Big investors are betting on regime change in Cuba

Havana, Cuba, The Ministry of the Interior located in the Plaza de la Revolucion.
Donald Nausbaum | Getty Images
Havana, Cuba, The Ministry of the Interior located in the Plaza de la Revolucion.

Some big-money investors are betting on a regime change in Cuba.

As many as ten hedge funds in London have amassed positions in Cuba's long-unpaid debt, according to a market maker who has served as middleman on the trade. Of the ten, two in particular hold the greatest concentration, as does one private individual, a separate source said.

Recent rumors that former leader Fidel Castro may be dead or on life support are leading to speculation that these positions—some of which have been held for years—may finally pay off.

These investors hope that once Castro dies, there is more likely to be a "normalization process" (a term used among emerging markets investors) that would include the settlement of past-due obligations.

Cuban debt has traded between 6 to 10 cents on the dollar for the last decade, when it trades at all, according to Exotix Limited of London, a frontier market investment banking boutique specializing in illiquid bonds, loans, and equities.

An investor presentation made by one hedge fund, and obtained by CNBC, suggests Cuban bonds could ultimately settle somewhere between 26 cents to 49 cents depending on the outcome of future negotiations, leading to returns of between 180% to 512%.

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Because of the U.S. embargo against Cuba, American investors are prohibited from owning Cuban debt—a situation that frustrates some frontier-market hedge-fund managers in the U.S. They argue that holding Cuban debt would better serve U.S. foreign policy interests because it would give Americans a seat at some future negotiating table.

Leadership change is frequently good for deadbeat sovereign bonds.

Iraqi debt, for example, traded at 10 cents for years during the period of U.S. sanctions against the country. After the U.S. invasion, a debt settlement was negotiated, and with past-due interest, bond holders received 32 cents on the dollar.

Liberian debt traded at 3 cents on the dollar in the 1990s. When former World Bank economist Ellen Sirleaf became president, the country bought back the debt at 21 cents—the high price due to substantial past-due interest.

When the U.S. embargo against Vietnam was lifted in 1993, Vietnamese debt appreciated 500% in five years. In Yugoslavia, after Milosevic was deposed and the embargo lifted, the country's debt skyrocketed almost immediately in September of 2000.

When holders of bonds make claims against countries for unpaid debt, they aren't just asking for the payment of the principal, they also make a claim for past-due interest or PDI. The longer the bond is unpaid, the more the PDI grows, through the power of compounding.

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Thus, even if there is a substantial write-down of the country's debt, there is still a handsome profit to be made if the fund has bought at a low enough price. Exotix most recent estimates on the value of the past-due interest on the Cuban bonds ranges from 182% to 193%.

The Cuban government defaulted on certain debt issuances in 1986, despite multiple restructurings in the early '80s. It was mainly contracted in the 1970s and is denominated in either Japanese yen, Swiss francs, German Deutsche marks (which don't exist anymore) and Canadian dollars .

The face value of the bonds is equivalent to roughly $3.2 billion, according to Exotix which quotes a report from the Cuban Office of National Statistics.

(Castro defaulted on $52 million of U.S. dollar denominated bonds on January 1, 1960. Known as Batista bounds, they don't trade as most market participants consider them to be worthless. Dusty old copies of the Wall Street Journal make frequent reference to "Cuban 77s, " bonds with a maturity date of 1977.)

Current U.S. law dictates that before the embargo against Cuba can be lifted, the island nation must come to some settlement with U.S. corporations whose businesses were seized by the Castro government in 1960. Additionally, if Cuba is to reenter the world of modern finance, it must settle its debts with what is known as the Paris Club and the London Club.

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The Paris Club is a group of nations that get together and negotiate settlements on government-to-government debt. The London Club negotiates settlements of loans to countries that were extended by private institutions such as banks. Historically, the Paris Club takes precedence and the London Club often accepts the same terms.

Of course, there is no guarantee that once Fidel Castro dies, anything will change. His younger brother Raul has taken over, and while he has said publicly it is important that Cuba reestablish credibility with its lenders, it's not clear that is going to happen anytime soon, at least not with the United States.

However, another potential catalyst for an improvement in relations between the U.S. and Cuba, and hence an improvement in the value of the bonds: the U.S. presidential election.

Owners of this debt are optimistic that if President Obama is reelected, he will loosen up restrictions on trade with Cuba, as he would no longer need to worry about reelection. If Romney wins, the assumption it's another four years of the status quo.

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What will complicate future negotiations is the all the other money Cuba owes to other entities including Venezuela, Russia, and China, Spain, and Japan—just to name a few.

Russia wants to reclaim what it says is $21 billion of aid during the time of the Soviet Union. Cuba refuses to even acknowledge that debt, though a report last month out of Russia suggested that once again they were in negotiations.

It's unclear how much money Cuba owes Venezuela because it receives oil at discounted prices and sends doctors to Venezuela in return.

(Read More: Venezuela's Chavez Hails "Perfect" Democracy, Mocks Tyrant Image )

While Venezuelan President Hugo Chavez is still alive, there likely won't be much pressure to make good on any past-due debt. But if the relationship changes, so could the leniency shown to the island nation.

—By CNBC's Michelle Caruso-Cabrera