Russian bonds tumble as new sanctions trigger default fears

Russian bonds tumbled on Monday as investors braced for the possibility that the latest round of Western sanctions on Russia could lead to Moscow defaulting on its debt for the first time since 1998.

Steps taken by the United States and Europe over the weekend to insulate Russia from the global financial system, as Moscow stepped up its invasion of Ukraine, stoked concerns that foreign holders of Russian debt might not receive interest or principal payments.

Sanctions against the Russian central bank are expected to seriously hamper its attempts to use its more than $600 billion in foreign reserves to shore up its finances, prompting markets to contemplate the possibility that a country with debt of only 20% of GDP (Gross Domestic Product) may fail to repay creditors.

“A Russian default is a real possibility today,” said Tim Ash, an economist at BlueBay Asset Management. “It’s absolutely amazing how the mighty have fallen.”

Russia’s dollar-denominated bonds plunged on Monday, with its biggest — a $7 billion bond due in 2047 — halving to $0.33. 70), a level associated with high levels of stress, according to data from Tradeweb.

The measures came after S&P Global downgraded Russia’s credit rating to “junk” on Friday.

The cost of buying derivatives that insure against a Russian debt default has soared. The price of Russian credit default swaps, which offer holders an insurance-like payout if the country defaults, has risen sharply, with the five-year CDS rising 20 percentage points to 37% on an “upfront” basis from agreement with derivatives market operators.

The CDS is quoted “in advance” when fears of financial difficulties increase. This is because the cost of buying default protection rises well above the standard trading cost defined in derivative contracts, so brokers start quoting the additional payment they need at the beginning of the transaction.

Monday’s trading levels mean it would cost $37 million (BRL 190.1 million) to secure $100 million (BRL 513.9 million) in debt against default for five years, plus $1 million ( R$5.14 million) per year in premiums.

A Russian default would be painful for foreign investors, who are already suffering from falling bond prices. At the beginning of the year, foreigners held US$20 billion (R$102.7 billion) of Russian foreign-currency debt, as well as local debt worth more than 3 trillion rubles (R$186.2 billion).

Some investors cautioned against overinterpreting bond prices amid extremely tense trading conditions on Monday. “I think the current price may be depressed by the forced liquidation and does not correctly reflect the default probabilities,” said one fund manager.

Russia may even choose to refuse to repay its debt to conserve precious dollars given central bank sanctions, an emerging market fund manager said. However, he added that the price drops were because some holders were forced to sell their bonds, and “do not correctly reflect default probabilities.”

Although the Russian state had a strong balance sheet before the Ukraine invasion, traders and investors are increasingly concerned that sanctions and other measures could prevent Moscow from paying interest to international investors. These technical factors can still trigger an indemnity in CDS contracts.

There are also growing concerns that these factors could interfere with the process used to determine payouts for CDS contracts, which requires traders to deliver Russian bonds at auction.

“The risk, in our view, could arise in a scenario where current restrictions are potentially expanded to include a total ban on secondary trading,” Citigroup credit analysts wrote in a note to clients on Friday.

Ray Attrill, a strategist at the National Bank of Australia, warned that a Russian sovereign default would also have repercussions for the European banking system, estimating that banks in France and Italy hold about $25 billion in bonds. Russian banks, and Austrian banks hold about US$17.5 billion (R$89.9 billion) in exposure.

“A default would be of macroeconomic importance,” he said. “It would have significant implications for banks’ balance sheets and lending capacity — as we last saw after the 2011-2012 Greek debt crisis and restructuring.”