediately, but they don’t. This is the Bolivarian Arbitrage, the subject of this post and the question I have been getting from readers: Why are they different, why doesn’t the gap close immediately? How can it make sense for Venezuela to be yielding 15.7% (same coupon, higher price of 86.4%), while an identical bond from PDVSA yields almost 19% (same coupon, lower price of 74%)? Aren’t markets “efficient”?

The answer is that this exists because of the dynamics of the bond sales by the Government and the banks. Eventually, the difference will close, but it will take time. Here is why:

Companies don’t want to buy the bonds, they want to get the dollars when they get the bonds and sell them. So, they go to a local bank and say: I will place an order with you, of say US$ 50 million, if you can guarantee a price for each dollar such that no matter what amount I get, the price will not change.

For the bank this is not easy. The client could be assigned zero of the bonds or it could be assigned the 50 million, the rules are never clear and vary from bond to bond. So, suppose that the bank expects the new bond to have a fair value of 82%, that means that each dollar costs (Bs. 4.3/0.82)=Bs. 5.24, but the company wants a guaranteed price, so you say I will pay you 70% for the bond, no matter how much you are assigned. This means, for the company, that the dollars will cost Bs. 6.14. This is a great deal in a country where there are no dollars to be had, so if your objective is to get dollars cheap, you are not very sensitive to the price, between not having access to any dollars or paying Bs 6.14 per US$, it is still a bargain. In fact, I bet most companies would pay even higher values, if they could get all they wanted.

VII.-Why the Government wants to sell cheap dollars

And here is another distortion. The Government knows that people would pay more, but it does not want to sell the dollars at a more expensive price (offering a lower coupon) because it wants to keep inflation down. Thus, it prefers to give away the dollars cheap, than to have the political risk of higher inflation. (Although in the end it is not as important for inflation as the Government thinks, it is mostly financing capital flight)

VII.- How local banks affect the international markets

But now, the bank has a problem. If six customers show up, each asking for a US$ 50 million guarantee of purchase, then the bank has undertaken US$ 300 million of risk, which could be dangerous. So, the bank measures how much risk it can take and starts selling these bonds in the international markets at say 74%, like the first day of the PDVSA 2022. It guarantees it will make a four point profit and lowers the size of its risk.

What is the risk? Well, the bank could have the opposite problem, that all customers are given nothing and then it has to go buy the bonds that it promised to deliver. Or that prices will go down because oil goes down or too many bonds hitting the market.

The problem is that these are huge issues for the markets, US$ 3 billion. To give you an idea, two weeks ago Petrobras issued the largest corporate bond in Brazilian history, a US$ 6 billion issue. PDVSA has issued US$ 9.15 billion since last November! Thus, there is an over supply of PDVSA bonds and when the bank tries to sell US$ 100 million, there are only buyers at a low price, if there is no bargain, there are no big buyers.In time, prices will go up as the bonds leaving Venezuela are absorbed by the international markets.

This is the Bolivarian Arbitrage, another artifact of the distortions and complicated schemes the Government has built in around the exchange controls and the large and frequent issuance of bonds. These type of arbitrage has allowed many people in the past few years to make a lot of money, it was just not as obvious to the average person because the bonds were never identical like this time.

VIII.- Making money with the Bolivarian Arbitrage

Let me give you an example. Suppose you had a Venezuela 2010 bond in 2009 which you bought at 70-75% in the middle of the world financial crisis. In August of 2009, that bond was back up at 94% when PDVSA announced a Petrobono 2011 with no coupon. This 2011 bond came out at around 64%, you could have sold the 2010 and bought the Petrobono 2011. Then, PDVSA issued the PDVSA 2014, which was sold at around 56% when the Petrobono was already at 82%. Then, you could have sold the PDVSA 2014 at around 63% to buy the Global 2022 at 76%. In that sequence, ignoring interest, you would have made over 100% profit in less than two years and now you are ready to make some more money again, switching to the PDVSA 2022.

IX.- The risk of playing this game.

The risk, obviously is that one day you will not get paid if Venezuela decides not to pay and the bond will drop to around 30-35% of its face value, the so called recovery value. (That is why some people buy the long dated bond, which trade around 45%) You will lose a lot of money, in fact, you will lose all your gains. Of course, everyone assumes they are so smart that if that ever happens or comes close to happening, they will have no Venezuelan bonds in their portfolio by then. They did not expect Russia to default in the 90’s or Argentina in the new century. They both did.

