Russian bonds tumbled on Monday as investors braced themselves for the possibility that the latest round of western sanctions on Russia could push Moscow to default on its debt for the first time since 1998.
US and European moves over the weekend to cut Russia off from the global financial system, as Moscow stepped up its invasion of Ukraine, have fanned concerns that foreign holders of Russian debt will not be able to receive interest or principal payments.
Sanctions against the Russian central bank are expected to seriously hamper its attempts to deploy its more than $ 600bn of foreign reserves to shore up its finances, leaving markets contemplating the possibility that a country with a debt of only 20 per cent of gross domestic product could fail to repay lenders.
“A Russian default is now a real possibility,” said Tim Ash, an economist at BlueBay Asset Management. “It’s utterly staggering how the mighty have fallen.”
The dollar-denominated bonds plummeted on Monday, with its largest – a $ 7bn bond maturing in 2047 – halving in price to 33 cents on the dollar, a level associated with high levels of distress, according to Tradeweb data.
The moves came after S&P Global downgraded Russia’s credit rating to “junk” status late on Friday.
The cost of buying derivatives that insure against a Russian debt default soared. The price of Russian credit default swaps, which offer holders an insurance-like payout if the country defaults, rose sharply, with five-year CDS surging 20 percentage points to 37 per cent on an “upfront” basis, according to traders in the derivatives market.
CDS flips to being quoted on an “upfront” basis when fears of financial distress become elevated. This is because the cost of buying protection against default soars well above the standard running cost defined in the derivative contracts, so traders start quoting the additional payment they require at the start of the transaction.
The trading levels on Monday mean it would cost $ 37mn to insure $ 100mn of debt against default for five-years, on top of $ 1mn a year in premiums.
A Russian default would be painful for overseas investors, who are already reeling from the decline in bond prices. At the start of the year, foreigners held $ 20bn of Russian foreign currency debt, as well as local debt worth more than 3tn rubles.
Some investors cautioned against reading too much into bond prices given the extremely strained trading conditions on Monday. “I think the current pricing might be depressed by forced liquidation, and does not correctly reflect default probabilities,” said one fund manager.
Russia might even prefer to refuse to repay its debt to conserve precious dollars, given the sanctions on the central bank, said one emerging markets fund manager. However, he added that Monday’s price declines were driven by some holders being forced to sell their bonds and “do not correctly reflect default probabilities”.
While the Russian state had a strong balance sheet before its invasion of Ukraine, traders and investors are increasingly worried that sanctions and other measures could prevent it from making interest payments to international investors. These technical factors could still trigger a payout on the CDS contracts.
There are also growing concerns these factors could interfere with the process used to determine the payouts on CDS contracts, as it requires traders to deliver Russian bonds into an auction.
“The risk in our view might arise in a scenario where current restrictions are potentially extended to include a complete ban on secondary trading,” Citigroup credit analysts wrote in a note to clients on Friday.
Ray Attrill, a strategist at National Australia Bank, warned that a Russian sovereign default would also echo through the European banking system, estimating that banks in France and Italy each own about $ 25bn of Russian government bonds, and Austrian banks held roughly $ 17.5bn of exposure.
“A default would be of macroeconomic significance,” he said. “It would have significant implications for bank balance sheets and lending capability – as we last saw post the 2011-2012 Greek debt crisis and restructuring.”