War in Ukraine raises fears of Russia’s first foreign debt default

With much of Moscow’s $640 billion in reserves held in the West and sanctions hampering the flow of capital across borders, investors fear Russia is heading for its first hard-currency sovereign debt default.

On Wednesday, foreign investors were effectively stuck with their positions in ruble-denominated bonds — known as OFZs — after the Russian central bank temporarily stopped paying coupons and the Euroclear settlement system stopped accepting Russian assets.

A ruble debt default is unprecedented—Moscow reneged on OFZs during its 1998 financial crisis, but even then it kept paying US dollar bonds. Before the latest devastating sanctions from the West that froze central bank assets, such a default was not on anyone’s radar.

That’s partly because Russia, which classifies its Ukrainian stock as a “special operation,” has just $40 billion of international bonds across 15 dollar- or euro-denominated issues — a very low volume compared to its peers. and its own Gross Domestic Product.

Bonds had generally been trading well above their par value until mid-February, with investors ignoring Moscow’s troop buildup on the Ukrainian border and US warnings that an invasion was imminent.

Two weeks later, bond investors now reckon that a default is no longer a distant prospect. Russia’s risk premium has soared and credit default swaps — derivatives used to hedge exposure — are at record highs.

And some dollar bonds are now priced below 30 cents on the dollar, with abysmal trading volume.

Foreigners, who hold about half of Russia’s hard-currency debt, are focused on March 16, when the country would need to pay $107 million in coupons on two bonds.

“Will Russia pay or not? There is very significant uncertainty at this point, following the sanctions imposed on Russia’s central bank and the Ministry of Finance,” said Marcelo Assalin, director of emerging debt markets at financial services firm William Blair, in London, which holds part of the Russian debt.

JP Morgan and global banking lobby group IFI (Institute of International Finance) have warned that there is significant growth in the risk that Russia may be heading for its first foreign debt default.

After March 16, a further $359 million is due on the 31st of this month for a 2030 bond. The first principal payment is due on April 4, when a $2 billion bond matures.

NO SWIFT

In theory, Russia has ample reserves to cover debts. In practice, the asset freeze reduced what the central bank has available for payments.

Second, executing payments will be more complicated after sanctions limit Moscow’s access to the Swift global payments system. And finally, the asset freeze undermines Russia’s ability to defend its currency, increasing the cost of foreign debt.

“Freezing foreign exchange reserves could greatly weaken the ruble and raise fears of a default for sovereigns and corporates,” said Dirk Willer, director of macro, asset allocation and emerging markets strategy at Citi in New York.

The central bank and finance ministry did not respond to Reuters’ request for comment on the possibility of a default.