Russia on the brink of technical insolvency

Moscow is at risk of defaulting on an international government bond because the US Department of the Treasury has blocked repayments in US dollars. The rouble payments offered would likely lead to a technical default. Legal proceedings are therefore potentially needed in order to settle creditors’ claims. What scenarios should foreign investors expect?

The ten-year government bonds of the Russian Federation (ISIN XS0767472458) that were due to mature on 4 April and have a coupon of 4.5 per cent are turning into a litmus test for Russia’s solvency as far as the capital markets are concerned. The €2 billion euro bond was issued ten years ago in US dollars. At that time, Russia was deemed a reliable borrower and had not defaulted on government bonds denominated in foreign currency since 1918.

But war has now broken out in Ukraine. As a result of the related sanctions imposed by the West on Russian banks and assets of the Russian central bank, it has been uncertain since March whether Russia wants to repay outstanding bonds and settle the coupons (‘willingness to pay’), whether it is capable of doing so (‘ability to pay’) and whether repayment is allowed (‘permission to pay’).

Growing difficulties for Moscow

In mid-March and at the end of the month, coupon payments in US dollars for a Russian government bond were still reaching western investors. But that has now changed. Following the news that the US Department of the Treasury has forbidden the Russian Federation’s correspondent bank from permitting the transfer of two payments of around US$ 650 million to the paying agent Citibank, Russia is now at risk of a technical default. This will occur if the Treasury department does not find other settlement channels outside the US financial system, e.g. through European or Chinese banks. However, it is doubtful whether they would be willing and able to jump into the settlement chain at short notice.

It is becoming increasingly difficult for Russia to make payments in hard currencies. At the end of March, the Russian Finance Ministry published an offer at short notice for the US dollar bond that matures on 4 April in order to at least minimise the problem for domestic bondholders. This resulted in roughly 72 per cent of the volume being repurchased, not in US dollars as had been agreed in the prospectus but in roubles. This may be the pattern for other bonds that are due to mature soon. If there is no clause in the government bond prospectuses that permits payment in roubles rather than in a hard currency, the Institute of International Finance (IIF) will consider this a default.

Russia on the brink of technical insolvency

5-year credit default swap (basis points)

Russia on the brink of technical insolvency
Sources: Bloomberg, Union Investment, as at 8 April 2022.

Grace period until 4 May

The situation is currently rather uncertain. It is not clear whether foreign holders of the bond due to mature on 4 April will be repaid in US dollars, as set out in the prospectus. The grace period runs for 30 days, i.e. until 4 May. As an alternative, the Russian Finance Ministry has already ordered repayment to foreign investors in roubles to accounts at Russia’s National Settlement Depository (NSD). In principle, investors with a rouble account at the NSD could therefore receive the repayment, just not in US dollars. If the grace period expires without a US dollar payment being made, the International Swaps and Derivatives Association (ISDA) is likely to classify this as a default. This would mean payments on credit default swaps (CDSs) on the Russian Federation would become due. The CDSs on Russian government bonds recently hit a record high, which indicates a 99 per cent probability of default within five years. Western rating agencies announced in March that if payments were not made in a contractually agreed currency, they would declare a selective default on the bond. The Russian Federation considers itself willing and financially able to fulfil its obligations as a borrower but says that western sanctions are standing in its way.

Possible scenarios for foreign investors

What happens next? In the first instance, the Russian Federation is at risk of a technical default. If this is confirmed, it is likely to trigger a chain reaction of defaults. The sales prospectuses of other Russian hard-currency bonds contain a cross-default clause that, in the event of a single government bond defaulting, enables the general meeting of investors to make all other hard-currency government bonds become due immediately (acceleration clause). However, the Russian government may be able to avoid this by repaying creditors via another channel or by offering settlement at par or in a different currency.

It is also conceivable that Moscow can get a resolution passed at a creditor meeting to change the payment terms and conditions of the past due bond. After all, it holds the majority of the bond that was due to mature on 4 April as a result of repurchasing more than 70 per cent of the outstanding volume and because of its existing holdings before then. If changes to the payment terms and conditions were to result in a settlement for all creditors, this would prevent other Russian government bonds from being made due but would not stop a default on CDSs.

Only a small volume outstanding at international level

The IIF estimates that the volume of Russian government bonds held by foreign investors stood at approximately US$ 20 billion at the start of the year. A considerable portion of this is likely to have since been transferred to Russian bondholders as a result of fire sales. Conversely, there are several hundred billion US dollars of currency reserves of the Russian central bank, which are held by commercial banks and central banks in the West.

Should there be a default on Russian government bonds, foreign investors will probably try to seize currency reserves at western central banks. This could lead to lengthy legal disputes that block Russia’s access to capital markets, which would result in high economic costs for Moscow in the medium term. If the war in Ukraine ends and Russia starts to look to the West again, there is a possibility that international investors will be able to recover receivables from the Russian Federation.

There is not necessarily any causal link between default on the part of the Russian state and the default of Russian corporate bonds. Nevertheless, the legal and operational risk associated with Russian issuers has increased, and there is a growing number of cases in which hard-currency payments are transferred from issuers but are then blocked by banks in the US or EU for compliance reasons. As with Russian government bonds, case-by-case analysis is needed in order to make a proper assessment.

 

As at 8 April 2022

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