Venezuelan President Hugo Chavez faces one of the toughest elections of his life this coming weekend, and the uncertain outcome is leading investors to back off from the country’s bonds.
Interest rates have risen in the last week as investors fear a contested result this Sunday, and in a worst case scenario, unrest and violence.
Chavez, in power since 1999, is facing a much tighter race than many expected against rival Henrique Capriles. While most polls show Chavez still holds the lead, the margin has narrowed since mid-summer, and some polls show a virtual tie.
Eurasia Group’s Dan Kerner wrote to clients this week: “Our view remains that Chavez is favored to win what looks to be a tight election, but that the chances of a Capriles victory should not be underestimated.”
At least two Wall Street firms have downgraded the country’s bonds from buy to hold in the last few weeks, and urged investors to await the outcome of the election before jumping back in.
Exotix’ Stuart Culverhouse, who rated Venezuelan bonds as a buy for more than a year, says he’s now moved to a hold because of event risk. “We are now a week before an election which is a significant event with a high-tail-risk,” he said.
Venezuelan bonds are actively traded because they are one of the few places to find yield in the emerging market space, or anywhere for that matter. They currently yield 11%.
The most problematic outcome for the country’s bonds is if Capriles wins by only a small margin, says Culverhouse, and is prevented from taking power by Chavez. Culverhouse fears widespread protests.
“You could easily see a situation where it just spirals out of control," he said. "I’m not saying it will, but investors are now beginning to factor in that possibility.”
There is great debate about whether the last few elections and referendums have been subject to tampering. CNBC Contributor Jorge Castaneda, a long-time journalist, and former Foreign Minister to Mexico, reported on these issues in Newsweek back in 2009 during a referendum on whether the Constitution should be amended so that Chavez could stay in power indefinitely.
Castaneda wrote:“This was undoubtedly not an exemplary contest. Chávez used every conceivable instrument of the state, every imaginable subterfuge, every trick in the book, to stack the deck in his favor and against his opponents.”
JP Morgan, also long-term bulls on Venezuelan bonds, echoes the view of Exotix. Three weeks ago analysts there downgraded Venezuelan bonds saying “the balance of risks in the aftermath of October 7th suggest the prudent move is to reduce long term exposure.”
JP Morgan breaks down five possible election outcomes and the expected market reaction. If Capriles wins outright and there is a smooth transition (only a 15% probability in their view) Venezuelan bonds would rally dramatically and push their interest rates lower by 400 basis points or 4%. (When a bond rises, its corresponding interest rate falls.)
Also a 15% probability: If Capriles wins and there is tension that leads to “disruptive resistance from hard-care Chavismo that could raise serious doubts about governability.” In that case, Venezuelan bonds would still move higher, but not by as much, leading to interest rates falling 200 basis points or 2%.
The worst case for Venezuelan bonds, is if Capriles wins and there is “the tail-risk event of violence or even a constitutional rupture.” They see only 5% chance of that happening, but it would lead to a dramatic sell off in Venezuelan bonds that could cause the country’s interest rates to rise by 4.5% or 450 basis points.
The most likely outcome, with a 50% chance of occurring, is that Chavez wins by close margin. That would lead to a less dramatic sell off in the country’s bonds, pushing interest rates up 1.5% or 150 basis points.
If Chavez wins by a landslide, a 15% probability, JP Morgan’s analysts believe Venezuelan bonds would sell off as well, and interest rates would rise by 2.5% or 250 basis points.
In the long-term, analysts believe Venezuelan bonds will rally in the face of Hugo Chavez no longer being in power, either due to the election or due to his waning health.
There was a huge rally in Venezuelan bonds from October of last year to June of this year, driven by news that Chavez had cancer and was possibly dying. If he were to die, analysts believe a new government would be more market-friendly.
Chavez’s 14 years of socialist reign have been marked by nationalizations of major industries and companies, along with increased state-involvement in every aspect of the economy, as he pushes forth with his so-called Bolivarian revolution, named after Latin American icon Simon Bolivar.
Still, despite Chavez’s anti-market rhetoric, many analysts have been bullish on the Venezuelan bonds because the country brings in so much revenue from its oil production with is more than 2.5 million barrels per day.
