According to IMF estimates, about three-fourths of Russia’s debt is held by domestic investors, still leaving nearly $75 billion in the hands of foreign financial institutions.
Based on Bloomberg data, the single largest holder of Russian debt is Allianz, the German insurer and asset manager, with nearly $3.2 billion across rouble, Euro, and USD-denominated bonds. The next four largest are U.S.-based investment complexes: Capital Group, with $1.31 billion, Vanguard ($868 million), Legg Mason ($837 million), and Western Asset Management ($807 million).
Dozens of prominent European, Canadian, and Japanese investment groups—including, somewhat paradoxically, many ESG-focused vehicles—have respective exposures in the hundreds of millions. Because of this, a potential Russian default will impact investors around the world.
Key Contractual Provisions
“These are the worst-written contracts I have ever seen on the international markets,” observed a preeminent sovereign debt scholar. Indeed, the “booby-trapped” agreements include materially off-market provisions, appearing to, all things being equal, confer significant advantages to the issuer. For instance, “the bonds lack a waiver of sovereign immunity and, while they are nominally governed by U.K. law, they don’t appear to submit to a jurisdiction,” making enforcement much more difficult.
For our purposes, the contracts’ most distinctive provisions concern the relevant payment currency. Typically, this dimension of sovereign bonds is not much of a moving target, with the applicable currency clearly specified. Indeed, while intensive sovereign debt–related conflicts are not uncommon, the fracas usually center on other provisions, such as Argentina’s now-infamous pari passu clause.
Russia’s bonds, however, contain a relatively unique “Alternative Payment Currency Event” provision. The language purports to allow Russia to make payments in a currency different than the one specified in the event of “reasons beyond its control.”
In this respect, Russia’s outstanding obligations can be separated into three sets: (i) bonds predating the 2014 Crimea invasion, without any “Alternative Currency” provision; (ii) post-2014 bonds allowing for USD payments to be made in European currencies; and (iii) post-2018 bonds, contemplating payments in roubles.
Specifically, the second set of “post-Crimea invasion” bonds provide the following language:
[I]f, for reasons beyond its control, the Russian Federation is unable to make payments of principal or interest (in whole or in part) in respect of the Bonds in U.S. dollars (an “Alternative Payment Currency Event”), the Russian Federation shall make such payments (in whole or in part) in Euros, Pound sterling or Swiss francs (the “Alternative Payment Currency”) (emphasis added)
The post-2018 vintages go a step further, providing that:
“[N]otwithstanding any other provisions in the relevant Conditions, if, for reasons beyond its control, the Russian Federation is unable to make payments of principal or interest (in whole or in part) in respect of the New Bonds in U.S. dollars, the Russian Federation shall make such payments (in whole or in part) in euros, Pound sterling or Swiss francs or, if for reasons beyond its control the Russian Federation is unable to make payments of principal or interest (in whole or in part) in respect of the New Bonds in any of these currencies, in Russian roubles on the due date at the Alternative Payment Currency Equivalent (as defined in the relevant Condition 7) of any such U.S. dollar-denominated amount. (emphasis added)
In other words, the post-2018 vintage USD-denominated bonds provide two sets of fallbacks, essentially stating that: (i) the obligations should be paid in USD, unless (ii) “for reasons beyond its control” Russia cannot use USD, in which case the payments will be made in “Euros, Pound sterling or Swiss francs”; unless (iii) for additional “reasons beyond its control” Russia cannot use those currencies, in which case the payments will be made in Russian roubles.
One impact of these provisions is that bonds with the Rouble fallback were determined ineligible as “deliverable obligations” by the Credit Derivatives Determinations Committee.
It is difficult to parse the evolution of this language without inferring a degree of premeditation in respect of anticipated future sanctions—why else would one include such oddly specific provisions?
Following Russia’s invasion of Ukraine, the U.S. led a plurality of the world’s advanced economies in enacting a sanctions regime against Russia “unprecedented to a scale and scope that we haven’t seen since the Cold War.”
The restrictions span everything from terms of trade to asset ownership and participation in cultural events, such as the Eurovision competition, which Ukraine won. Along with the Russian state, the sanctions also target related entities, leading to financial stress at a range of companies, such as steelmaker Severstal.
Prior to the invasion of Ukraine, Russia stockpiled vast reserves totalling $630 billion, with nearly $500 billion in foreign currencies and the balance in gold. Indeed, in late January, before the invasion, The Economist observed that Russia’s cash pile was “more than enough to weather sanctions.”
However, in a strategy “beyond comparison to previous sanctions regimes, particularly involving a major power like Russia,” the U.S. and its allies deployed sanctions targeting Russia’s central bank and its assets worldwide, precluding Russia from utilizing as much as half of its total reserves.
The sanctions regime is largely made operable through directives to financial intermediaries, in this case essentially prohibiting them from transacting on behalf of the Russian central bank.
The interplay between the sanctions regime and Russia’s bond payment obligations has raised unique legal and commercial considerations.
Following its invasion of Ukraine, Russia had two sets of payments due on its foreign bonds—both of which were ultimately paid following down-to-the-wire acrobatics.
The first set of payments was due on March 16. Russia was able to make the payment using its now-frozen foreign reserves.
The second payment, due April 4 for a total of about $2 billion in principal and interest, came far closer to default, following the U.S. Treasury’s decision to block Russia from using its foreign reserves to make the payment. Russia initially tried to pay in roubles; however, this was deemed impermissible. At the very end of the bonds’ thirty-day grace period, Russia made the payment in dollars, avoiding a formal default by the narrowest of margins.
Interest Payments Carve Out Expiration
Thus far, investors have been legally permitted to receive payments on Russia’s bonds because of a carve-out to the sanctions regime. According to the U.S. Treasury FAQ regarding Russian debt transactions:
GL 9A also authorizes U.S. persons to receive interest, dividend, or maturity payments on debt or equity of the Central Bank of the Russian Federation, the National Wealth Fund of the Russian Federation, and the Ministry of Finance of the Russian Federation through 12:01 a.m. eastern daylight time on May 25, 2022.
On Tuesday, May 17, the U.S. Treasury indicated that this safe harbor would not be extended. “After May 25, 2022, U.S. persons would require a specific license to continue to receive such payments” in respect of Russian bonds. Treasury Secretary Yellen stated that “[w]e’re actively involved in an evaluation of the risks and impact of not renewing the license.”
This is particularly significant because Russia has two payments due on May 27. Though the contracts include a customary interest payment grace period, it is not clear how Russia would be able to deliver the payments.
The chart below, from the Bloomberg Terminal, shows Russia’s sovereign CDS curve as of May 19 (green) and a week prior (yellow). Two observations are particularly notable. First, the term structure is highly inverted, with near-term credit default swaps much more expensive than longer-dated protection, suggesting market perception of a near-term risk. Second, the change between the two lines illustrates the impact of the waiver expiration, with the market now pricing in a much higher likelihood of a Russian default.