Big Investors Are Betting On Regime Change in Cuba

Big Investors Are Betting On Regime Change in Cuba
Published: Wednesday, 17 Oct 2012 | 11:38 AM ET
By: Michelle Caruso-Cabrera
CNBC Senior International Correspondent

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%.

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.

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 [JPY=X
78.84 -0.02 (-0.03%) ], Swiss francs [CHF=X 0.9225 -0.0035
(-0.38%) ], German Deutsche marks (which don't exist anymore) and
Canadian dollars [CAD=X 0.9787 -0.0077 (-0.78%) ].

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.

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.

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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.

(Read More: Cuba Cuts Education Spending, Shifts Priorities)

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.

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
@MCaruso_Cabrera

http://www.cnbc.com/id/49437343