Russia sanctions and emerging market debt – when is a default not a default?

The US Office of Foreign Assets Control, EU and UK, along with other jurisdictions continue to adopt new and enhanced economic, trade and investment restrictions targeting Russia. The sanctions, which are coordinated across countries, are wide-ranging and have significant investment implications. We won’t go into the details of the complex web of global sanctions. However, for most international and emerging market (EM) bond investors, the practical upshot is that US persons (and those following US sanction rules) are now essentially prohibited from adding exposure to any Russian sovereign or corporate entity. Non-US persons may continue to purchase Russian names, but liquidity is limited with risks of trades failing due to the reluctance of some intermediaries to process transactions.

The divestment challenge

For the roughly USD20 billion (bn) of Russian sovereign bonds held by foreigners, the sanctions have led to a collapse in the value of their holdings. Investors in this situation essentially have two choices: 1) keep a hold of their existing (highly impaired) assets in the hope of an eventual resolution of the Ukraine conflict that potentially leads to an easing of Russia sanctions; or 2) try to extract any residual value now by looking to offload their Russian holdings in the secondary market.

In practice, with most western banks effectively pulling back from trading in Russian securities, investors with Russian exposure were effectively forced to adopt position one. In July, however, the US Treasury published new guidelines clarifying that US holders could look to wind down their positions in entities that are not Specially Designated Nationals. Furthermore, US financial institutions may clear and settle, or otherwise serve as market intermediaries in divestment transactions in the secondary market for non-US persons.

Following this, there have been reports of some US banks cautiously returning to the market for Russian bonds solely for divestment purposes. (1) Although little light has been shed on the potentially thorny issue of the general type of buyer in these divestment trades, we've observed some recovery in Russian bond values since late July.

The wider asset class context

It’s important to bear in mind that the value of outstanding Russian sovereign and corporate bonds is fairly modest compared to the overall size of the EM sovereign and corporate bond market. As a result, the direct asset class level impact has been fairly modest. For example, even before the start of Ukraine tensions, Russia’s weighting in the USD1,365bn JPM EMBI Global (sovereign) Index was 3.2%, and 4.7% in the USD1,372bn JPM CEMBI Broad (corporate bond) Index (2). Furthermore, given the relatively high volatility of Russian bonds, the asset class level stability of EM bonds has arguably improved following the zero-weighting of Russia in indices from end-March 2022.

A highly unusual bond default

While the direct impact of Russia sanctions may have been manageable for most professional EM bond investors, the future impact from a risk perspective could still be quite significant. This is owing to the highly unusual and unprecedented circumstances in which Russian bonds were recently considered to have ‘defaulted’.

Typically, when a country or company defaults on its bond payment obligations, it’s because of dire conditions leading to an inability to pay. Sometimes, there can also be instances where the issuer is unwilling to pay. However, in the Russia sovereign case, it clearly has ample capability to pay. Indeed, despite the adverse overall economic impact of sanctions, it has still been able to sell its oil and gas (at discounted but still strong prices) to big non-sanctions-participating countries such as China and India.

With Russia also demonstrating its willingness to pay, its default has thus essentially stemmed from it not being allowed to pay due to sanctions and exclusion from established global payment systems. Sanctioned and non-sanctioned Russian corporates are facing similar problems when seeking to pay bondholders. Some have issued ‘consent solicitations’ to defer payments and requested that bondholders allow alternative payment mechanisms.

New risk paradigm for EM bond investors?

Arguably, the most important forward-looking investment lesson of the Russia sanctions episode could be the need for investors to incorporate a new ‘global systemic exclusion’ default category into their risk framework. An important consideration here is the extent to which the recent Russian default case can be seen as a one-off anomaly. In our view, though, the undeniable emerging reality in recent years of more a protectionist and generally less co-operative world system suggests otherwise.

Potentially decreased demand for USD as a reserve currency

From the perspective of issuers, it’s not implausible that the recent Russia sanctions episode may help drive initiatives to mitigate such systemic exclusion risks. For example, one likely effect could be accelerated efforts on the part of some countries to push an alternative global reserve currency to the US dollar.

To be clear on this front, the overwhelming dominance of the US dollar is unlikely to end any time soon. Still, anecdotally, at least some signs are emerging. Recent examples of this include Russian companies, such as the aluminium producer Rusal and gold producer Polyus, issuing bonds in yuan (3). At the same time, there have also been reports of Saudi Arabia exploring the possibility of accepting yuan (instead of US dollars) for its oil exports to China (4).

Putting everything together…

To sum up, the main direct impact of Russia sanctions for EM debt investors has been an effective ban from adding new or additional Russian exposure. For those with existing Russian exposures, the choice is to hold or sell, with the latter technically challenging at the present time. Fortunately, given the relatively small amount of Russian bonds held by foreigners, the overall impact for EMD asset class has been manageable. Going forward, however, the Russia sanctions episode and its highly unusual recent default instances, could be much more meaningful in terms of how investors consider EM debt risks.