Russia could still default this week

Last Friday, Russia did a reverse rug pull. After weeks of moaning about sanctions it unexpectedly said that it would make $649mn of bond payments originally due on April 4.

The last-gasp attempt to stave off a formal default when the one-month grace period expires this Wednesday was unexpected. And that’s putting it mildly.

The $564.8mn bond that was due for repayment on April 4 went from trading at 20-30 cents on the dollar last week to 88 cents by the end of Friday. There was also a separate $84.4mn coupon payment due on Russia’s 2042 bond, which Moscow apparently also belatedly made on Friday.

The entire Russian bond curve repriced on the back of this twist, which seemed mostly designed to annoy financial journalists that had pre-written default stories for May 4.

But over the weekend FT Alphaville caught up with sovereign debt law supremo Lee Buchheit. The tl;dr is that we may still have a default on our hands by Wednesday, and there are reasons why the bond didn’t trade up to par despite Russia making payment in full (beyond the fact that for a lot of big investors, buying any Russian securities in the ESG era is difficult).

The reason why investors — and FTAV —- were surprised by Russia’s payment is that the US Treasury would not let Moscow use any of its frozen reserves to make the payment, while the Russian government had very clearly said that it would only pay in roubles. Naturally, for a dollar bond that would mean a default, whatever Moscow might bleat.

The Treasury’s Office of Foreign Assets Control, or Ofac, has previously let some payments happen from Russia’s overseas frozen accounts, but has since then tightened its policies. Only unfrozen dollars held in Russia will be allowed to be used to service debts, on the basis that this sucks valuable dollars out of the country. From the FT’s article on Friday:

A US official said the debt payments announced on Friday were made using dollars that were in Russia, and not immobilised funds in the US, meaning they would no longer be available for Moscow to keep funding the war in Ukraine. The transaction was not specifically authorised by the US, but was allowed under a carve-out for such payments put in place as part of the sanctions regime.

However, Russia might have blinked too late to actually prevent a default.

Buchheit still reckons that Citi — the “paying agent” that received the money from Russia and is then supposed to distribute it — will hold on to the money until it gets a clear and unambiguous green light from Ofac.

Before it does so, Ofac will want to verify that all the money came from unfrozen accounts, something that Buchheit doubts can be done by Wednesday, when the grace period ends.

If the money does not reach the bondholder accounts by then, a fully-ripened event of default will have occurred. Russia will argue that the paying agent received the money, but these bonds are issued under fiscal agency agreements. The fiscal/paying agent is the agent of Russia, not the bondholders. The legal analysis might have been different if Russia had used a trust structure.

In other words, since Citi is technically acting at Moscow’s behest, and not for Russian bondholders, depositing the money with Citi is not sufficient in itself to be considered a discharge of its financial obligations. Hey presto, it WOULD still be the first Russian default since 1998.

Of course, this would likely be a very shortlived default if Citi does eventually get approval from Ofac to transfer the money. Bondholders aren’t going to rush to the courthouse when they know the money is likely to tick into their accounts any day. So aside from the implications for buyers and sellers of credit-default swaps on Russian debt (hello Pimco), the practical consequences might be limited. For now.

The reality is that the US now seems as determined to force a default as Russia is to avoid it. It is therefore an open question whether Ofac will maintain its policy that Russia can service its debts even with money in unfrozen accounts after May 25, when the sanctions regime tightens and prohibits US entities from processing or even receiving any Russian money.

Buchheit thinks they should keep this policy, as draining dollars out of Russia is a boon, and ending it might give Moscow a plausible legal defence when creditors sue over its default. But even if Ofac keeps this loophole open, he thinks Russia will soon default anyway.

I question whether Putin will long endure the humiliation of appearing to knuckle under to the sanctions regime . . . The argument that some in Moscow must be making (“we need to preserve our market reputation”) looks pretty silly when Putin is rendering Russia an economic, diplomatic and even cultural pariah.

That said, I can well imagine that someone on the Titanic felt it was important to continue to polish the silver even as the deck began to tilt.

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