According to strategists and investors at Citigroup Inc., CreditSights Inc., and Vanguard Asset Management, international sanctions imposed on the country in response to President Vladimir Putin's invasion of Ukraine may both trigger credit-default swaps and prevent the underlying bonds from being used for settlement.
As things currently stand, sovereign debt can be delivered into CDS," said Nick Eisinger, co-head of emerging-markets active fixed income at Vanguard in London. "The challenge will be determining how to conduct the auction if this is fully sanctioned."
Traders have been rushing to purchase protection on Russia's sovereign debt as the country has become almost uninvestable for global investors. According to ICE Data Services, swaps now indicate a 65 percent chance of default within five years and a 40 percent chance within one year.
Investors are clamoring for clarity as the war enters a more brutal phase, with debt payments looming. Russia has $117 million in coupon payments on dollar bonds due on March 16, as well as $5 billion in international debt maturing over the next two years.
"If harsher sanctions are imposed that prohibit holding all existing Russian sovereign debt, this could have a material impact on the CDS market's ability to hold an auction or settle in the event of any credit event trigger," CreditSights analysts wrote in a note Tuesday.
Credit-default swaps only protect against losses on Russia's foreign-currency debt, but investors are keeping a close eye on how the government handles payments on ruble bonds known as OFZs.
Russia paid a ruble-bond coupon on Wednesday, but it's unclear how foreign holders such as Allianz SE, BlackRock Inc., and Vanguard Group will access the funds after the central bank prohibited transfers to foreign investors.
Technical error
"This will almost certainly be a technical default," Vanguard's Eisinger predicted prior to the payment. "We also see a high likelihood of technical default on sovereign Eurobonds."
Citi strategists also stated that the government may be unable to pay interest on international debt due to potential infrastructure issues, but that credit-default swaps on Russian companies such as Gazprom and Lukoil are unlikely to be triggered.
Euroclear and Clearstream, the world's largest settlement systems, are no longer handling Russian assets.
"There are now rising concerns about the future dynamics in Russian sovereign credit-default swaps," Citi strategists led by Arup Ghosh wrote in an investor note on Friday. "The risk, in our opinion, could arise if current restrictions are potentially extended to include a complete ban on secondary trading." This could cause significant problems with cash settlements."
The most recent test
Russia could be the latest litmus test for the credit derivatives market, which has been chastised on several occasions since the financial crisis for failing to compensate investors for losses on underlying debt.
Citi compared Russia's potential settlement issues to Novo Banco SA, which was left without deliverable bonds after the Bank of Portugal decided to transfer the notes to a bad bank in 2016. This occurrence suggested that rules put in place two years ago to address flaws were still insufficient to provide full protection to bondholders when governments or regulators intervened.
According to Citi, a potential ban on secondary trading of Russian sovereign bonds could result in an orphaning event similar to Novo Banco's, in which derivatives become worthless because there is no underlying debt to insure.
"It does not appear to be an imminent risk at this time," the strategists said, "but investors must be aware of the risk." "In a trigger situation, the credit derivatives determination committee must determine how widespread the inability to transfer bonds at settlement is."
Concerns Are Growing
Credit-default swaps on Russian sovereign debt surged this week, with protection sellers demanding upfront payments amid fears of a default. According to ICE data, contracts insuring $10 million of the country's bonds for five years were quoted at around $4.6 million upfront and $100,000 annually on Tuesday.
According to the Depository Trust & Clearing Corp., outstanding contracts covered approximately $41 billion of Russian debt as of Feb. 11, the most recent data available.
"The determination of Western governments to cut Russia off from the international financial system, combined with a potentially weaker willingness on the part of the Russian government to service its debt on time and in full, raises the probability of more severe credit outcomes for foreign holders of Russian debt securities," Moody's Investors Service said on Tuesday.