Of course, that is what markets are about. Some think oil is going to soar. Others that the Government will change. Many that Venezuela can do this for a few years without defaulting. Everyone has a different opinion on it.

In the meantime, they will continue riding the Bolivarian Arbitrage.

X.- Why this is so crazy.

But this whole thing is absolutely crazy and it should not be this way. Venezuela’s risk premium is high because of the constant  supply of bonds to the market and the non-transparent way in which things are done. If the Government set up a road map every year telling markets exactly how much it will issue and in roughly which part of the year, the risk premium would go down, the debt would not be as costly. Instead, after telling investors for weeks there would be no issuance in the first few months of the year, PDVSA surprised them with this bond. A road show abroad by the Government once in a while to explain its finances, would also not hurt either.

Additionally, there is no justification for the overvaluation of the currency in these sales. Venezuela has high inflation because monetary liquidity keeps going up and up while productivity goes down and down. It is the classic inflationary set up. But instead of attacking the real causes of inflation, the Government decides to sell these dollars cheap to those that have access to them. It is in the end a subsidy to the well to do and to foreign investors, who are as happy as can be investing in yields that are impossible to find anywhere else in the world.

But it is a crazy scam that will one day come back and get us. It is the Bolivarian Arbitrage.

44 Responses to “Bolivarian Bond Arbitrage for Dummies”

  1. pjk Says:

    wow. nicely done.

  2. jb Says:

    it couldn’t be better!!! thank you very much for taking the time to lay it out this way! congrats!!!

  3. Aristo Says:

    Very nice.

  4. A_Antonio Says:

    You really make your homework. :-)

  5. moctavio Says:

    A_Antonio: I breathe this stuff as part of my job.

    Somone objected to me saying that the Government is financing capital flight. Since no dollars leave the country when the bonds are issued. My take is simple, this is precisely why you are financing it, the country is selling cheap dollars which will have to be paid in the future at a higher price.

  6. Kepler Says:

    Miguel,

    Excellent post. I referred to it in a German one.
    I am a dummy in economics, but I am puzzled people like your colleagues fail to see it as capital flight finance. If they have that attitude (I am sure they understand pretty well the consequences), what to expect from the rest of Venezuela’s population that may eventually have some influence in this kind of process?

  7. Miki Says:

    De pana viejo, tremendo articulo…

  8. Pygmalion Says:

    Good way of making money and well thought out. An aside – Miguel – you say that the risk is if the government says it will not pay (defaults?) Since 1998 has the Venezuelan government ever reneged on paying the bonds it has issued? Just a question to put my mind at rest since we all know that the government is on the verge of bankrupcy. Correct?

  9. Kepler Says:

    Pygmalion,
    Try to answer to this:
    will Venezuela’s oil prices keep going up 26% year after year?
    If not, can you interpret this chart I drew some weeks ago?

  10. Nedsram2000 Says:

    Thanks for that. Great post, meticulously explained.


  11. Pygmallion: Country’s dont default until they do, at the current rate, if Venezuela sells 9 billion a year in bonds, you can be sure that unless oil goes to 200 dollars, Venezuela will default, is very simple math. The fact that it has paid so far is absolutely meaningless and irrelevant.

  12. Pygmalion Says:

    I am sure of one thing – if your calculations were so correct, no one would even think about buying these bonds. Arrogance always oversteps itself, Miguel, as it did with the casas de bolsa and the estafadores inmobilarios.


  13. Venezuela has the worst risk premium in the world, the worst, not the second worst the worst BY FAR. Clearly I am not the only one making the calculations and you obviously don’t read what I write, I said:

    “Of course, everyone assumes they are so smart that if that ever happens or comes close to happening, they will have no Venezuelan bonds in their portfolio by then. They did not expect Russia to default in the 90′s or Argentina in the new century. They both did.”

    That is the key, they think they will collect 16% and get off on time.

