How Sanctions Are Pushing Russia to Brink of Default

How the Russian Bond Market Is, and Isn't, Being Hit by New Sanctions

War, sanctions and disrupted payment systems have left the holders of about $150 billion in bonds sold by Russia and its companies abroad bracing for defaults. Fears eased in mid-March when the first interest payments due since Russia’s invasion of Ukraine came through, proving that at least some of the country’s borrowers could still service their foreign currency bonds. The relief was short-lived. In early April, an attempt to pay Russian government dollar-debt obligations was rejected by foreign banks, increasing the risk of the country’s first sovereign default since 1998. 

1. What went wrong? 

Russia’s Finance Ministry said it still made the payments by transferring the money in rubles to a special account for foreigners with the country’s National Settlement Depository, citing a local decree allowing foreign debt payments in local currency. However, neither of the securities involved allowed payment in rubles, according to bond documents. Credit assessors including Fitch Ratings and S&P Global have said Russia will be considered in default if it doesn’t pay coupon payments in dollars within a 30-day grace period. Shortly after the dollar payment was rejected, the cost of insuring Russia’s government debt surged to signal a record 99% chance of default within the year.   

2. What’s obstructing Russian debt payments?

Governments have frozen about half of Russia’s foreign reserves, sanctions have isolated its banking system and some payments are being delayed by banks doing lengthy checks that they aren’t breaching any restrictions. In early April, the U.S. Treasury halted dollar debt payments from Russia’s accounts at U.S. banks, depriving it of an important source of funds to cover its obligations. An exemption that’s allowed U.S. and overseas investors to continue receiving payments on Russian debt is set to expire at the end of May. State enterprises such as Gazprom PJSC and Rosneft PJSC have continued to honor their foreign debts, but Severstal PJSC ran out of time for an interest payment after Citigroup Inc. blocked it for fear of breaching sanctions. Russian Railways JSC and EuroChem have also missed payment deadlines as the cash got stuck for compliance checks on its way to investors. Moves by the world’s biggest clearing houses -- Clearstream and Euroclear -- to curb settlement services they provide for Russian bonds have further complicated the flow of funds.

3. What’s the Russian government’s response? 

Officials in Moscow have previously warned that Russia would be forced to pay in rubles if sanctions block the transfer of dollars or euros. Such a switch, if applied to all Russian debt, would widely be seen as a default. If it weren’t, the world “would be awash in Venezuelan bolivars and Argentine pesos,” according to Elena L. Daly, a sovereign debt restructuring lawyer based in Paris. It may work in some cases: Six of the government’s dollar and euro-denominated bonds have what’s known as “fallback optionality,” which would allow the borrower to pay in other currencies, and in some cases, the ruble. But there’s little sign that Russian firms would emulate the government and try to switch payments to rubles -- or that foreign investors would be willing to receive them. 

How Sanctions Are Pushing Russia to Brink of Default

4. What happens next?

The debacle takes Russia a step closer to its first sovereign default since shockwaves from the Asian debt crisis and tumbling oil prices pushed Boris Yeltsin’s government to renege on about $40 billion of domestic debt. It took Russia about six years to gain so-called investment-grade status, which meant it could be held by a broad pool of investors. Russia’s credit ratings were dramatically slashed after the Feb. 24 attack on Ukraine in a sudden fall from investment grade. It has been sanctioned in various ways by the U.S. and its allies since it annexed Ukraine’s Crimean Peninsula in 2014, though it has been building foreign reserves

5. What principles are at stake? 

Russia’s situation is unusual because companies could possibly keep servicing their debt even if the sovereign defaults. Some of them sell bonds via foreign subsidiaries and have dollars offshore. Issuers also have a responsibility to treat all bondholders fairly and must follow the “pari passu” principle (Latin for “equal footing”), meaning that they can’t treat holders of the same note differently. That idea played a role in Argentina in 2014, when it was blocked by a U.S. judge from paying some bondholders until it resolved a long-running legal saga between the government and holdouts led by Paul Singer’s Elliott Investment Management.

How Sanctions Are Pushing Russia to Brink of Default

6. What options do investors have?

If bondholders don’t get paid, it’s likely the start of a very long, complicated process. History is an imperfect guide, but Russia already holds the record for the longest time between default and some form of resolution with creditors: After the Bolsheviks refused to service or recognize the czar’s debts a century ago, the Soviet Union signed an agreement to settle at least some of those claims in 1986. Even if many of the notes are governed by English law and hence bondholders can take the Russian government to court in England, any attempt to enforce an agreement now will likely involve Russian assets and Russian courts. How foreign investors will access them is hard to know at this stage. The price of Russia’s dollar-denominated debt plunged in expectation of a default, with bonds due in 2023 quoted at just over a third of their face value on April 5. It fell 11 cents on the dollar on the new U.S. restrictions.

7. Are investors insured? 

Some investors purchase credit-default swaps, or CDS, insurance-like instruments designed to cover losses if a country or company fails to meet its obligations. However, roughly $13 billion of Russian government debt could be ineligible, a panel of banks and investors ruled March 11, because of the possibility of ruble payments on six of the bonds. 

8. What’s the broader impact? 

Concerns about a Russian default are rippling through other emerging markets. A Russian sovereign default is no longer an “improbable event,” International Monetary Fund Managing Director Kristalina Georgieva said March 13, though the exposure of global banks to Russia is “definitely not systemically relevant.” Some investors have warned that a Russian default could ultimately lead to a global sovereign debt crisis if investors start shunning risk and more countries are locked out of financial markets.

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