da Market Axess
Swaps Market Prepares for a Venezuelan Default
Venezuela is really feeling the pinch from sliding oil prices. Now its bonds are in such bad shape that some investors are treating the country's default as a near certainty.
And they are taking action. How? Well certain banks have started to offer swap contracts that allow investors to fix the amount they can recover on insurance bought against a restructuring of the country's debt, according to investors.
If CDS contracts are triggered, the cheapest Venezuelan bonds trading in the market at that time will be used to determine payouts to protection holders. Those not wanting to take any chances that this CDS auction produces a lowball number can enter a swap to lock in their payout level now.
The appearance of these instruments -- known as recovery locks or swaps - usually acts as a prelude to a debt restructuring. Recovery locks were briefly seen on traders' screens in the run-up to Argentina's default in July and, prior to that, around the Greek restructuring in March 2012.
Investors' views on Venezuela continue to sour as a result of tumbling oil prices. Venezuela's oil basket, a mixture of crude oil and refined products, is currently $68 per barrel and is expected to fall to $66, say Morgan Stanley economists. That compares to an average of $92 year-to-date for the Venezuela oil basket. The country relies on the black stuff for 96% of its export revenues.
Venezuela's 2027 bonds have plummeted to a cash price of 51.5 cents in the dollar, while the cost of insuring against the country's default as measured by five-year credit default swaps hit a new high of 2,749bp yesterday, according to Markit.
That means investors have to pay $2.7 million a year to insure against the default of a notional $10 million of Venezuela's five-year bonds. This compares to $2.2 million on Friday and lows of $894,000 this summer.
Some analysts still think a default can be avoided. "We are not that bearish on Venezuela and believe that it could avoid a credit event in the next 12 months" said Robert Tancsa, a fixed income strategist at Morgan Stanley.
Still, investors said Goldman Sachs was one of a handful of dealers quoting one-year recovery swaps on Venezuela at a bid-offer spread of 30/34 on Monday, while five-year swaps were trading at 27 to 32 cents on the dollar.
This means investors who think Venezuela will restructure its debt within the next year can lock in the amount they will recover on their CDS protection at 34 cents on the dollar, or buy a five-year hedge to recover 32 cents on the dollar.
This is almost a 20 point discount from where the bonds currently change hands, suggesting the market in recovery swaps may still be finding its feet -- or else takes a much dimmer view of recovery prospects than the bond market.
Academics Carmen Reinhart and Kenneth Rogoff called Venezuela the "modern-day sovereign default champion" in their 2009 book This Time Is Different, noting it has defaulted 10 times since it achieved independence in 1830 -- an average of once every 18 years.
