War, sanctions, perplexing government decrees and disrupted payment chains are leaving investors in Russian bonds scratching their heads. Payments to foreigners were halted under a set of Russian capital controls designed to insulate the economy from sanctions triggered by the invasion of Ukraine. Then a decree suggested the majority of foreign investors would be paid, not in the currency the bonds were issued, but in Russian rubles, which have lost more than a quarter of their value in the last two weeks. Is that a default? The question has bondholders digging into the fine print.
1. What do the Russian rules say?
Creditors from “countries that engage in hostile activities” can only be paid interest and principal payments in rubles, rather than the currency of the bond, according a decree signed by President Vladimir Putin March 5. With the U.S., European Union and most of its allies ratcheting up sanctions since the invasion began, that means most foreign investors. A government website includes a list of more than 50 “unfriendly” jurisdictions, including Australia, the U.K., Japan, Switzerland, the U.S. and members of the EU. Creditors in countries that haven’t imposed sanctions may be able to receive payments in foreign currencies with special permission.
2. What’s the idea?
Russia is probably trying to find a way to show it can honor its obligations amid uncertainty about whether the country and its companies will default. The plan divides creditors into two distinct categories: Holders of Russian bonds denominated in foreign currencies in the U.K., U.S. or other countries where sanctions have been imposed can expect to receive payments in rubles, and their debtors will have to open special accounts for foreigners in Russia for the creditor to receive the money. The others may potentially receive cash in the currency the debt was issued in, provided the borrower gets special permission. About $250 billion worth of Russian corporate and sovereign bonds in euros and dollars are outstanding, with roughly $40 billion of that owed by the government, according to data compiled by Bloomberg. A key test will come with the next payments from two dollar-denominated bonds, which have coupons due March 16, with a 30-day grace period. If there’s a default on foreign obligations, it would be the first time since the Bolsheviks refused to service or recognize the czar’s debts a century ago. According to guidelines established by ISDA -- the organization that’s governed the global derivatives market since 1985 -- repudiation of debt is considered an event of default. The Soviet Union signed an agreement to settle at least some of those claims in 1986. In 1998, Russia defaulted on $40 billion of domestic debt, but not on foreign currency notes.
3. Isn’t this a default?
Probably, but it isn’t without debate. Some Russian eurobonds have clauses in their documents that address the issue of making payments in a different currency if changes in law make it difficult to do it any other way. In that case, the borrower needs to reach an agreement with the lender to make alternative payment arrangements. Some contracts have what’s known as “fallback optionality,” which would allow the borrower to pay in other currencies, and in some cases, the ruble. Six of the government’s dollar and euro bonds have this fallback mechanism, JPMorgan Chase & Co. strategists led by Trang Nguyen wrote in a note to investors. Some have already made up their minds. “An issuer cannot discharge its obligation to pay a USD or EUR- denominated bond by delivering local currency,” Elena L. Daly, a sovereign debt restructuring lawyer based in Paris said in an interview. “If it could, the international financial community would be awash in Venezuelan Bolivars and Argentine pesos.”
4. What do the ratings agencies say?
In a note published March 4, analysts at S&P Global Ratings said that if sanctions make it impossible for an entity to access foreign currency and it pays in a different currency than the one agreed, the ratings firm may deem this payment a default. Even if investors agree to the payment in another currency, it could be considered a default if “investors receive less than the value of the original promise,” according to the note. All of the major ratings agencies have downgraded Russia’s sovereign debt and the cost of insuring it rose to a record high. Fitch Ratings downgraded Russia to a single C rating, reflecting the agency’s view that a “sovereign default is imminent.”
5. What principles are at stake?
Investors will want to be paid in the currencies they used to buy the securities, and they could argue that paying out in a different currency leaves them worse off. Issuers also have a responsibility to treat 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. The confusion has creditors watching all payments with interest. Some holders of Gazprom PJSC notes received a principal payment in dollars on March 7, but it’s possible that the company’s payment process was too far along to be impacted by Putin’s recent directives.
6. What can investors do about it?
That’s hard to say. With tensions between the “unfriendly” nations and Russia ramping up, legal action could certainly be very difficult. Any attempt to enforce an agreement with a borrower that noteholders believe is in default will likely involve Russian assets and Russian courts, but how foreign investors will access them is hard to know at this stage. The bonds that have coupon payments due March 16 are governed by English law, meaning that holders would have to try and sue the Russian government in a U.K. court to enforce after a default.
7. What about CDS?
Some bond investors also purchase credit-default swaps, or CDS for short, as a type of insurance on the debt. As the name suggests, if a bond defaults the CDS is designed to pay out. But establishing exactly what constitutes a default in this case is not all that straightforward and will depend on a careful examination of the fine print of bond prospectuses. For example, the ruble fallback optionality “may render these bonds out of scope for CDS,” according to Nguyen at JPMorgan. It’s a matter the Credit Derivatives Determinations Committee will meet on Wednesday to consider.
• How a quirk in Russian bonds could hamper the payout of CDS.
• Bloomberg QuickTakes on the SWIFT payment system and the history of sanctions against Russia.
• A statement by the U.S. Treasury Department on initial sanctions concerning Russian debt and the Treasury’s 2021 global sanctions review.
• Morgan Stanley’s Simon Waever, the firm’s global head of emerging-market sovereign credit strategy, sees a default by Russia as “the most likely scenario”, with Venezuela as the most relevant comparison.
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