The insurance-type products that investors use to hedge against a Russian default may not pay off, as escalating penalties threaten to wreak havoc on the intricate settlement system of derivatives contracts.
Prices of $ 39 billion of Russian dollar-denominated government bonds plummeted last week following Western sanctions that effectively cut the country’s markets out of the global financial system. Credit default swaps – derivatives that act as insurance against non-payment of this debt – also increased, but the moves were smaller than those seen in the bond market.
Investors and analysts say the discrepancy reveals growing concerns that sanctions on Russia will interfere with the settlement mechanism of CDS contracts, potentially leaving investors who used them as hedges for their losses on defaulting bonds out of their own pockets.
“We are strongly convinced of it [Russia] it won’t pay, “said Marcelo Assalin, William Blair’s head of emerging market debt.” But the market is totally dysfunctional. The problem we face is that CDS imply unrealistic recovery value. “
Russia’s five-year CDS are now trading around 45 basis points upfront, a level that implies that investors can expect to receive more than 50 cents per dollar in a restructuring of Russia’s foreign debt. The price of the bonds themselves, however, around 20 cents on the dollar indicates a much less favorable outcome for the holders.
The matter could come to a head if Russia does not make its next interest payment on its dollar debt on March 16, which investors consider increasingly likely. Moscow this week paid interest on its ruble-denominated debt – which is not covered by CDS – but said the money will not reach foreign holders, citing the central bank’s ban on sending foreign currency abroad.
Some traders even fear swaps may end up paying nothing, emulating previous CDS incidents like car rental company Europcar in 2021 and Dutch lender SNS Reaal in 2013.
JPMorgan analysts say the small print of some debt could mean that bonds are beyond the scope of CDS in the event of default. Six of the Russian $ 15 bonds contain a “fallback mechanism” that allows Moscow to repay in rubles rather than dollars or euros.
Three other bonds are subject to settlement in Russia, which means they have effectively become non-marketable since Russian authorities blocked offshore settlement at Euroclear.
Some traders look to Venezuela’s default as a model for what could happen. The country has been subject to penalties for foreign investors buying its new debt, similar to Russia. The International Swaps and Derivatives Association, the world’s leading derivatives association, helped amend CDS contracts to refer only to older, non-sanctioned bonds, a move it could repeat again.
“Members are working to comply with the sanctions and the impact and action required will depend on their individual circumstances,” an ISDA spokesperson said. “The ISDA is in regular contact with members to identify any common market-wide problems that may arise and to help find shared solutions where appropriate.”
While most bonds are still technically tradable, there is also the possibility of further Western sanctions banning secondary trading, JPMorgan said.
The bank said all of these factors could affect whether the bonds are “deliverable” at a CDS auction, a mechanism used to determine the amount of payment in the event of a default by bidding on outstanding bonds. If fewer bonds are eligible, the price is likely to be higher, meaning CDS holders are in line for lower compensation.
“In situations where secondary market bond trading would be prohibited by sanctions, the auction process would not be able to take place in its standard form,” the bank’s analysts wrote in a statement this week.