Bond ETFs grapple with fresh US sanctions against Venezuela

On page seven of the prospectus for BlackRock's flagship emerging markets debt ETF, known as EMB, there appears the following risk about investing in Russia (emphasis ours):

Investing in Russian securities involves significant risks, including legal, regulatory and economic risks that are specific to Russia. In addition, investing in Russian securities involves risks associated with the settlement of portfolio transactions and loss of the Fund’s ownership rights in its portfolio securities as a result of the system of share registration and custody in Russia. A number of jurisdictions, including the US, Canada and the European Union (the “EU”), have imposed economic sanctions on certain Russian individuals and Russian corporate entities. These and future sanctions, or even the threat of further sanctions, may adversely affect Russia’s economy and the Fund’s investments.

Much to BlackRock's chagrin, the same can be said for Venezuela, especially in light of the US Treasury's decision on Monday to expand the list of Venezuelan securities now subject to sanctions.

Ever since the US first issued restrictions that US citizens could hold but not buy Venezuelan debt in late January, trading in the country's sovereign and PDVSA bonds has halted. Given this lack of liquidity, JPMorgan, which manages the most popular EM debt benchmarks, is considering dropping Venezuelan debt from its indices. JPMorgan did the same with Russia's Rusal bonds in April, following US sanctions on the country.

Should JPMorgan do this — a move which typically comes at the end of the month — funds like EMB that track JPMorgan's indices could be forced to offload their holdings at a time when broker screens have essentially gone blank and there are no market makers.

According to Jane Brauer, a sovereign debt fixed-income strategist at Bank of America Merrill Lynch, of the $350bn that tracks JPMorgan EM debt indices, roughly $16bn is invested in Venezuelan sovereign and PDVSA bonds. One of the largest of such ETFs — a $28bn iShares fund — holds around $1.1bn worth of these assets, according to Brauer.

In a new note, Brauer offers up some ideas about how this could play out if JPMorgan removes the bonds from its index and the Treasury's trading restrictions remain in place.

In that scenario, she writes, "investors and ETFs will be stuck with their [sovereign/PDVSA] bonds and it will be impossible to track the index." ETFs will also be "unintentionally overweight," considering that there's no market to sell the bonds and downsize positions. And as prices fall naturally from the drying up of liquidity, she warns that many funds are set to underperform the benchmark.

Not all investors will lose, though. "The winners will be non-US hedge funds that are not seeking a lot of diversification and have deep pockets," she says.

What's more, according to Brauer:

Those with a high estimate of recovery value would find the low prices attractive. However, some of those hedge funds may tend toward litigation as a tool to maximise their return over all other investors.

It looks like the already messy debt restructuring process is set to get a whole lot messier.

Related Links:
Venezuelan bondholders face an uphill battle for repayment - FT Alphaville
Venezuela sanctions pose conundrum for bond ETFs
- FT
Puzzling new sanctions for Venezuela's bondholders
- FT Alphaville

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