Cross-posted on Shawn’s blog, Macro-Man.

“The time between the “outrageous” and “yeah, you didn’t know that?” can be incredibly short.”

This tweet was about the Hollywood harassment scandal, but it applies to markets on a regular basis and it certainly did in Venezuela last week.  

Intrigue surrounded the amortization and maturity of two PDVSA bonds, which required roughly $2 billion for bondholders. Sanctions preventing US dollar transactions and new US dollar funding for the regime complicated the already difficult task of cobbling together payments with an absolutely broke government.

And yet… it paid.

PDVSA somehow bundled the October 28th amortization payment across the line, and promised, with some credibility, that the check would be in the mail for the maturity of the PDVSA bond of November 2nd.

Then, one of the more surreal events in the history of sovereign defaults happened: after market hours on Thursday evening, Maduro announced that the government will stop paying principal and interest on the current debt load, the same day they pledged to pay back a bond at par. And what had been a tumultuous but profitable week for Venezuela bondholders, turned into a total nightmare.

The 7% December 2018 bond saw its value cut in half from the high 60s Thursday afternoon, to the mid 30s on Friday, just above what many people use as assumption of what defaulted sovereign debt is worth in a restructuring.

With the wave of Maduros magic wand, “Venezuelan default” went from “outrageous” to “yeah, you didnt know that?”

Heres where “macro” comes in. Those who’ve been following me for the last few months know that I have a healthy skepticism of macro trading strategies. There are traders out there who are constantly ahead of the curve, who see opportunities more quickly and accurately than the rest of the crowd, even in markets they dont trade in every day. But for the vast majority of the universe, there has to be a definable edge when you are doing something the rest isnt, whether it’s a different type of analysis, or taking advantage of some market breakdown or regulatory change.

The different pools of capital in financial markets should produce enough diversity to keep markets “honest” in the same way Leo Messi keeps defenders “honest” because they have to protect against him charging to the goal or threading a brilliant pass to a teammate. You can’t “cheat” towards one or the other because you’ll pay for it.

How did markets miss that Venezuela could default any day? Did they miss out on this chart, which shows nearly $4bn in payments going out the door in Q4 2017, for a country with stated foreign reserves of $10bn?

A few months ago, I talked to some EM managers on the subject. One suspects that (debt holders) are going to start bailing when it’s too late, ourselves included. Anyone that has anything to do with an index gets burned by being underweight, so they inevitably come back. To step out of the position, you would have to compensate, and there isn’t enough risk-adjusted yield to do so elsewhere.”

That’s the “cheat”; for bondholders, Venny debt was a case study of game theory in Emerging Markets. The market structure is set up in such a way that the biggest foreign investors were afraid to sell and afraid to buy. Macro investors should step in and say “Look, the market is pricing a greater than even chance 2018 bonds will be paid at par.  There’s nearly $4bn in bond payments this year, another $10bn next year, versus $10bn in foreign reserves at best, for a country under sanctions that prevent access to new dollar funding.”

Why didn’t they? There’s a few reasons:

  • The capacity of repo markets to lend bonds has been greatly curtailed. After the post- Global Financial Crisis reforms, banks don’t want the risk of lending bonds in a credit on the edge of default. This situation leads to a lot of difficulty in trying to establish a sizeable short position in the bonds, and when you can, it can be prohibitively expensive;   
  • The size and risk appetite of global macro has been overwhelmed by the size of real money investors. The days of George Soros pushing around markets and central banks are over; enter the era of the multi-trillion-dollar passive asset managers such as Blackrock, Vanguard, Fidelity, etc.
  • The liquidity provided by Wall Street banks seized up further when the US imposed sanctions on USD transactions with the regime. A couple key players in the interdealer “wholesale” market stepped out after the August round of sanctions, worsening market liquidity and amplifying the wild swings Venny Bonds are known for.
  • Call it what you will, self-preservation, or the Bachaquero on Wall Street trade, but guessing the date of the Venezuelan default has been a trader parlor game for over three years now more than one hedge fund trader got carried out on the short Venny theme. Traders were lulled into complacency that Maduro would simply find a way. He didn’t.

With macro traders sidelined and real money investors petrified, liquidity dried up and the market became hostage of local brokers and regime insiders, rather than economics and risk. A break that macro traders were unable to exploit… and Venezuelans couldn’t prepare against. It is yet another testament to the power of market efficiency, and the consequences when it breaks down.

