Investors fret over default protection for Russian bonds

The insurance-like products investors use to protect against a Russian default may not pay out, as escalating sanctions threaten to wreak havoc on the intricate system for settling the derivative contracts.

Prices on Russia’s $39bn of dollar-denominated government bonds have collapsed over the past week following western sanctions that have effectively cut the country’s markets off from the global financial system. Credit default swaps — derivatives that act like insurance against non-payment of this debt — have also surged, but the moves have been smaller than those seen in the bond market.

Investors and analysts say the discrepancy reveals growing concerns that the sanctions on Russia will interfere with the settlement mechanism for CDS contracts, potentially leaving investors who used them as a hedge for their losses on defaulted bonds out of pocket.

“We have a high conviction that [Russia] will not pay,” said Marcelo Assalin, head of emerging market debt at William Blair. “But the market is totally dysfunctional. The problem we face is CDS is implying a recovery value that’s not realistic.”

Russia’s five-year CDS now trades at around 45 basis points upfront, a level that implies investors can expect to receive more than 50 cents on the dollar in a restructuring of Russia’s foreign debt. The price of the bonds themselves, however, at around 20 cents on the dollar indicates a much less favourable outcome for holders.

The issue could come to a head if Russia fails to make its next interest payment on its dollar debt on March 16, something investors see as increasingly likely. Moscow this week made an interest payment on its rouble-denominated debt — which is not covered by CDS — but said the money would not reach foreign holders, citing a central bank ban on sending foreign currency abroad.

Some traders even fear that the swaps could end up not paying out anything at all, emulating previous CDS mishaps such as car rental company Europcar in 2021 and Dutch lender SNS Reaal in 2013.

Analysts at JPMorgan say the small print of some of the debt may mean the bonds are beyond the scope of CDS in the event of a default. Six of Russia’s 15 dollar bonds contain a “fallback mechanism” allowing Moscow to repay in roubles rather than dollars or euros.

A further three bonds are subject to settlement in Russia, meaning they have effectively become untradeable since Russian authorities blocked offshore settlement at Euroclear.

Some traders are looking to the default of Venezuela as a model for what may happen. The country became subject to sanctions on foreign investors buying its new debt, similar to Russia. The International Swaps and Derivatives Association, the main global derivatives association, helped amend CDS contracts to reference only older bonds unaffected by the sanctions — a move it could repeat again.

“Members are working to comply with the sanctions, and the impact and required actions will depend on their individual circumstances,” said an ISDA spokesperson. “ISDA is in regular contact with members to identify any common, marketwide issues that may emerge, and to assist in finding mutualised solutions where appropriate”.

Although most of the bonds are still technically tradeable, there is also the possibility of further western sanctions prohibiting secondary trading, JPMorgan said.

The bank said all of these factors could affect whether the bonds are “deliverable” to a CDS auction — a mechanism used to determine the size of the payout in the event of a default by bidding on the outstanding bonds. If fewer bonds are eligible, the price is likely to be higher, meaning CDS holders are in line for less compensation.

“In situations where secondary market trading of bonds would be prohibited by sanctions, the auction process would not be able to occur in its standard form,” analysts at the bank wrote in a note this week.

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