Huge demand from international investors to sell Russian hard-currency government bonds should ensure that payouts on credit-default swaps referencing the country's debt will be substantial, according to a report from JP Morgan strategists published on Monday, suggesting recent concerns over the value of the derivatives contracts are overdone.
Russia is due to make US$117m in interest payments on two US dollar bonds on Wednesday, but a wave of sanctions from Western governments following the country’s invasion of Ukraine (along with retaliatory measures from Moscow) have made it look increasingly likely that Russia will fail to honour its external debt payments.
Those same sanctions had also raised questions around the effectiveness of the CDS contracts investors took out to protect themselves against a Russian default. Those concerns centred on how readily traders can buy and sell Russian hard-currency bonds eligible for a so-called CDS auction, a market-led mechanism used to determine payouts on the derivatives contracts.
But JP Morgan strategists identify a number of bonds that should be deliverable into a CDS auction, including some that trade at a price as low as 9% of face value. At the same time, a deluge of selling pressure on Russian bonds (and limited appetite to buy) should mean that an auction will produce a low recovery rate for CDS, ensuring a very high payout for protection holders.
"As it stands, it looks like there will be a CDS trigger on Russian sovereign bonds," the strategists wrote. “The Russia situation is unique. The bonds are being exited from major bond indices, there is a large international divestment from all Russia assets and dealing, and there are capital controls stopping foreign investors from taking out capital from Russia. These all mean no prospect of restructuring this debt at present."
"Investors who have bought Russia CDS to hedge their bonds will most likely want to be rid of their bonds when their CDS triggers. It is not clear who will want to bid for those bonds. So the likelihood seems that there will be a large open interest to deliver (sell) bonds in the auction," the strategists added, before concluding "the recovery rate is likely therefore to be very low".
While the process to start a CDS trigger could begin on Wednesday if Russia doesn’t make its US dollar coupon payments (or attempts to pay the coupons in roubles, as it has threatened), a CDS credit event wouldn’t be confirmed until the end of a 30-day grace period for payments on April 15.
There aren’t any sanctions prohibiting trading in Russian hard-currency bonds in secondary markets at present. But there have been concerns over the availability of bonds to be delivered into a CDS auction, threatening to undermine that process and raising the prospect of CDS not working properly.
That led to a significant disconnect between CDS and bond prices earlier this month, which has since narrowed somewhat without disappearing entirely. CDS were still trading cheap to bonds on Monday, with investors having to shell out about US$6.2m upfront for five-year protection on US$10m of Russian debt, as well as a US$100,000 annual fee.
By contrast, many Russian US dollar bonds trade at 20% to 30% of face value (implying a much lower recovery rate) and some trade as low as 9%. This second group of lower-valued bonds are heavily discounted as a result of being settled locally on Russia’s National Settlement Depository. Despite those concerns, the JP Morgan strategists still believe these bonds should be deliverable into a CDS auction and so could be used to determine protection payouts.
The auction mechanism is complex, but essentially uses market forces to determine the value of Russian bonds. CDS payouts can then be calculated to ensure protection holders are adequately compensated for losses that they face on bond positions.
Anyone can participate in the CDS auction to buy or sell bonds, presenting investors keen to dump Russian exposure with a handy opportunity to do so. JP Morgan estimates US$9.1bn in market value of debt is at risk of forced selling as a result of Russia’s exclusion from global bond indices.
“The challenge will be to find the marginal buyers,” the strategists said.
"Settlement concerns ... have likely prevented CDS from pricing a higher likelihood of a default – although these concerns look lower than CDS markets currently price in our view," they added.