The losers in this game? Not the regime, the fixed income investors or even the hedge fund guys that shorted Venny too early: the real losers were the Venezuelans who died because there weren’t enough dollars to service the debt and import food and medicine.  

18 COMMENTS

  1. You are making two structural arguments that are extremely important

    1. “The capacity of repo markets to lend bonds has been greatly curtailed. After the post- Global Financial Crisis reforms, banks don’t want the risk of lending bonds in a credit on the edge of default. This situation leads to a lot of difficulty in trying to establish a sizeable short position in the bonds, and when you can, it can be prohibitively expensive”

    2. The world is dominated by trillion dollars passive funds.

    What you are implying is that in a post 2009 world nobody will risk into risky bond markets because they will find themselves in a bottleneck (lack of liquidities for bulls and for bears at the same time)?

    • Eduardo – On your question #2, I read it the other way around, that passive funds “passively / mandatorily” diversify based on the entire spectrum. You buy 0.05% of Sewer Soup Co. because it is 0.05% part of the index. That’s not new – the size of it may be. Global GDP was estimated at around $50 trillion, the last time I looked about a year ago. At that time, the notional value of derivatives was estimated at over $500 trillion – 10x global GDP. Most of that is very probably very legitimate old-fashioned definition of “hedging”: you sell a billion worth of products in Yen, due in 30 days, so you go to the derivatives (or futures) market and short the Yen against the dollar, to hold your value. I would hazard a logical guess that currency markets have more volume than bond markets which have more volume than stock markets.

    • @eduardo, yes, that is what I am implying, that is certainly the case in high-yield distressed situations like this one. Someday someone will write a dissertation on passive inflows into EM hard currency debt in 2017 and its impact on the funding and ultimately the sustainability of this regime. History shows debt crises are generally triggered by a sudden stop or sudden reversal of capital flows. Well, over the past two years (going back to the nadir in EM and oil prices in early 2016) the money kept flowing in, and the flows into passive money firewalled the bonds from selling by active investors.

      I think that’s the case to a lesser extent in more liquid, developed markets. That being said, the days of bigger bank balance sheets and huge leverage were fraught with their own problems, which is what the latest round of regulations sought to reduce. To be fair to the regulators, there’s no easy solution without unintended consequences.

      • Thank you for your reply. I am now in a position to understand “a dissertation on passive inflows into EM hard currency debt in 2017 and its impact on the funding and ultimately the sustainability of this regime”.

        I think that is one of the most important, never-talked-about topics regarding the current economic situation. EM fund managers having to hit their asset’s class quota and Chavismo saying Oh my god, they are lending me money my my…

        Thanks for clarifying this.

  2. “Shawn is a portfolio manager who has yet to find a decent arepa in his home state of Minnesota”

    Rochester. Not that they can be purchased… the aunties are constantly pumping out various incarnations every Sunday evening (chicken and avocado most recently) when the extended family gathers. Norwegians I believe are genetically incapable of creating an edible arepa.

    Other than expats, I doubt you can find them, even down here in the tropical southern part of the state.

    • There are lot places in Texas, California and Florida that sell them. I even located some in Edmonton and Fort McMurray, Alberta that sell them – for Tar Sand ex-pats – when I used to go there. There are many Venezuelans that had to get used the cold there. But they a future there.

      • Been there…good but not great the one time I was there. I’d like to give it another shot. But duly noted! I should amend my bio to say I’ve yet to find a *fantastic* arepa in Minnesota.

  3. Maduro is probably trying to pull off an Ecuador and ‘restructure’ the debt through what is essentially insider trading. Drive the bond prices down and buy them yourself when everyone thinks they’re toxic. Twenty years in a civilized country but a sound economic policy in Latin America apparently.

  4. If thats what he is doing , then good for him , buying bonds on the cheap to save on paying their full value is something smart that helps the economy , already in a highly distressed situation, I am skeptical though in that they are really broke and incapable of buying many of such bonds even at baseman prices , if he goes for that he will need the chinese or russians to help out with big amounts of money which they may not want to risk or which will ultimately have to be paid by the country giving them a free hand to take possesion of our resources….!!

    • All this could be, but Venezuela probably doesn’t have the funds necessary to buy back any significant amount , nor would Russia/China be likely to participate, except maybe only for a small amount/short-term fix. This smells more like they’ve run out of way-overstated intl. reserves, and “mientras como vaya viniendo, vamos viendo.”

