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Venezuela bonds to be zeroed out in J.P. Morgan indexes

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      By Emerging Markets Debt TeamEaton Vance Management

      Boston — In another wrinkle to Venezuela's sad decline, J.P. Morgan announced that it would zero out the weightings of the country's issues in its widely followed dollar-denominated sovereign emerging-markets indexes.

      These include the Emerging Markets Bond Index Global (EMBIG), Emerging Markets Bond Index Global - Diversified (EMBIG-D), and the Emerging Markets Bond Index + (EMBI+).

      J.P. Morgan's decision to zero out Venezuela includes its sovereign and state oil PDVSA bonds, which went on watch last April following the U.S. sanctions against President Nicolas Maduro's government and the trading disruptions that have occurred.

      As of June 30, the weightings of Venezuela in the EMBIG-D, EMBIG and EMBI+ were 0.62%, 1.00% and 1.65%, respectively. As of July 31, J.P. Morgan started to reduce the index weightings of Venezuela's sovereign and state oil PDVSA bonds in a transition that will wind down to zero by November 29. Technically, the debt will still be part of the indexes and pricing will be maintained.

      The market for Venezuela's bonds is already frozen and illiquid, so investors with passive portfolios that track the indexes may suffer losses if they are forced to sell -- the bonds are trading at cents on the dollar. As part of the U.S. sanctions, Venezuela's bonds may not be sold to U.S. investors - something that has weighed heavily on the secondary market.

      The fact that Venezuela will still technically be in the index may be a relief to some investors. Depending on mandate guidelines, investors with passive, index-based portfolios may avoid immediate forced selling and/or be able to unwind positions gradually.

      J.P. Morgan said it will return Venezuela back to weight levels proportional to its market cap "in the event of any favorable official guidance around easing of trading restrictions or consistent, observable improvements in liquidity and replicability."

      Bottom line: While it certainly is an extreme example, this episode underscores the pitfalls of investing in passive EM portfolios that track indexes. We believe that investors are better served through actively managed strategies that focus on country-level macroeconomic and political research, and standalone analysis of specific risk factors such as currency, credit spreads and interest rates.