    Do you have a calculation? It’s trivial. Add 9-10 billion a year, how many years before we can’t pay?
    And, of course, markets are never zero or one affairs. At 44%, a PDVSA 2027 bond has a downside of 9% with a yield of 16-17%, collect a few years and you make a bundle. So, that statement about “nobody” show ypu have no clue what you are talking about. Every bond has a buyer…at a price…which is why Venezuela’s bonds yield 14-18% today.

    I do have a calculation. I know exactly how many years this can go on at these levels of oil, which does not mean that Hugo will not decide not to pay before that. That is exactly my worry, not the calculation.

  14. Isa Says:

    Miguel, the best argument is the one you gave in Twitter: Egypt in the middle of its “crisis” was yielding 6.3%, while Venezuela, same year, was yielding 16%. Can it be any clearer than that?

  15. GeorgeS Says:

    Mathematically it is very simple. Venezuela issues 10 billion dollars per year, because IT DOES NOT HAVE THEM. At 10%, this is one billion dollars more in interest added to the total each year. Which means that next year, you need 11 billion, not 10 (Which is what we have seen, each year, there is one or two more of issuance). The problem is that Venezuela has to pay at least 1.5 billion in capital per year and some years more.Which implies that in 6-7 years unless the model is changed, you are bust: DEFAULT!

  16. A_Antonio Says:

    In other words, this is a kind of gambling, you buy and hold the Bonds expecting a return 16%, making a bet of getting out of it, before default.

  17. island canuck Says:

    The stupidity is just amazing.

    This morning we wake up to the announcement that the government is going to reduce the amount of gasoline used in the country by 16%.

    http://www.lapatilla.com/site/2011/02/15/gobierno-decidio-bajar-16-consumo-interno-de-gasolina/

    The emperor said on Sunday that the government was subsidizing the cost of gasoline by 90%. I don’t believe that. It has to be more. Just the cost of transportation must be BsF.0097 not even talking about pumping the crude, refining it, transporting it & then selling it as well as all the back office stuff like accounting, collecting payments, etc., etc.

    His solution – rationing! You gotta be kidding.

    What about this novel idea Hugo – just raise the price like you should have been doing for each of the last 12 years. That will bring in more money & cut consumption.

    Rationing. LOL!

  18. moctavio Says:

    No, people dont see it as gambling. Some think they will get out in time. Others that oil will keep going up and there will be no default. Others that Chavez leaves in 2012 and issuance of large amounts will stop. Others are just in for the trade: They buy the new bond, ride it to the reasonable value and get off. And so on..

  19. aleksanderboyd Says:

    Thanks very much for this post Miguel. The way I see it, from my economy-ignorant viewpoint is, this is nothing but a reenactment of Bernie Madoff at country level. The regime keeps issuing bonds, so that it can keep collecting money to pay those they have issued in the past. I could well be wrong, but Bolivarian Arbitrage seems like a gigantic Ponzi scheme.

  20. moctavio Says:

    In the end it is, because if you dont change the model and stop issuing or have the price of oil soar, you will not be able to pay.

  21. aleksanderboyd Says:

    So could we then argue that Bolivarian Arbritage of the XXI century is nothing but a gargatuan, XX century Ponzi scheme?

  22. moctavio Says:

    Well, not quite, very soon, it will become so expensive to issue that they will look for cheaper alternatives, other than selling bonds. As they issue more and more the market will ask for a higher and higher yield. It is in the end a self-correcting mechanism.

  23. Kepler Says:

    Cheaper alternatives? What’s left? Selling off Venezuelans’ first-born babies or selling out land not to Russians now but to the Chinese?

  24. moctavio Says:

    In December 2009, 14 months ago, the Ukraine and Venezuela had exactly the same yield. The Ukraine reached an agreement with the IMF and got a huge loan very cheap, today the Ukraine yields less than half of what Venezuela does.

  25. Kepler Says:

    Hm…I read something about Ukraine in Der Spiegel some weeks ago…it is just a soap opera for Soviet zone news junkies only
    (you can do MT on

    http://www.spiegel.de/spiegel/print/d-75936269.html

    )
    but this sentence sticks out:

    “But Kiev itself is also short of money. Since the outbreak of the world financial crisis it lives from credits from the IMF alone”

  26. An Interested Observer Says:

    Come on guys, default isn’t the only option – there’s always hyperinflation when they print extra currency to pay…


  27. Yes, they can devalue to contract demand to levels such that they can pay the debt, but I am not sure under that scenario, they will be able to issue.

