Venezuela Sanctions Could Shake J.P. Morgan Index -- WSJ

This article is being republished as part of our daily reproduction of WSJ.com articles that also appeared in the U.S. print edition of The Wall Street Journal (August 25, 2017).

What will J.P. Morgan Chase & Co. do? That question is weighing on emerging-markets debt investors as the Trump administration considers sanctions that could affect the ownership or trading of Venezuelan debt.

The reason: J.P. Morgan is the backer of the most widely followed emerging-market bond index, the J.P. Morgan Emerging Market Bond Index. Depending on their form, sanctions could in some cases require the bank to remove Venezuelan debt from the index.

That, in turn, could roil the emerging-markets bond world. Pension and investment funds globally could try to dump the debt for fear of falling out of step with the benchmark index's performance.

So far, it isn't known whether the U.S. government will take action. The Trump administration is considering banning trading by U.S. banks of new debt issued by Venezuela or its state-owned entities, and possibly imposing restrictions on some existing debt, The Wall Street Journal reported this week. Potential moves would be aimed at weakening a government that Washington says has moved toward dictatorship.

"In the event that there would be a ban, it would certainly require market participants to try to liquidate positions," said Sean Newman, a senior portfolio manager who runs Invesco Ltd.'s emerging-market fixed-income team. He added that investors still think it is very unlikely the U.S. government would take such a dramatic step.

BlackRock Inc.'s iShares, which manages the largest exchange-traded fund tracking the J.P. Morgan Index, is keeping its Venezuelan investments in line with the index, said Benjamin Souza, Latin America strategist at BlackRock. Selling in anticipation of a potential ban could backfire if Treasury picks a different option, "and we don't want to create tracking error," he said.

Ultimately, the fund's exposure to Venezuela will depend on the severity of the measures Treasury imposes, according to Mr. Souza. The Treasury could bar U.S. investors from owning Venezuelan bonds altogether, forcing them to liquidate their holdings, or it could take a more lenient approach, allowing fund managers to keep previous purchases and block them from buying bonds in the future, he said.

Several other firms, including Morningstar, Markit, Barclays PLC, Citigroup Inc. and Bank of America Corp., have emerging-market indexes that have exposure to Venezuela debt. But J.P. Morgan's measure is the most widely tracked by investment funds; Venezuela comprises about 1.51% of the index.

Reports earlier this week that the administration was considering sanctions initially caused the price of Venezuelan debt to skid, but bonds rallied strongly Thursday on news Russia and China are throwing a lifeline to the embattled Maduro regime. Prices of PdVSA bonds due on Nov. 2, jumped 6.2% to 93.98 cents on the dollar; Venezuela's 2035 bonds gained 5.6% to 37.55 cents, according to MarketAxess BondTicker.

A Reuters story, citing oil traders, said Russian oil company Rosneft has sold its quota of Venezuelan crude for the remainder of the year to several buyers, including U.S. firms. This sale would essentially provide Venezuela with fresh cash, analysts said. Some U.S. refiners have struggled to buy Venezuelan crude as U.S. banks refused to extend letters of credit that buyers need to complete imports from Venezuela.

Whether any sanctions would affect Venezuela's position in the J.P. Morgan index would come down to the benchmark's rules for inclusion.

One of the biggest issues is whether sanctions would affect the trading of outstanding debt, or secondary market trading. That is because debt in the index must meet minimum liquidity thresholds; bonds have to have daily pricing available from a third party.

Failure to meet those thresholds could cause bonds to be removed from the index, according to people familiar with its workings.

"As with most indexes, ours are rules based and simply reflect the more liquid securities in the global marketplace," J.P. Morgan spokesman Brian Marchiony said. Since 2010, the bank has made available to investors a version of the index that excludes Venezuela, he added.

Since an index is meant to replicate market reality -- what is being bought, sold and traded -- investors have to be able to replicate the index. If an investor is using J.P. Morgan's index as a benchmark, then a certain percentage of a portfolio should be invested in Venezuelan debt. Otherwise a fund could have what is known as tracking error.

While an outright ban of trading in Venezuela debt would be a dramatic step, the U.S. government would likely give investors a road map for dealing with holdings caught up in the sanctions, said Shamaila Khan, director of emerging-market debt strategies at AllianceBernstein Holding LP. "Any sanction that restricts secondary trading would have to provide some clause or ability to deal with this situation," she said.

Still, bondholders are dealing with a lot of unknowns, Ms. Khan added.

Should sanctions be imposed that affect secondary market trading, a determination by J.P. Morgan as to the liquidity of Venezuela's debt wouldn't be automatic. The bank has an index group that meets monthly, or more often if there is a major event, to assess the liquidity of every bond in the index.

So far, J.P. Morgan hasn't called for internal meetings yet on this or the possibility of sanctions, according to people familiar with the matter.

This isn't the first time J.P. Morgan has faced issues with countries in this index. When the U.S. Treasury Department in 2014 barred U.S. financial institutions from participating in new bond sales by Russia, the secondary market remained active. Therefore, there wasn't an impact on the index.

J.P. Morgan previously has also offered a version of the index excluding Russia as well as Argentina since investors may not want to invest in countries that are very volatile. The bank also eliminated South Korea from the index when its credit rating improved after the Asian crisis and it no longer met certain index criteria.

Matthieu Wirz, Justin Baer and Carolyn Cui contributed to this article.

Write to Emily Glazer at emily.glazer@wsj.com

(END) Dow Jones Newswires

August 25, 2017 02:47 ET (06:47 GMT)