Default risk hangs over Russian bonds

Default risk hangs over Russian bonds

The Ukrainian conflict has thrown the Russian fixed-income market into turmoil.

Although Western sanctions imposed on Russia following its invasion of Ukraine on 24 February limit the ability of the sanctioned firms to service their debts, it is actually the harsh capital controls imposed by the authorities that have significantly increased the prospects of Russia defaulting on its sovereign debt and of Russian companies following suit. The decree that bars making coupon payments on ruble-denominated Russian sovereign debt to non-residents came into effect on 2 March, with only Russian residents receiving coupon payments on such debt.

The widespread freeze on the Central Bank of Russia’s (CBR) external assets imposed by the western powers is likely to significantly impair Russia’s ability to service its external debt. The risk that coupon payments are not honoured or are not honoured in foreign currencies has triggered sharp rating downgrades. All three of the main ratings agencies now consider the Russian government is likely to default on both its local and foreign currency long-term debt. Current ratings are consistent with an expected recovery rate of between 35% and 65%, which is above the price at which most Russian hard-currency sovereign bonds were trading on 10 March. Further downgrades could be on the cards if Russia officially defaults and the expected recovery rate falls close to zero. Russia already defaulted in 1998. In 2000, it exchanged the defaulted bonds with a face-value cut of 36%, giving them an estimated recovery value of 38%.

In January, Russian hard-currency corporate bonds outstanding amounted to USD98 bn, larger than the USD39 bn of external government debt. Investors are left wondering if Russian companies will be able to meet their coupons and debt repayment obligations in hard currency. The Russian government is allowing them to repay debts to foreign creditors of "hostile" nations only in rubles, unless they obtain a permit to do so in hard currency. In the absence of fallback mechanisms for their hard-currency corporate bond issues, Russian companies are likely to be in technical default if they service such bonds in rubles.

Although the Russian fixed-income universe is relatively large (approximately USD237 bn of Russian government bonds in rubles and in hard currency and USD98 bn of hard-currency corporate bonds), foreigners’ holdings are relatively low, according to our estimates. Foreigners held 19% (USD38 bn) of ruble-denominated Russian sovereign bonds in January 2022 and 50% of Russian sovereign bonds in hard currency (equivalent to approximately USD20 bn). While the data is less clear, JP Morgan estimates that institutional foreign investors held around 22% (or USD21 bn) of Russian hard-currency corporate bonds at end-January.

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