  28. lo cal Says:

    Great post. Thanx for spelling things out so clearly.
    Now I’ve got a problem –
    I need Bolivares for personal use in Caracas.
    So which bank [Mercantil Commerce?]
    should I go to with my US dollars to buy Bolivares?
    Cheers, Lo

  29. moctavio Says:

    Find a friend! They will love to buy them from you at a better rate than 4.3

  30. lo cal Says:

    Thanx moctavio,

    But it will have to be a transfer to my vzlan provincial account.
    I won’t be carrying greenbacks in my hands…
    Cheers

  31. lo cal Says:

    A year or so ago, I could do it with EconoInvest,
    so nowadays is there a broker or bank outside of
    vzla that sells vzlan bonds for US$ to be redeemed in Bs?
    Thanx

  32. moctavio Says:

    lo cal: No, as far as I know there is no legal way for exchange other than the Government’s and what we call “friends and family”

  33. lo cal Says:

    Thanx moctavio
    Cheers, lo cal

  34. leo Says:

    Por favor, traduzcan este post, es sumamente dificil tratar de hacerles entender a alquien en un pais normal, perdón, en el resto de los paises del mundo, como es eso de un control de cambios, bonos, etc.

  35. moctavio Says:

    Prometi hacerlo a unos amigos, lo hago este fin de semana.

    Miguel

  36. Edouard Says:

    Excellent post, thanks. Question for you: what do you think of the ELECAR 18 bonds? I see that the yield is like 20%, which is significantly more than VENZ or PDVSA bonds. Thanks for any comments on these.

  37. moctavio Says:

    The problem with teh ELECAR bonds is that the Government is transferring ownership of ELECAR from PDVSA to CORPOELEC. Thus, your risk is no longer BB rated PDVSA but unrated CORPOLECE which makes no money and has lots of debt. This is why they yield so much more than the other bonds. Even a simple statement by the Government about these bonds would make them rally. Sidetur bonds are in a similar situation. The advantage of Sidetur is that it is sinking fund, so that you at least know you will get part of the capital at 100% even if the bonds trade lower.

  38. Edouard Says:

    Thks for the answer. Who owns CORPOELEC? If it is owned by the state, could it then be argued that it is all the same then? And that 20% is cheap compared to VENZ & PDVSA?

  39. moctavio Says:

    Yes, you could argue that, but…

    Corpoelec is run independently and if it found that it had no dollars to pay a coupon, it could delay payment a few days, until teh Government gives them the dollars. In contrast, the Government is on top of all of its payments to make them in time.

    The Sidetur bond is an example. The company was taken over by “The State”, there are clauses that say any change of management or ownership represents a default and a call for full payment. The Government ahs said nothing. It keeps paying coupons and capital, but the clause has not been even commented on.

  40. jak Says:

    “why it is that the PDVSA bond issued last week, the so called PDVSA 2022, has a price that is so much below the identical Global 2022 Venezuela bond issued by the Republic last summer”

    Because Chavez and his ministers are STUPID

    My question to Chavez is, What is the definition of a traitor? His policy’s are ultimately destined to destroy Venezuela.
    He will realize if he hasn’t already that everything he has done has been to the detriment of the country, Chavez you just have to define your level of stupidity.

  41. someone Says:

    http://www.wertpapier-forum.de/topic/32942-7000-venezuela-boliv-republik-eo-bonds-2005/page__view__findpost__p__676242

    I hope, this reference is ok:

    “Olala… The situation down there seems to get out of control, PDVSA issued a new bond in February yielding 12,75% to support the “official” exchange rate.”

  42. someone Says:

    By the way, PDVSA just sold the German refineries for astonishing 1,1 billion €.

    http://www.peopleanddeals.de/article/14681/rosneft-uebernimmt-50-prozent-von-ruhr-oel

    This limitied corporation made 1,1 billion € profit after taxes in 2009 as you can see, if you search for “Ruhr OEL” in

    https://www.ebundesanzeiger.de/ebanzwww/wexsservlet

    Either there is a by side deal with Russia to get arms (the buyer Rosneft is mostly Russian state-owned), or it was just given away for some unexplicable reason, though Venezuela has to repay 1 billion Euros of state debt in July. Would fit.


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