  5. repo markets?, risk adjusted yield?… You even “threaten” us with an article about “passive inflows into EM hard currency debt”. It seems that all this was written for other traders, not the general public. I think it would be better to use a less technical way to talk about these issues.

    • This definition of macro in the link below might help. Apparently it’s a new word or refinement of the [archaic notion] of fundamental analysis. Fundamental analysis looks at causes and effects, as distinguished from “risk analysis” which is based on probabilities of events based on past occurrences, and “technical analysis” which is based on charts and includes such things a trendlines and market momentum. This isn’t complicated stuff, it is the jargon developed that confuses things. It’s the same thing with acronyms – you get some groups to whom “CD” is a disk with music, and others to whom it is a certificate of deposit.

      http://www.sevendaysahead.com/what-is-macro-trading.html

      An interesting paragraph:

      “Macro Traders need to understand and anticipate the actions of big players like Governments, the World Trade Organisation and OPEC. These big players have access to economic levers which they can pull to directly affect trading markets. This ranges from raising or lowering interest rates to restricting the supply of a scarce commodity over which they have control like oil or gold or aid. Big players are driven by social economic and political forces which the dealer needs to understand.”

      Is Venezuela losing its ability to influence markets?

      As to where some of the money came from, the regime forfeited gold deposited at Deutsche Bank. The gold was security for a loan of, I believe, $1.2 billion. As part of the agreement, the regime received an additional $400 million cash. Dolar Today had an aritcle (reprint) that said something about 90 tons of gold, but didn’t say when the loan originated, so the price of gold at the time isn’t in the article, but taking $1,000 an ounce as ballpark, and assuming they mean short tons (1,000 pounds of 16 ounces a pound), 16,000 ounces a ton by 90 tons is 1,440,000 ounces at $1,000 an ounce is $1.4 billion, so it’s in the ballpark. Then Reuters gave the total transaction value at $1.7 billion, so that fits the picture. (The loan was $1.2b and the cash was $400m, so somewhere I didn’t read carefully enough.)

    • @Rafael, I think that is a fair criticism. What I want to express is how and why markets have failed the Venezuelan people because they did not operate in a way that held the regime responsible for their fiscal profligacy, and arguably aided and abetted the actions of the regime over the past three years. Heck, markets even failed *the bondholders*, who saw the managers they hired sit on their hands while the value of their bonds got cut in half last week. Digging into why that happened requires getting into the details. It is a tough line to walk–i see financial journalists doing a poor job of it many times. Most people can probably think of an example where they have seen a news story written by an outsider journalist about their area of expertise that was way too simplistic, missed the larger point, was outright wrong, or some combination of all three. I hope I was able to bring an insider’s viewpoint to a complex issue that is all too often oversimplified in the media.

      • Shawn – You got the major point across, and it is a very fuzzy area, not because the mechanics are complicated, but because there are different emotions, reasons, equations, and all for each of the holders or potential holders, sellers, hedgers, and they all want to keep the reasons for their orders secret. Not to mention the spreads in thinly traded or oligarchically owned (96% owned by institutions who follow the Penguin Playbook https://www.youtube.com/watch?v=Q6S42U4M09Y) issues generally – viz the dive in the price on the chart.

        I’d encourage you to write another article about it for two reasons i) it may help bring clarity to bondholders if they ever read it, and so help put pressure on, ii) it might even help the market oligarchy clarify their philosophies.

      • Shawn, I’m not sure markets should have “…held the regime responsible for their fiscal profligacy.” Markets simply make an educated guess on risk-reward, present and future, and act accordingly, usually in a fairly efficient manner, changing as circumstances change. Markets are certainly somewhat less-efficient in the murky dealings of emerging markets/distressed debt, and fund managers, judged on quarterly performance vs. peers, are constantly reaching for that extra fraction of a % yield which will allow them to keep their jobs for a while longer. In that respect, to include Venny debt, or not, and in what proportions, becomes sort of a Game of Chicken, where you may be damned if you don’t, damned if you do, the latter as evidenced by recent events in Venezuela. Sure, the macro changed with U.S. financial sanctions, but the real underlying fundamental factor of financial inability to pay was decisive, only the timing of which was being bet on in the markets by the fund managers, in a giant Game of Chicken.

  6. Maduro did not announce that the government will stop paying principal and interest on the current debt load, it announce that they will start a restructuring process while continuing to service the debt as usual. Default day has not yet arrived, even if there is a non-negligible risk that it could be as soon as tomorrow.

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