Venezuela's dollar-denominated bonds, which have fallen to trade as low as a third of their original value after pricing in the likelihood of default, are attracting the interest of hedge funds jostling to take advantage of any future debt swap.
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Venezuelan dollar bond prices fell sharply again on Tuesday after Sunday's election expanding President Nicolas Maduro's powers brought sanctions from the United States and plunged the country into a new political crisis.
Two opposition leaders were seized overnight from their homes in what critics called an expanding crackdown.
Sovereign bonds, maturing 2038, traded around 36.5 cents on the dollar on Tuesday, a 13-month low. The 2037 bond of state oil firm PDVSA fell to 31 cents .
While Monday's sanctions don't cover Venezuela's oil sector, the White House has made clear that the door is open to further steps. Energy sector curbs would deal a devastating blow given the United States is the country's No. 1 crude importer.
Few investors believe Venezuela, rocked by daily protests and facing a humanitarian catastrophe with shortages of food and medicines, can dodge default for much longer.
Betting the endgame is not far away, some are piling back in.
"We do have some exposure to Venezuela now ... and we're in the middle of putting on new trades," said Jason Maratos, founder of London-based hedge fund Onslow Capital Management, whose fund holds sovereign and PDVSA bonds.
Some hedge fund managers believe the writing is on the wall for Maduro, who is highly unpopular with Venezuelans, Western powers and Latin American neighbors for driving the economy into the ground.
Deep in recession, the country suffers the world's highest inflation rate. Central bank reserves are estimated at less than $10 billion.
Of the $120 billion of Venezuela's external public debt, around $48 billion is in bonds, according to estimates by brokerage Exotix Capital, based on central bank data from end-2015.
Although Maduro has steadfastly prioritized debt repayments over food imports, any future government is expected to immediately open negotiations to restructure the debt.
That will almost certainly result in significant writedowns on bonds' principal - haircuts in bond parlance - but investors reckon the securities are still a good buy at current prices.
"If you get a more rational government, they could pursue a debt restructuring, which – if done in a credible way, associated with credible economic policies – you could end up with bond prices higher than where they are today, despite the fact you get a haircut," Maratos said.
Adar Capital Partners, a hedge fund based in Israel, also sees Venezuela as a buying opportunity.
"We bought bonds with very low prices so there is capital protection and some upside in any event," Zev Marynberg, Adar's chief investment officer, told Reuters on Friday.
The timing of any payback depends on how long Maduro can hold on and the severity of U.S. sanctions, which if imposed on the energy sector would also hurt U.S. refiners and U.S. firms that operate in Venezuela such as Chevron.
A person familiar with the White House deliberations said an "escalatory process" could follow the latest sanctions depending on how far the Venezuelan government goes in implementing the newly minted constituent assembly.
The co-founder of one London-based hedge fund, who requested anonymity because he was not authorized to speak to the media, sold his Venezuelan bonds recently but is tempted to return.
"We think this likely is a buying opportunity, but we are a little gun-shy," the manager said.
Analysts at Oxford Economics, a global advisory firm, has advised clients to "buy the dip." UBP emerging markets macro and FX strategist Koon Chow told Reuters the bonds could at least recoup the 20 percent lost over the last month if it becomes clear Maduro is on his way out.
In May this year, Goldman Sachs confirmed it had purchased $2.8 billion worth of Venezuelan bonds at around 31 cents on the dollar, maturing in October 2022.
Some investors have been encouraged by the case of Ukraine, whose 2015 restructuring agreed with creditors inflicted a 20 percent haircut on debt principal but also awarded bondholders a juicy 7.75 percent coupon and extra payments linked to future economic recovery.
Some fund managers believe Venezuela, with some of the highest crude reserves in the world, will see recovery in oil production, exports and economic growth once its investment-starved energy sector starts receiving capital inflows again.
Not everyone is so bullish, however. Exotix Capital warns that holders of Venezuelan bonds could recoup as little as 40 cents in the dollar after a default and restructuring, given the extent of the country's economic mess. But it sees the most likely recovery value around 52 cents.
Patrick Esteruelas, head of research at Emso Asset Management, says many investors could be underestimating how long it would take to stabilize the country's politics, how complicated the debt restructuring process could be and the potential for more losses before any eventual agreement.
"It's possible (to make money on the bonds) but depending on how soon and how quickly you can see a transition to a regime that is willing to do the hard stuff," Esteruelas said.
He noted the bonds hit record low prices around 20 cents in early-2016, which could happen again.
"You could be stuck with a mark-to-market loss on your books for an extended period of time...I think it's too early to just wade in with an outright long position."
Hedge fund interest can also limit a country's ability to maneuver in the event of a default.
In the case of Argentina, litigious hedge funds including Elliott and Aurelius snapped up the country's bonds cheaply in the years following its 2001 default but rejected a series of restructuring offers as they held out for full payment.
The battle, fought in New York courts, pitched Argentina into default again in 2014 before it finally settled last year, paying the holdout funds far more than what other creditors had received.
The risk is acute for Venezuela given that almost $40 billion of its dollar bonds - most of them from oil firm PDVSA - have no collective action clauses (CACs) - terms that spell out that a debt restructuring can go ahead with a 75 percent approval from participants, binding any dissenting creditors into the process.
"Is there is a risk of litigation? I would say there is very much a risk of that," said Bart Turtelboom, CEO of emerging markets-focused investment firm APQ Capital and previously co-head of GLG Partners, a hedge fund.
"In the context of Venezuela there has to be a significant risk this will happen as the capital structure at least in the case of PDVSA is very convoluted."
Turtelboom holds Venezuelan debt, sharing the market's view that "the recovery rate will not be too far off where the bonds are trading at this point." But he says investors must be prepared for an arduous restructuring process, which will include not just bondholders but also bilateral creditors.
"One of the first challenges is to get a true picture of the stock outstanding, how much borrowing has taken place and how much has been pledged already to various creditors," he added.
(Reporting by Maiya Keidan; Editing by Sonya Hepinstall)